The end of the “yen carry trade”, recognition of the American slowdown and the FED’s unreserved affirmation of monetary support for the economy: a rich summer, full of hope.
The summer was turbulent on the stock markets. A few weaker-than-expected figures on US growth alerted investors to the possibility of an overly high valuation of US stocks, quickly confirmed by the publication of the second quarter results accompanied by a slight reduction in forecasts for second-half earnings growth. Cautious comments from major players in the tech sector, in the artificial intelligence sector, made the markets fear that they had pushed their prices a little too high or too quickly. The outcome of the US presidential election has been more uncertain since Joe Biden’s withdrawal, and the probability of a supply-side economic policy favorable to growth has reduced accordingly. Internationally, geopolitical tensions in the Middle East have rekindled while China continued to make investors despair with its apparent inaction in the face of its economic slowdown. Finally, the Bank of Japan confirmed its desire to make its monetary policy less accommodative.
The rise in Japanese interest rates played an important role in the correction of equity markets, because the structural weakness of the yen for more than a decade, enabled by its consistently zero rates, led a growing number of market participants to borrow the yen to invest in currencies or other assets that were supposed to produce a higher return (a “carry trade”). The Bank of Japan seems to have put an end to this practice, which for years provided liquidity to financial markets. The rise of the yen by around 10% in a few days forced the accelerated unwinding of positions. The most visible corrections concerned currencies such as the Mexican peso, one of the main beneficiaries of the “carry trade”, and equity markets, which most often lost between 10% and 15%. The Japanese bank index lost 17% in a single day, without any significant contagion from fragile markets. Interest rate markets remained calm. Yet, curiously, the US stock market volatility index experienced its third strongest surge since 2008 – with the Lehman Brothers shock – and 2020 – due to the Covid pandemic. Let us therefore remember this volatility event even if it was able to escape the most disconnected holidaymakers, who were also deceived by the rapid rebound of the markets before mid-August.
The most important lesson of this summer is rather to be found in the joint fall in American interest rates, inflation, the dollar and oil, indisputable evidence of the markets’ anticipation of an economic slowdown, at least across the Atlantic.
The US Federal Reserve (FED) has taken note of this, and has pre-announced for this month of September its first rate cut since March 2020 while simultaneously expressing its conviction that US inflation was now under control and that it was therefore appropriate for the issuing institution to focus on its objective of maintaining full employment. A very accommodating FED in the perspective of an economic slowdown, however limited by the electoral demagogy contest that will generate budgetary support. Lower long-term rates compressed by the fall in short-term rates, a dollar weakened by monetary easing faster than elsewhere, oil prices driven down by the continued Chinese slowdown and an OPEC eager to loosen its grip on production a little constitute a potentially very favorable combination for financial markets. These factors are in fact the materialization of a “fairy tale economy” (“goldilocks”) which translates into very positive behavior of financial assets. The coexistence of these factors also carries within it the seeds of a revitalization of global growth (lower dollar, interest rates and oil prices) in the wake of the emerging American slowdown.
The very healthy household and corporate debt situation should prevent a financial crisis from accompanying the economic slowdown and transforming it into a recession, but it will not spare us from new episodes of volatility. The very favorable scenario that we describe, made possible by persistent disinflation, nevertheless requires the American economy to be able to produce support for middle-class consumption, whose signs of weakness are already evident.
