Japan ended free money – Traders are shocked

Outlook

What just happened? Japan ended free money. Traders are shocked! Shocked! To discover A! was overhyped. Warren Buffett retreated from Apple.  Is there anything here of concern to the Fed? No. Funding/liquidity is just fine, thank you. No banks are failing. For all we know, the payrolls report was a fluke. The ISM services report was okay. Chicago Fed chief Goolsbee did not tell TV audiences there is a sudden new need for rate cuts, and he is a dove.

Talk of an emergency rate cut is just plain silly. The Fed doesn’t act that way. For one thing, the stock market is not their concern. The public and even some traders who should know better think the Fed (or somebody in government) should step in when the stock market freaks out. No. It does happen, but not here. Besides, an emergency cut would scare traders even more—what do they know the rest of us do not know?

Nobody really knows what triggered the global equity sell-off. A splendid summary comes from Dolan at Reuters London: “The finger points squarely at the build-up of low-volatility trades, variously involving currency 'carry' plays funded by Japan's yen, short positioning in stock options and even Treasury futures arbitrage involving leveraged 'basis trades'.” To that list we would add greed in the form of over-leveraging.

The usually savvy Authers at Bloomberg wrote yesterday that the giant sell-off in the Nikkei started with Buffet halving his stake in Apple.  “This is a case of a butterfly flapping its wings in New York causing a typhoon in Japan, not the other way around.”

Well, no. The unwinding of carry trades, margin calls and BoJ interest rate hikes should not be ignored. VIX is a US metric and was already rocketing upward before the Buffet news. Buffett likes cash sometimes, that’s all. Authers also says “When the US employment rate triggered the Sahm Rule, it also triggered the selloffs.” Like so many others, Authers ignore Sahm’s own warning that the rule might not be valid this time because of special circumstance, namely the peculiar, one-time-only Covid recovery. Besides, the Sahm rule is hardly a household word and only Fed-watchers and nerdy types even know what it is, having gained a bit of a cult status only recently.

We prefer the term “perfect storm.” We had to look it up to be sure, but it means “an extremely bad situation in which many bad things happen at the same time.”

The Washington Post quotes an economist we would like: “This is not the recession train; it’s just a good old-fashioned market panic. This is not a D.C.- inspired event, about a slowing job market or the Fed being behind the curve. It’s about a larger regime change, where investors are adjusting to the end of easy money globally.”

It’s also a wake-up call to those who have only ever seen the stock market go up. Yes, Virginia, it can go down, too. We are impressed by a Bloomberg article by Matt Levine who emphasizes margin and its ability to cascade. And finally, let’s not forget the many who follow Buffet no matter what. If he likes taking profit and sitting on cash for a while, that’s worth following. Not all selling is panic selling.

Contagion: Contagion is not well understood. It has economists tearing their hair out. Events that should set off routs do not, while a small series of perceptions can drive a nail though the heart of several markets and darn fast. It’s the madness of crowds, and nobody ever knows when or how it will start. It’s important to note that it doesn’t need a black swan.

As we saw with the Long-Term Capital fiasco, it’s not a single butterfly flapping its wings that sets off a tornado somewhere else around the world, but rather a series of events so close together that expectations built on perfectly rational and statistics-based models get turned upside down. The LTC issue started in overvaluation in Thailand, shifted to Argentina in a blink and thence to Russia. The Nobel-winning management team expected convergence, using yield curve arbitrage, even in emerging markets and, fatally, was over-leveraged. It was bailed out by private parties whose arms were twisted by the Fed. 

Sound familiar? To return to today and to start at the end, crypto gained popularity in the first place out of the fear by the average Joe that the financial system would break, the government would bail out its cronies, and it would be the average Joe paying the bill in the end. It was therefore out of keeping for crypto to have fallen yesterday. It “should” have gone up as the average Joe felt he was being vindicated by the Establishment stumbling. Instead, crypto is just another asset class, and not an especially good one, at that. 

As for leverage, remember that when interest rates were at zero, yield-seeking got wild and woolly. Even after interest rates went up, and remember they went up very fast and very far in only two years, the yield-seekers were still out in force. They liked Turkey, for example, as well as India and Mexico. The Institute of International Finance (IIF) twice-yearly report in May showed vast capital flows into EM’s, expected up 32% at $903 billion. “Net inflows of FDI are projected to jump to $426 billion in 2024, while net flows into foreigners' portfolios could hit $259 billion, from $161 billion in 2023, as China, a massive source of outflows over the last two years, modestly recovers.”

At a guess, emerging markets are in for an unhappy drop in foreign investment and their currencies.

Then there’s the leverage. In the US, the max for equities is 50%, although nobody can deliver the actual percentage in use today. The S&P is worth some $35-45 trillion. We need to worry that a big fat correction would set off as cascade of margin calls. Now multiply that by all the equity indices around the world, and you have a problem.

To return to FX, when crises hit, the safe havens get the flows. The Swiss franc and Japanese yen are havens, especially to their own residents, but overall, it’s the dollar. It seems abnormal for the dollar to suffer a sell-off when risk aversion sinks its teeth into equity markets. In fact, the inverse correlation of the dollar index and S&P is not all that reliable—especially in times of crisis and contagion.

The monthly chart shows the S&P (red) falling as the Covid crisis peaked while the dollar index (black) rose.

What is reliable is the dollar tracking the relative yield. Not just the US yield, but the yield differential between the US and other countries, especially Germany, the UK and Japan. And here we see a reason for the dollar to respond badly—the most sensitive 2-year German differential against the US 2-year is rising. It was 1.07% in Dec 2023, and as of yesterday, it was 1.49%, dragging the euro up with it. See the chart from Kshitij. Note that the differential is narrowing again this morning.

Forecast

As we wrote yesterday, the US equity market wants to believe everything all at once—yen, Nikkei, overhyped AI, Big 7 overinvestment, recession, panicked Fed, etc.  Granted, the P/E ratio is pretty high (but under 30, vs. the long-term average of 17.91), but not all that scary. It’s the Big Seven where the P/E is out of whack. See the chart from Macrotrends.net. We didn’t take the full 90 years.

The FX market tends not to go nuts when all around others are losing their minds. The wild swings we are seeing are pretty rare and usually come from Major Events like Brexit, not stock markets. That we got such a big move this time points to the yen having devalued so much on the Bank of Japan bucking the global trend toward raising rates as inflation bloomed. It’s understandable after two decades-plus of Japanese deflation, but still, it was a maverick policy stance and the blow-back was tremendous, and may not be over yet. Next up will be guessing where the yen stops (we like 120).

A confluence of Big Events that drives prices wild is never a one-day wonder. We will be dealing with the fall-out for a week, or two or three. But this is not structural like Long-Term Capital nor built on serious changes in the fundamentals. That recession and a panic emergency hike are dumb ideas should be validated with today’s Atlanta Fed GDPNow for Q3. The dollar will be coming back. 

Political Tidbit: The momentum of the Harris movement, which is also the anti-Trump movement, is still racing along. Yesterday a survey showed a whopping 49% think Trump lacks the mental health and acuity to run the country. Harris gets 64%. 

Today we learn the Harris selection of a running mate. We are betting on Mark Kelly (literally), mostly because he was an actual warrior in a real war and an astronaut, to boot, compared to the draft-dodging Trump and military but public relations Vance. He can probably deliver the swing state of Arizona (and let Biden do Pennsylvania).

We have reasons for rejecting the others widely seen as on the list—the Pennsylvania gov is who is Jewish (sorry), the transportation secretary who is gay (sorry again). We guess the voter can take one minority or even two (black/Indian and female) but not a third.  We’d like all-American Kentucky Gov Beshear but methinks “Yon Cassius has a lean and hungry look.” It has been years since we had any actual fun in US politics.

Weird Stuff: A hurricane made land in Florida yesterday morning and could be headed for RTS headquarters in Virginia and perhaps even Washington, DC. It’s the hurricane season, determined mostly by heated water in the Atlantic. The record heat wave in the US this summer has the climate change deniers oddly silent these days. And the earth will get an asteroid fairly close on Friday the 13th.

Don’t laugh, but something is going on with sunspots, too. We are in Solar Cycle 25 and flares were recently few and weak, but picking up now. If you like statistics, the correlation of stock markets and sunspots/flares is not bad. If you Google “correlation of sunspots with stock markets” you will get hundreds of perfectly respectable papers by sane people, some going back decades.

Today we have a thing named a coronal mass ejection that will be visible to sky watchers in England and Denmark.

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