Storm Watching
An update on recent market volatility
In June, we compared the UK economy to the England football team's journey to the knockout stages of the Euros. Like the British economy, England outperformed low expectations set by expert opinion. A few weeks later, whatever our news feeds tell us, global investors increasingly consider the UK a safe haven. A premium yield on its sovereign debt, an improving economy, and an undervalued stock market are attractive features in volatile markets.
We also noted that England's chances of footballing success required the form teams to falter; several did, but not Spain. Similarly, the UK's recovering market fortunes come at a time when the global economic tectonic plates are shifting, the mighty US economy is faltering, bond yields are collapsing, and equity markets concentration around US tech stocks and the Yen carry trade are unwinding in a potentially era-defining moment of uncertainty.
So, what happened? Last week, more negative economic indicators flashed from amber to red as the US labour market weakened, undermining confidence in the soft-landing narrative, recently held as inviolate. As yield curves flatten, the recessionary warnings of their period of inversion now look prophetic. But what spooked markets most was the triggering of the labour markets' Sahm Rule, the new kid on the macro forecasting block using the rate of change in unemployment as its trigger.
The rule, devised by former Federal Reserve economist Claudia Sahm, says that the economy has tipped into a recession if the jobless rate, based on a three-month average, is a half percentage point above its lowest point over the previous 12 months. Friday's jobs report technically meets the Sahm Rule's criteria. If the rule holds, the US economy is in recession, and significant variables must adjust.
Over the last month, the oil price has fallen 11%, the copper price by 13%, the $ index (DXY) by 2%, the NASDAQ 100 by 11%, and Nvidia by 20%. As US rates decline and Japanese rates rise, the spread earned from the lucrative Yen carry trade narrows. In response, the Yen's value has soared by 12%, tanking the Japanese stock market by 25%. Yet, amidst all this, the FTSE 100, and the value of the £ held broadly steady, despite the Bank of England implementing its first rate cut since 2020.
Of course, it would be foolish to suggest that the UK is immune from this period of financial market volatility. Indeed, history suggests that extended volatility eventually impacts the safest of havens. For now, at least, the UK is not in the firing line, and for good reason.
The UK's new Chancellor, Rachel Reeves, struggled last week to fit her government's spending plans into the country's fiscal straight jacket. William Hague described her shocked reaction to the state of the books she inherited as like someone arriving at a surprise birthday party they knew about in advance.
Not only was the debt quantified, but also the excessive cost of servicing it—a long-term hangover from the Truss debacle, which only years of fiscal rectitude can remove. (Marcus Ashworth at Bloomberg observed that the UK's "moron risk premium" costs about 90 bps pa, which, annualised, is greater than the £22bn "black hole").
Yet, the Labour Party is not uniquely guilty of failing to discuss the debt implications of its spending plans during the election. Indeed, the UK's fiscal position will be a sideshow compared to the US in a few months. Both main presidential candidates share the West's conspiracy of silence regarding its burgeoning sovereign debt levels. Whoever wins in November, the US Treasury's spiralling indebtedness and consequent servicing costs are heading towards DC like a freight train at full speed.
As if on cue to these more uncertain times, Dr Doom himself, Nouriel Roubini, best known for his timely warnings about mortgage debt in 2006, has stepped out of the shadows to warn of the world's fiscal problem and specifically what he sees as political meddling in US monetary policy via Active Treasury Issuance (ATI).
ATI is the underreported trend for the US Treasury to issue a more significant proportion of T-Bills (notes of a year or less in duration) instead of longer-maturity (2-30 yr.) bonds. Roubini and his co-author regard ATI as quantitative easing delivered by a politically motivated Treasury, calculating that the size of stealth QE provided to date is roughly $800 billion, equivalent in economic terms to about one percentage point of cuts to the Federal Funds rate. Contrary to the Fed's insistence that monetary conditions are restrictive, they are not, and the Treasury's issuance policies help explain the persistence of inflation and strong economic growth.
The authors believe that whoever becomes president next will have $1 trillion of excess bills to refinance by early next year, coinciding with the next deadline for the Congressional debt ceiling negotiations. The numbers are mind-numbing.
For now, though, the primary vector shaking financial market foundations is unwinding the one-way bet Yen carry trade. Borrowing in Yen and buying any other asset has delivered excess returns for banks, macro hedge funds, and other arbitrageurs over the last 20 years. The surprise increase in the Yen policy rates from 0.1% to 0.25% last week and the greater acceptance of lower rates in the rest of the world has seen the estimated +$1tn carry trade unwind, sucking liquidity from entire asset classes in the process.
The Yen carry trade has long been seen as a source of potential financial instability. Just as the Liz Truss "not-so-mini-budget" revealed the fractious nature of the UK's defined benefit pension fund liabilities, so too has the BoJ's rate normalisation plan revealed the destabilising forces of the world's Yen indebtedness. Having been considered uninvestable for much of the last decade, the UK has not seen the extreme asset bubbles experienced elsewhere. It remains outside the main force of this powerful unwinding. However, the more frenzied the search for liquidity continues, the more vulnerable all assets become.