The first alarm bells sounded towards the end of last week, as economic data in the US started to raise concerns of a recessionary hard landing for the American economy.
While the Federal Reserve, yet again, kept interest rates on hold last week, weak US unemployment numbers released last Friday ruffled more than a few feathers.
The numbers led to the so-called the “Sahm Rule”, an indicator that the economy is already in recession.
The rule is named after its creator, Claudia Sahm, a former Federal Reserve and White House economist.
It indicates that a recession has already started when the three-month moving average of the US unemployment rate is 0.5 percentage points or more above its lowest during the previous 12 months.
So, the Sahm Rule was activated on Friday as figures released showed the unemployment rate hit 4.3 per cent in July, its highest level since October 2021.
However, not all saw the technical triggering of the Sahm Rule as a portent of doom and drilled down into the unemployment figures to prove a point.
“Most of the rise in the unemployment rate so far has been due to labour force growth outpacing employment growth, rather than employment falling as has often been the case when the Sahm Rule triggered in the past,” said Stephen Brown, deputy North America economist at Capital Economics.
Economists like Mr Brown also think Hurricane Beryl might have had some degree of short-term influence on the unemployment figures, given some people may have been unable to work because of the storm which hit Texas in early July.
Nonetheless, as a result of the unemployment and jobless claim figures, concern grew that the Federal Reserve had kept interest rates for too high for too long and that instead of stamping on inflation, they were now stamping on growth.
Speculation rose that the Fed would have to make an emergency cut to interest rates before its next scheduled meeting in September.
Keep calm and carry trade
By Monday morning however, the jitters over the US economy was magnified in Asia by a specific issue in the Japanese market.
A surprise rise in interest rates by the Bank of Japan a week before had already caused some consternation on the Tokyo stock exchange.
The rise in rates led to the unwinding of the Yen carry trade. The carry trade is when traders borrow money in currencies where interest rates are low, like Japan, and use it to invest in a currency where interest rates are higher, like Mexico.
Trouble is, once interest rates in the low rate currency start to rise (and therefore the currency strengthens), margins get squeezed and trades start to unravel, which has a knock-on effect on the share markets, often because the borrowed money is funding the purchase of equities.
For Stuart Cole, chief macro economist at Equiti Capital, the concerns over the Yen carry trade came at just the wrong time.
“This trade was already coming under pressure on the back of the tightening the Bank of Japan delivered last week, and with certainly more to come,” he told The National.
“Thus, the market was already nervous about a strengthening Japanese Yen and the potential need to start closing these short Yen funding positions.”
By the end of the trading day on Monday, the Nikkei index in Tokyo had plunged by 12.4 per cent.
The contagion of falling share prices spread in Europe's stock markets later on Monday, but the losses were nowhere near of the same magnitude as those in Asia. European traders concerned themselves more with the prospect of a recession in the US, with the old market adage of “when the US sneezes, the rest of the world catches a cold” uppermost in their minds.
By the end of Monday, Europe's bourses were all in the red and the regional Stoxx 600 was 2.17 per cent lower.
Meanwhile, the US markets had their worst day for almost two years – with losses of 2.6 per cent and 3 per cent, the Dow Jones and the broader market S&P 500 had their biggest daily falls since September 2022.
Tomorrow's a new day
The turnaround came on Tuesday and was no less than spectacular in Tokyo, where the market rose by 10 per cent following its worst day in 37 years on Monday.
Indeed, the bounce back was so dramatic in Tokyo that trading in Nikkei and Topix futures contracts was automatically suspended.
European markets regained some lost ground on Tuesday morning and a degree of stability appeared to have returned to the market.
But the swings, particularly in Asia, did point to an exaggerated reaction to the possibility of a US recession, rising geopolitical tensions in the Middle East and the unwinding of the Yen carry trade.
What the global market swings, big and not so big, illustrated was what Richard Hunter, head of markets at Interactive Investor referred to as a “tendency to overshoot in both directions”.
“However, investors remain on high alert and further volatility cannot be ruled out,” he told The National.
“In the meantime, a continuation of what has been a relatively successful earnings season in the US should soothe some nerves, while the air which has been taken out of the tyres (especially in mega cap tech stocks, which had been facing worries of being overvalued) may yet come to be seen as something of a healthy correction to what had become bloated markets.”
'Too early to call'
The summer months often experience an increase in volatility on the stock markets. Some analysts speculate that as traders go on holiday in August, trading volumes drop and this, theoretically at least, can exaggerate price movements.
In any case, the speculation now is whether this two-day rollercoaster is the end of it? Has the froth been taken out of what was already an overheating market?
“The question is – was that enough to reset markets or is there going to be more?” asked Chris Beauchamp, chief strategist at IG.
Others were pretty sanguine about the possibility of more swings to come and felt that the two-day white-knuckle ride was more the result of a perfect storm of elements rather than any single, overriding portent of doom.
“The aggressive market reaction over the last few sessions was due to a combination of heavy positioning, unwind of carry trades, summer illiquidity and geopolitical concerns which amplified the shift in market perception of the US economy,” said Mohit Kumar, chief European economist at Jeffries.
Analysts across the world are now taking a wait-and-see attitude towards the immediate future of global markets. Next week, more economic figures are due out in the US covering consumer sentiment, retail sales and inflation, all of which could give an indication as to the timing and substance of a possible cut to US interest rates by the Fed.
“At this juncture, it is too early to call the market bottom given multiple moving parts and the momentum of selling,” said Vasu Menon, managing director of investment strategy at OCBC in Singapore.
“However, the key question to ask would be whether the economic and earnings outlook has changed materially and for now, it’s too early to jump the gun.
“We will have to monitor economic data in the coming weeks to see if recession fears are indeed warranted.”
