Unprecedented volatility
We are dedicating this weekly update to the extreme volatility experienced in the financial markets this week. If you follow financial markets, you might have heard that stocks started this week in dramatic fashion, and you may have heard about factors such as the Japanese carry trade contributing to this situation. In our view, multiple factors played a role. We'll go through them individually, explaining what we think happened and what might happen going forward.
On Monday morning, overnight from Sunday (Monday morning in Japan), we experienced significant volatility. The Japanese stock market was down 12-13% overnight, and U.S. stocks were indicated to be down over 4%. The VIX, a measure of volatility, spiked to 65, a level only seen twice in the past two decades during the financial crisis and the COVID-19 pandemic. This spike signaled extreme stress and panic in the market, leaving many scratching their heads as to why, considering we are not seemingly in a crisis.
Japan carry trade
The situation can be traced back to the weakening of the Japanese yen. As we've discussed over the past few years, the yen has lost significant value against the dollar. With low interest rates in Japan, often at zero, market participants engage in a carry trade, borrowing yen to invest in currencies with higher interest rates. The problem arises when the currency rate shifts, leading to significant losses on leveraged positions.
In early July, the Bank of Japan intervened to prop up its currency. Last week, they raised interest rates, marking a shift in their long-standing zero-interest regime. This caused the yen to strengthen dramatically, leading to losses on carry trades and forcing financial players and hedge funds to sell assets to unwind these trades.
Leveraged hedge funds de-grossing
Hedge fund strategies, such as multi-manager, multi-strategy hedge funds, have grown significantly over the last decade and are highly leveraged. Names like Citadel and Millennium are key players in this area. When the market turns against them, even slightly, they are forced to unwind positions, perpetuating market selling.
Positioning
Given the outperformance of technology stocks, most have been very long technology stocks while underowning or even being short other parts of the market. When selling begins, market participants tend to sell the things that have been working and are the most liquid. This begets more selling as momentum takes hold. For example, Nvidia dropped about 35% from its peak within weeks and was down 15% at some point on Monday before recovering.
US election change
Adding to the uncertainty, Kamala Harris emerged as a new Democratic presidential candidate, shifting U.S. election polls, which had previously favored Donald Trump against Biden. Markets generally see Trump as strong on the economy, so this shift added to market volatility.
Time of the year - August
August is typically a quiet time of year, with many people involved in markets taking vacation. This lack of participation leads to low liquidity, which exacerbates these kinds of moves.
What happens next?
Overnight Tuesday, the Bank of Japan said it would not hike interest rates if markets were turbulent, which helped calm down the situation. Then, on Tuesday morning, the ISM number came in better than expected, calming fears of an imminent US recession. On Thursday, a smaller-than-expected Jobless Claims number further confirmed this sentiment, and the S&P 500 had its largest rally in 18 months.
By the end of the week, markets recovered, and the VIX returned to a more reasonable level. This situation could be a temporary blip or the beginning of a new market regime. If it's the latter, it signals important changes in the market.
One significant event that may signal the regime change is the yield curve un-inverting briefly this week. Since 2022, the yield curve has been inverted (meaning the short end of the bond market is trading at a higher yield than the longer end). This is an unnatural state; this week, it was uninverted for the first time. One thing to note is that in prior periods of yield curve inversions when the un-inversion happens, it is typically in line with a recession.
We have discussed at length that new market regimes bring new market leadership. For years, big tech has led the market, and this may be coming to an end. As an example of a potential indicator, healthcare stocks have actually led technology year-to-date. While we can’t predict (we have our views) of what new leadership may be going forward, it is important to be cognizant of this change.
