Markets seem convinced that the recent stock sell-off in the US is due to growth concerns — after a weak labor report. We think they are mistaken. The real cause of the sell-off is the unwinding Yen carry trade.
Hedge funds have been making a killing on the Yen carry trade, but they just got killed. Borrowing cheaply in Yen and investing in stocks and Treasuries in the US, the trade benefited from ultra-low interest rates in Japan, far higher short-term rates in the US, massive appreciation in the top ten stocks on the S&P 500, and a rapidly weakening Yen against the Dollar.
But the Bank of Japan just pulled the rug from under them, raising interest rates and indicating that they plan to normalize monetary policy over time. The move caused a sharp rise in the Japanese Yen, with the US Dollar plunging below 150.
Japanese stocks followed, possibly due to concerns over the impact of a strong Yen on export sales.
The contagion soon spread to neighboring markets.
Stocks
Unwinding carry trades caused a sell-off in US stocks as traders hastily closed their leveraged positions. The S&P 500 broke support at 5400, and the Trend Index crossed to below zero, warning of a correction to test 5200.
The equal-weighted index ($IQX) similarly broke support at 6800, offering a target of 6600. The long tail indicates strong buying pressure but this often fails, or takes several days, to reverse a sharp market fall.
There was nowhere to hide, with the Russell 2000 Small Caps ETF (IWM) also breaking support and the Trend Index dipping below zero.
Treasury Markets
The Fed left rates unchanged this week but indicated that rate cuts will likely commence in September. Treasury yields fell but the primary driver was the strong flight to safety from the stock sell-off, with the 10-year yield plunging to a low 3.8%. We expect retracement to test resistance at 4.0% but the Trend Index peak below zero warns of strong buying, with downward pressure on yields.
Financial Markets
Financial market liquidity remains steady. The Chicago Fed Financial Conditions Index declined to -0.58, indicating further monetary easing.
Commercial bank reserves at the Fed edged lower for the third consecutive week but the changes were marginal.
Bitcoin is retracing to test support at $60K but shows no sign of a significant liquidity contraction at this stage.
Dollar & Gold
Unwinding carry trades also caused a sharp fall on the Dollar, with the Dollar Index testing support at 103.
Gold failed to get much of a lift from the flight to safety, with most of the flow going to Treasuries.
Silver, likewise, failed to benefit.
Energy
Ismail Haniyeh was assassinated in Tehran, presumably by Israel. Iran’s supreme leader, Ayatollah Ali Khamenei, vowed that Israel would pay a price for killing the Hamas leader on Iranian soil, raising fears of escalation.
However, concerns over Middle East supply failed to move crude prices, with markets dominated by record US production of 13.3 million barrels per day.
Nymex WTI crude is headed for a test of support between $72 and $73 per barrel. Breach would offer a target of $68. The US Department of Energy will likely support prices at this level, refilling the strategic petroleum reserve (SPR), as many shale producers’ cash costs are around $60 per barrel. Lower prices risk a drop in production as producers shut marginal wells.
Uranium
Sprott Physical Uranium Trust (SRUUF) retreated below support at 18.00, confirming a bear market for uranium. Trend Index peaks below zero warn of strong selling pressure.
Base Metals
China over-invested in manufacturing capacity in an attempt to compensate for falling investment in their troubled real estate and infrastructure sectors. They now face resistance from international trading partners, unwilling to accept the massive surge in Chinese exports of manufactured goods and surplus steel and base metals. The dispute will likely cause increased trade protection and a sharp decline in global trade.
The down-trend in copper and aluminum is expected to continue.
Labor Market
A weak July labor report reinforced the Fed’s stance on early rate cuts, with job growth slowing to 114 thousand in July.
The normally reliable Sahm recession indicator broke above 0.50 to indicate a recession. But the unemployment rate is rising off an unusually low base, so this time could be different.
Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. (Claudia Sahm)
Layoffs fell to 1.5 million in June which is different from what one would expect when the unemployment rate rises.
Average weekly hours fell to 34.2, however, usually a warning that economic activity is slowing.
Job openings of 8.2 million in June are still above unemployment, indicating a tight labor market.
Continued claims for unemployment remain below 2.0 million, also indicating a tight labor market. Above 3.0 million would warn of recession.
Average Hourly Earnings
Average hourly earnings growth declined to an annualized 2.75%, indicating that inflationary pressures are easing.
Economy
Aggregate hours worked are growing at 1.3% year-on-year, suggesting low but positive GDP growth in the third quarter.
Heavy truck sales also held up well in July, indicating sustained economic activity.
Employment in cyclical sectors — Manufacturing, Construction, and Transport & Warehousing — also grew by 40 thousand jobs in July, showing no sign of a recession.
ISM Manufacturing
ISM manufacturing PMI declined to 46.8% but remained above the 42.5% threshold typically accompanying a recession.
Though declining new orders indicate some slowing ahead.
Conclusion
Stocks are expected to undergo a correction, with the S&P 500 testing support at 5200. Sales are fueled by unwinding carry trades as the Japanese Yen sharply strengthened after the Bank of Japan raised interest rates and indicated that they plan to normalize monetary policy.
The sell-off in stocks fueled a flight to safety which mainly benefited Treasuries, causing a sharp fall in the 10-year yield to 3.8%.
Gold and silver were left on the sidelines but could still benefit from low long-term interest rates and a weakening Dollar.
Declining crude oil and base metal prices warn of weak industrial demand from China. China’s efforts to compensate by exporting excess production is likely to meet stiff resistance from trading partners. Increased trade barriers are expected to further slow Chinese manufacturing and commodity imports, impacting Australia and other resource-based economies.
The Sahm rule warns of a US recession but the unemployment rate is rising from an unusually low base and there are plenty of signs of continued robust economic activity in the US economy. Expectations of a recession are likely premature, with a slow-down more likely to occur in 2025.
The full impact of a hawkish Bank of Japan monetary policy on US Treasury and financial markets should not be underestimated. However, the change is likely to be gradual, with frequent consultation with the US Treasury to minimize disruption after the initial impact of unwinding carry trades.
Acknowledgements
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
