Distilling a complex economic landscape

Markets

Still reeling from one of the most tumultuous periods in recent history, market participants face a relatively calm week ahead—a brief respite amid ongoing market turbulence.

The U.S. macroeconomic calendar is remarkably sparse this coming week. The sole highlight is the release of the ISM services data, which stands out in an otherwise empty docket.

However, given last week's dismal ISM manufacturing report, all eyes will be on the services sector update. If it mirrors the disappointing manufacturing data, it could be the next catalyst to stir the already jittery markets.

Equities are stumbling, caught on the back foot at a percentage drop level when you'd typically expect bargain hunters to step in. However, the notorious August seasonality is challenging this norm with traditionally weak inflow, and even the VIX's seasonal trends are intimidating.

Last week, the volatility complex erupted into chaos. Dealers were trapped in a gamma spiral as market participants scrambled for hedges amidst a growing panic over interest rates and a looming recession. To put it mildly, the spike in volatility-of-volatility is a spectacle that underlines just how jittery markets have become.

This reaction might seem excessive to seasoned traders, who typically view any increase in volatility as a selling opportunity, and even more so during dramatic spikes like those witnessed on Friday when the market was economically wrongfooted entirely. Hence, folks will be eyeing any further noise from systematic volatility-selling strategies or asset shifts under management from widely-head ETFs.

In the cacophony of market analysis—this endless buffet of causes, effects, and what's supposedly critical and what's not—I prefer to filter out what I call "noise." To me, only two things matter 10-year yields and the VIX. Specifically, how much of the drop in 10-year yields can be attributed to actual economic softening and whether the VIX will surge to 35.

The real question now looms: Can the typical market reflex to sell volatility or buy the market dip prevail over the deep-seated anxiety brought on by this sudden and sharp recession scare?

On Friday, the spotlight was on the job market: The U.S. economy is adding fewer jobs, Intel is slashing positions, and the Federal Reserve's task became significantly more complex.

After the Fed announced on Wednesday that it would hold off on any rate cuts until its September meeting—its first in years—it left the market in a precarious position, susceptible to adverse economic news. And true to Murphy's Law, what could go wrong did indeed go wrong.

The Friday jobs report painted a bleak picture, revealing a sharp slowdown in employment growth for July and an uptick in the unemployment rate to 4.3%, the highest it's been since 2021. This combination of factors adds another layer of complexity as the market moves into a September 50 mission cut. If the Fed is forced to make their first rate cut of the cycle a jumbo 50 basis points, it's their way of saying, "Oops, we goofed!" 

In trying to distill the complex economic landscape into one pivotal question: Is the U.S. consumer truly on the brink of collapse? The simple answer is that betting against the American consumer is akin to betting against America itself—it might seem compelling in theory and occasionally persuasive on paper. Still, historically, it's proven to be a losing gamble.

The resilience of the American consumer has been a cornerstone of economic recoveries and expansions. While economic indicators can point to periods of contraction or concern, the consumer's ability to bounce back and drive growth often defies pessimistic projections. This enduring resilience suggests that, despite current headwinds, counting out the U.S. consumer might be premature, if not misguided.

Forex

The USD/JPY pair remains under pressure as U.S. interest rates continue to slide, contributing to a broader risk-off environment. This rate downtrend coincides with a significant unwinding of positions in crowded sectors such as U.S. tech stocks and Japanese equities, further driving the currency pair lower.

Amidst this backdrop, higher volatility across financial markets has ramped up Value-at-Risk (VaR) metrics, a crucial barometer for financial institutions. As these VaR levels climb, reflecting heightened market risk, investors' appetite for risk diminishes, and the capacity of dealing desks to warehouse risk, assuming they are adhering to preset risk limits.

Focusing on the "Bermuda Triangle" zone for USD/JPY, which we've previously identified between 151.50 to 152.00—the former representing the old 200-day moving average and the latter the implied breakeven for JPY-funded carry trades in the G-10—illustrates the nuanced dynamics at play. Furthermore, the persistently low Japanese interest rates have spurred a surge in cross-border yen borrowing, complicating the currency landscape. A strengthening yen increases borrowing costs effectively, introducing additional layers of complexity to the currency's trajectory.

While the degree of hedging against these shifts remains largely opaque due to the lack of real-time transparency in FX position sizing—except for the somewhat outdated reports from Chicago's futures COTR—the implications are significant. The potential for USD/JPY to trade below 140 hinges on market dynamics and the extent of unhedged exposures unwinding, making this a critical juncture to watch in currency markets.