Issue #31: Aug'24 week 31

Block 1. Key Indices/Instruments

Block 2. U.S. macroeconomic landscape

During the reviewed period, the Federal Reserve held its scheduled meeting, where the key interest rate was left unchanged at 5.5%, as anticipated by consensus. The meeting can be characterised as "neutral-dovish," with Jerome Powell emphasising that "maintaining the rate at peak levels could negatively impact economic growth." It is equally important to note that the Fed Chairman mentioned progress concerning the dual mandate (price stability and maximum sustainable employment), highlighting that the decisions of the monetary committee members will depend on incoming data. He also noted that a rate cut might be considered in September, with the market almost fully expecting a cut, including a 67.5% probability of a 50 bps reduction.

However, the most significant data block was published on 02.08, which drastically changed the current market environment – the data on non-farm job creation and the unemployment rate. The data was negative: the number of new jobs was 114k, down from a revised 179k, significantly below the expected 175k. The unemployment rate rose to 4.3% from 4.1% the previous month, with expectations at 4.1%. This indicates a certain weakness in employment. On the positive side, the average hourly earnings saw a decrease both monthly and annually: from 0.3% to 0.2% and from 3.9% to 3.6%, respectively.

Given the market's sensitivity to labour market publications, as the Fed's position states, "...a sharp deterioration in the labour market could prompt the monetary authorities to take a more proactive stance..." and as an indicator of a possible recession, the reaction was swift. The US Treasury yield curve showed a significant downward shift, with the most substantial decline in yields on the 2-3 year segment, dropping by 25 bps.

Block 3: Cause and Effect

Following the publication of the labour market data described above, the US market experienced a broad decline. The significant weight of Big Tech stocks greatly influenced the fall in broad indices, while Treasury yields showed a rapid increase, indicating a shift to a risk-off sentiment. However, another significant variable contributed to these events.

On 31 July, the Bank of Japan unexpectedly raised its key interest rate by 2.5 times, from 0.1% to 0.25%, contrary to the consensus which had anticipated the rate to remain unchanged. Additionally, the Bank announced a reduction in its government bond purchase programme from 6 trillion yen to 3 trillion yen by the first quarter of 2026, followed by further quarterly reductions of 400 billion yen. Although the news of reduced bond purchases was less significant, the initial response of the yen was modest strengthening, which later surged by 6.39%, from 154 to 144 (USD/JPY).

Given that the yen had been the most attractive currency for carry trade due to near-zero interest rates, and considering that yen was borrowed to invest in dollar-denominated instruments, leading to short selling of the yen, this combination triggered a sell-off. This involved unwinding carry trades and forced closing of short yen positions, partly due to the high concentration of margin positions, similar to the correction observed in the US market.

It is also important to note that Japan is the largest investor in US debt. Additionally, Japanese households and institutional investors hold over $5 trillion in US dollar-denominated assets, which were also partially sold off. This undoubtedly deepened the correction in the US market following the publication of unemployment data and on Monday, 5 August.

Graph 1: USD/JPY Currency Pair, Nikkei 225 Index

As shown in the graphs below, the volume of margin debt reached record levels over the past two years, while the volume of free cash grew only slightly and disproportionately compared to the level of margin debt. Comparing the margin debt/free cash ratio, the average leverage level was approximately 5.4x, which undoubtedly acted as a catalyst for the broad market correction in the US.

Additionally, market sentiment was somewhat influenced by Berkshire Hathaway's (BRK US) substantial sale of Apple shares worth $76 billion and the notable increase in its cash and equivalents to $240 billion, of which approximately $234 billion is placed in Treasury bills.

Graph 2: Margin Debt and S&P 500, Margin Debt to Cash Ratio (Leverage)

As seen in the graphs above, the volume of margin debt has reached record levels over the past two years, while the volume of free cash has grown insignificantly and is disproportionate to the level of margin debt. Comparing the margin debt/free cash ratio, the average leverage level was approximately 5.4x, which undoubtedly acted as a catalyst for the broad market correction in the US.

Additionally, market sentiment was somewhat influenced by Berkshire Hathaway's (BRK US) substantial sale of Apple shares worth $76 billion and the notable increase in its cash and equivalents to $240 billion, of which approximately $234 billion is placed in Treasury bills.

Graph 3: Cash and Equivalents of BRK US

As a result, investor sentiment shifted to a risk-off mode, evidenced by substantial capital inflows into Treasury notes and bonds and the strengthening of the Swiss franc (partly stimulated by a decline in the DXY due to expectations of more significant rate cuts in 2024).

Graph 4: 10-Year Treasury Bond Yields and USD/CHF Currency Pair

The US Treasury bond market saw massive inflows following the sell-offs, with yields dropping by about 40 basis points across all maturities over the week, offsetting all losses since the beginning of the year (except for the 10-30 year segment). Formally, the yield curve has steepened since the start of the year.

Graph 5: US Treasury Yield Curve; Dotted Line – December 29, 2023, Solid Line – August 6, 2024

This rally was driven not only by a flight to the ultra-safe sector but also by increased recession fears and significant changes in the expected trajectory of monetary easing. At one point, the market almost fully priced in a 50 bps rate cut in September, 80% in November, and 25 bps in December, totaling 125 bps compared to 50 bps a few weeks earlier.

Table 1: US Key Rate Cut Expectations Market

Headlines in global financial media started featuring articles and opinions signaling a high probability of an emergency Fed meeting to support financial markets and "recession fears." This was partially dispelled by the ISM Services data released on August 5, showing an increase from 48.8 to 51.4, not indicative of recessionary conditions.

The cryptocurrency market reacted similarly, with major sell-offs occurring from Sunday to Monday. The consolidated cryptocurrency market dropped by 27%, equivalent to approximately $650 billion, also experiencing cascade liquidations. Notably, there were positive inflows into Bitcoin ETFs during this period.

Epilogue: quote from our financial analyst Daniel:

"The primary cause of the events described above was the cascading liquidations of margin positions in both the Japanese and US markets. This is evident from the rapid decline over several trading sessions. The fundamental picture has not undergone drastic changes, and the increased recession risk is minimal. Financial media are pushing this narrative, much like they did with stagflation; according to Goldman Sachs, the probability has risen from 15% to 25%. The likelihood of an emergency Fed meeting is near zero, as there have been no structural breakdowns in the system that would require intervention by monetary authorities. The broad indices, S&P 500 and Nasdaq 100, have declined by 7.54% and 12.56% from their historical highs, which does not even mark the beginning of a 'bear' phase. The largest declines were seen in the highest capitalised companies, while other companies experienced much more moderate declines (for example, the equal-weighted S&P 500 decreased by 5% from its historical highs). Such sell-offs are typically followed by at least a minor recovery. Apart from characterising this decline as technical, the Treasury bond market may correct after such a rise, especially as expectations for the extent of the Fed's rate cuts decrease. It is also worth noting the technical rise in credit spreads between Treasury and corporate bonds due to the more significant rise in the former."

Graph 6: VIX Volatility Index and MOVE Bond Index

Block 4. EU Update

During the period from 29 July to 5 August, notable data publications included the inflation figures (CPI) for the aggregated Eurozone economy. The data were slightly worse than expected: overall inflation rose from 2.5% to 2.6% compared to the previous month, while the core inflation rate remained unchanged at 2.9%, with the month-on-month value showing a decrease from 0.2% to 0%.

Spreads between German and French government bonds widened slightly, averaging a 5 basis points increase compared to the previous week. The decline in broad European indices and the fall in government bond yields were driven by a global 'shock' and prevailing risk-off sentiment.

Block 5. Great Britain

During the review period, the key event in the UK macroeconomic landscape was the Bank of England's meeting. For the first time since the beginning of its tightening cycle, the central bank reduced the key interest rate by 25 basis points to 5%. Notably, this decision was not unanimous: out of the nine members of the Monetary Policy Committee, five voted for the rate cut.

Recent data showed that inflation (CPI) reached the target of 2%, but it's important to note that the core component, particularly services inflation, remains elevated at 5.7% year-on-year. The Bank of England representatives refrained from providing forecasts regarding the future path of the key interest rate, adhering to a reactive policy approach. Investors estimate a 42% probability of another rate cut at the next meeting on 19 September. Additionally, there has been continued growth in repo volumes, now at 34 billion GBP (a 42% increase compared to 11 July 2024).

The decline in broad UK indices and the significant rise in government bond prices were triggered by events following the negative US unemployment data published on 2 August 2024, and the subsequent deep correction on 5 August 2024. This correction was driven by cascading liquidation of positions worldwide, indicating a prevailing risk-off sentiment.

Disclaimer:

This information serves as a snapshot of market trends and does not constitute financial advice. Always conduct thorough research or consult with a financial advisor before making investment decisions.