Muzinich Weekly Market Comment: The great carry unwind

August 12, 2024

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In our latest roundup of developments in financial markets and economies, we look back at how a surprise Bank of Japan rate hike and disappointing US job numbers set off a dramatic chain of events.

If you have been on leave since the start of August and are just logging back on to review the price action, you could be forgiven for thinking it has been a quiet time in financial markets. US and German 10-year government bond yields are unchanged, with a continuation of the normalisation of yield curves that began in late June.

The US 2/10-year spread is now just -6 basis points (bps), down from -100bps in 2023. Corporate credit has been resilient, with the US outperforming. There has also been plenty of supply, with US investment-grade corporate primary issuance totalling US$53 billion so far this month, and US Treasury issuance totalling US$125 billion.^[1] Commodities have been rangebound and the US dollar currency index, the DXY, has continued its slow depreciation, down 2.75% from a high of 106 on June 26.

If there was a clue something was amiss, it could be found in equity markets. The giveaway is that they are 3% lower globally month-to-date, with the outlier being Japan’s Nikkei index, which is 10% weaker.

The main event

Seasonally, August and September are known for event risks and negative surprises. Over the last twenty years, the worst two months of the year for global equity markets have been August and September, with September also being the worst month for corporate credit markets.

Examples from this century of major events include BNP Paribas freezing three asset-backed securities funds worth €1.6 billion on August 9, 2007, due to the rapid deterioration of the US subprime mortgage market.^[2] This was followed a little more than 12 months later by the defining moment of the global financial crisis, when Wall Street giant Lehman Brothers filed for bankruptcy on September 15, 2008.

On August 5, 2011, S&P cut the US’s credit rating from AAA to AA+, the first downgrade in the country’s history, due to concerns over political gridlock and a growing budget deficit.^[3] In the summer of 2015, the Chinese stock market crashed, ultimately leading to a devaluation of the yuan on August 11.^[4] That event coincided with growing fears that Greece would not secure a third bailout from the European Union and International Monetary Fund.^[5]

More recently, in 2022, European gas prices spiked dramatically, reaching an all-time high of almost €340 per megawatt hour due to uncertainty whether the region would be able secure enough gas to last through the winter. By way of comparison, the 5-year low for gas prices is €3.635 per megawatt hour.^[6]

The book of Sahm

This August will be remembered for the great unwind of carry trades, driven by the combination of a hawkish interest rate hike by the Bank of Japan (BoJ), as we referenced in last week’s Market Comment, and a poor employment report in the US.^[7] Unemployment increased for the fourth successive month in July to reach 4.3% and is 0.9% higher than at its lowest level in the current interest-rate cycle.

Many market observers pay close attention to the Sahm rule, which states that if the three-month unemployment rate rises by 0.5% above its lowest level in the last 12 months, it indicates a recession. We are in that territory now. Furthermore, working week hours fell, and only 49.6% of industries increased headcount; the diffusion index has only been below 50% outside a recessionary period once before, in May 2016.

Markets quickly concluded central banks are far behind the curve, with the BoJ now expected to hike faster and the US Federal Reserve expected to cut faster. As interest rate differentials adjusted, funding currencies appreciated, margin calls were triggered, carry trades^[8] were unwound and all markets were affected. This time, the epicentre was Japan, with the Nikkei sinking more than 12% on August 5, its biggest one-day slide since October 1987.^[9]

Carried away

In the aftermath, it is estimated that 75% of global carry trades have been removed.^[10] After the dramatic reaction to the BoJ’s rate increase on July 31, the overnight interest rate swap market is currently assigning only a 31% probability of the central bank hiking rates by a further 15bps this year.

For the US, JP Morgan now assigns a 35% probability that the US economy will tip into a recession by year-end,^[11] while the overnight interest rate swap market is pricing in 100bps of cuts by the Federal Reserve in the same period.

In our view, there are three conclusions that can be drawn from the events of the past week. The first is that central banks continue to walk a tightrope in communicating their intentions versus the market's interpretation of policy signals. Late last year, the Fed made a similar communication misstep as the BoJ, which led investors to price in six interest rate cuts of 25bps for 2024. So far, we have yet to see one.

The release of minutes from the BoJ meeting on July 30-31 was more balanced than BoJ Governor Kazuo Ueda's press conference. In the minutes, members of the Monetary Policy Committee projected Japan’s long-term neutral interest rate to be around 1%. However, they noted increasing rates would be done at a moderate pace that would not result in monetary tightening, while the two board members who voted against the hike questioned the sustainability of growth in Japan.

The second conclusion is that the excessive volatility seen this month underscores how difficult it is for central banks to manage market shocks while they unwind years of extraordinary monetary stimulus.

Finally, if price action is any indicator of leverage in the financial system, then fixed income appears to be the unleveraged safe haven compared to equities. In fact, equity holdings as a percentage of financial assets among US households and non-profit organisations are close to their historic highs, as our chart of the week illustrates. 

Chart of the Week: Equities held by households and non-profit organisations as a percentage of financial assets, 1955-2024 (per cent)

Source: Board of Governors of the Federal Reserve System, ‘Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Financial Assets; Assets, Level,’ as of June 7, 2024. For illustrative purposes only.

References

[1] Bank of America, August 9, 2024
[2] Financial News, ‘Sub-prime fallout claims three BNP Paribas funds,’ August 9, 2007
[3] The New York Times, ‘S.& P. Downgrades Debt Rating of U.S. for the First Time,’ August 5, 2011
[4] Bloomberg, ‘China Rattles Markets With Yuan Devaluation,’ August 11, 2024
[5] European Council, ‘Greece: the third economic adjustment programme,’ May 3, 2019
[6] Trading Economics, ‘EU natural gas prices,’ August 9, 2024
[7] Bureau of Labor Statistics, ‘Employment Situation Summary July 2024, August 2, 2024
[8] Carry trades involve investors borrowing at low rates in currencies like the Japanese yen to invest in higher-yielding assets in other markets
[9] Reuters, ‘Japan's Nikkei sees biggest rout since 1987 Black Monday,’ August 5, 2024
[10] Bloomberg, ‘BoJ’s damage control leaves traders guessing about true aims,’ August 8, 2024
[11] Bloomberg, ‘JP Morgan boosts US recession chance to 35% by end of this year, August 7, 2024

Past performance is not a reliable indicator of current or future results.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of August 9, 2024, and may change without notice. All data figures are from Bloomberg, as of August 12, 2024, unless otherwise stated.

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