This week worry? Stagflation in a crowded theatre

Markets

The recent whirlwind in financial markets can be chalked up to a perfect storm of triggers: geopolitical tensions simmering, the unravelling of the yen carry trade, a dash of U.S. election suspense, and tech sector jitters—all during the typically languid trading of August. At the core of this upheaval lies a rekindled anxiety about the global economic forecast. Just when the market had cozied up to the notion of a gentle economic descent—a "soft landing," if you may—the spectre of recession has gatecrashed the party, sending traders scrambling to reassess their positions.

Amid this financial maelstrom, the bears and the recession prophets seized the spotlight. Here’s a critical market morsel to chew on while recessions almost invariably follow major market dislocations; not every market shake-up forecasts an imminent recession. The key lies in understanding the phase of the economic cycle during which the turmoil unfolds. This latest episode, erupting after an aggressive monetary tightening phase and coinciding with an inverted yield curve, is a potent cocktail that merits serious attention. These indicators suggest that we're not just crying wolf—this time, the economic indicators might really signal something more ominous.

Sure, most assets have boomeranged back to where they were at the start of last week, but don’t be fooled—this VaR shock has left a mark that will linger like a bad hangover. The idea of quickly returning to a state of low Macro and FX volatility might be overly hopeful.

What are the chances of Wall Street slipping back into that low-risk euphoria we saw just weeks ago when markets were riding high? It's about as likely as finding a snowflake in the Sahara.

We’re coming off a week of extreme stress patches, with ludicrous intraday swings that had traders feeling like they were on a financial rollercoaster. Now, we’re staring down the barrel of a CPI report. One would be naive to think this week doesn’t have the perfect setup for investors to start screaming “stagflation” in a crowded theatre.

That’s the equities setup for CPI week in the US. Consensus is pegging a 0.2% MoM increase in the core reading, but let’s be real—the risk is all about an upside surprise. And with the current growth scare backdrop, that would be as welcome as a skunk at a garden party. The average estimate is sitting at +0.19%, and forecasts are in such a tight range that even a decimal point could send the market into a tailspin. If we see a 0.21% reading, it’ll challenge the 40 basis points of cuts the market is banking on, which would be flat-out bad for stocks.

But the real meltdown could come if we get a double whammy: higher CPI paired with lower retail sales. That combo would have folks running for the fire exits faster than you can yell “stagflation.” And heck, after the latest NFP growth scare, a higher inflation print might do the damage all on its own

Given this context, the key question is whether the momentum from the end of last week can be sustained. Some investors might use the lower equity volatility to move further out on the risk curve. However, others will likely remain cautious, mindful of potential aftershocks that could emerge in any part of the market—especially with key US inflation data looming and the fact that mid-August tends to see much thinner liquidity than usual.

Marked safe from carry trade analysis

I couldn’t believe the analysis was still dragging on over the weekend, but I might as well add my final touch since I’m convinced this trade is done and dusted.

The question of "How big is the yen carry trade?" has morphed into a full-blown existential crisis for market participants who were blissfully unaware—or too indifferent—to care. Now, they’re being rudely awakened to the structural beast that’s been lurking in the financial shadows.

When I first flagged the carry trade risk back on July 11, it wasn’t about your standard G-10 carry—it was all about the foreign gamble that was pushing Mrs. Watanabe’s nerves to the limit on her global safari for higher yields. Her hunt had Japan’s net international investment position entangled in a whopping $3.5 trillion portfolio of foreign equities and bonds before the correction hit, with a hefty 60% of that stash parked in foreign equities(mainly the US). So, when the skies over the US turned stormy, the NDX volatility was soaring, and the fallout wasn’t exactly a gentle breeze—it was more like a financial thunderclap.

The real fireworks ignited when an escalating US rate rally, fueled by some soft macro data, stirred the pot. Yen traders are already struggling to trigger stop losses after the Bank of Japan hike saw the perfect storm brewing. By the time the “average” market participant finally rubbed the sleep from their eyes, it was too late—the yen was already off to the races, leaving a trail of carnage in its wake.

But here’s the twist: the investment real flows powering the yen’s surge was more of a reaction to what was happening with US assets than a driving force in the FX world, although eFX is the conversion channel. As for BoJ policy? Well, let’s say they meant well. They left the back door open in case the yen rally got too frisky, but they didn’t exactly anticipate the chaos brewing in the US.

Was the BoJ’s move ill-timed? Was their communication a mess? Not really. But if they’d had a crystal ball handy, they might’ve hit the pause button and let the US markets take the reins. Instead, they got swept up in a storm that wasn’t entirely theirs, something akin to a perfect riptide.