Volatility ripples through global markets as weakening economic data exposes overstretched positioning

Volatility rippled through global markets at a breakneck speed in early August. An unexpected Bank of Japan (BOJ) interest rate hike on 31 July sparked an 8% rally against the dollar, triggering an unwinding of the yen-funded “carry trade”, where investors borrow interest-free in yen to invest in high-yielding assets globally. This was just the first domino to fall. Two days later, in the US, a weak jobs report revealed nonfarm payrolls came in well below consensus expectations – rising by 114,000 versus 175,000 forecast, in one of the weakest data points since the pandemic – while July’s unemployment rate jumped to a three-year high of 4.3%, according to the US Labor Department, triggering the Sahm rule, a closely-watched recession indicator. While cooler heads now suspect these concerns may be overdone, initially the weak data and market reaction renewed fears that the Federal Reserve’s higher-for-longer monetary policy stance is finally weakening the long-resilient US labour market. Fears of a “hard landing” and possible recession re-emerged at the start of the week, amid calls that the AI bubble was set to burst.

Simultaneously, markets opined that the BOJ had tightened monetary policy too soon, while the Federal Reserve’s decision to hold rates in July was too slow and risked a deeper economic slowdown. A global rout in equities and rally in bond markets followed – from Tokyo to New York to London. Japan’s benchmark Nikkei 225 index whipsawed from a three-day 12% plunge followed by a snapback one-day 10% rally, while the S&P 500 fell 6% over two days, before recovering some losses in subsequent days. The slump in bond yields wiped 12 trillion yen (around £64 billion) from the market value of Japan’s three biggest banks in two days, reports Bloomberg. Two-year US treasury yields slumped 23 basis points to 3.65% on Monday, marking a new 12-month low and falling below the 10-year yield for the first time in two years. On Wednesday (7 August), weak demand for a 10-year Treasury auction at lower yields renewed US equity selling pressure. The following day, the number of people claiming unemployment benefits – so-called jobless claims – fell more than expected last week, and by the most in almost a year. Initial claims decreased by 17,000 to 233,000 in the week to August 3, the Labor Department confirmed, further softening concerns that the US economy is faltering. Economists polled by Reuters had forecast 240,000 claims for the week. Bitcoin plunged 30% over eight days – from a local top spike of up to $70,000 on 27 July, when Donald Trump spoke at the annual Bitcoin conference in Nashville, Tennessee, to $49,061 on Monday 5 August, at peak Asian market meltdown. Bitcoin had since rallied back close to $58,000 by Thursday early afternoon.

Japanese markets were somewhat soothed by remarks from BOJ Deputy Governor Shinichi Uchida who assured that no further rate hikes would occur while markets remain unstable, stopping short of acknowledging that its rate hike was premature. The carry trade unwinding is expected to continue. Since July, the yen has appreciated by almost 10% against the dollar, meaning many recent carry trades are in the red. Three-quarters of the global carry trade has already unwound, according to Bloomberg reports that quote JPMorgan. 

In the US, markets initially priced in an emergency rate cut (which has since unwound), while the probability of a 50 basis points cut at the Fed’s September meeting is 72.5%, according to CME Group data. Overall, around 100 basis points of cuts are now expected before the end of the year. But markets should be careful what they wish for. If the Fed delivers the rate cuts the market is now asking for, it could reverse the current deflationary trend, as recent data indicates, and reignite inflationary pressures and dollar strength. This would significantly impact the broader US and global economy, FX markets, as well as capital flows. But the Fed is unlikely to yield to market expectations and will decide on the pace and timing of rate cuts dependent on upcoming data, including initial jobless claims, retail sales and CPI in the coming week. Later this month, Fed chair Jerome Powell is due to speak at the Federal Reserve’s annual Jackson Hole conference.

Monday’s meltdown was a climactic outsized overreaction caused by separate regional worries across the global economy that collided and were exacerbated by more obvious fault lines below the surface. Notably, high leverage in the financial system and substantial long positions had built up, including volatility and options trading strategies adding to the market froth. Stretched positioning became disconnected from fundamentals as successive weakness in data across the global economy accumulated – notwithstanding inflationary pressures abating in most markets. 

In the near-term, volatility is expected to continue, as investors digest a new market environment where Japan is hiking rates and Western central banks are cutting them. The Federal Reserve – which historically tends to be first among central banks to loosen policy after a tightening cycle – is expected to start cuts next month. This cycle, the Bank of Canada was first to cut rates, followed by the European Central Bank, which both reduced borrowing costs by 25 basis points in June. The Bank of England joined the trend with an equal size cut in August. Australia’s central bank, the Reserve Bank, is the other major outlier after governor Michele Bullock reiterated warnings it may hike rates again as the economy’s inflation battle re-intensifies. Global monetary policy divergence is generating high volatility during low liquidity environments, which is amplifying market moves during a period of traditional seasonal weakness. 

These events underscore the interconnectedness of global financial markets, where not directly connected regional macro risks become entangled and inflame one another, intensifying investor panic and market volatility. Overall, hard landing fears may be overdone, as there is no sudden panic in the US economy or evidence that “something has broken” under the surface. This calmer view was supported by the Institute for Supply Management’s (ISM) services sector index, which measures activity across the US services sector, as it climbed back into expansionary territory to 51.4% in July, after a dip below the 50% threshold to 48.8% in June, which marks expansion and contraction. The reading was also above economists’ expectations of 51.0%.

Economists assess that the risk of a hard landing have increased but is still not the base case. JP Morgan has increased its risk of recession in the US to 35% by the end of the year, while Goldman Sachs has increased the odds to 25% on weakening labour market risks. Capital Economics has put the probability at 27%. “The hard landing narrative was always likely to gain a foothold as economic and employment growth slowed,” explains Stephen Brown, deputy chief North American Economist. “We continue to judge that a soft landing is the most likely outcome, at 38%, with GDP growth set to slow below its potential later this year.” 

Translating this global tumult back to the outlook for the UK, the economy is finely balanced. Any further disorderly global market behaviour adds risks to economic activity, business investment, consumer sentiment and household spending, hiring, as well as investment activity and capital flows. This outcome is difficult to quantify with any reliable accuracy but reminds corporates that it is prudent to foresee and plan for uncertain probabilities, where such scenarios pose risks to normal trading conditions and corporate activity (e.g., new deals, refinancings, M&A, hiring, etc).

If near-term volatility and uncertainty prevails, business investment and activity may well slow into the fourth quarter, as corporates and investors digest the change in market behaviour. If disorderly market reaction is sustained, it could feed through to a higher chance of recession, as Capital Economics warns: “That could be either because financial firms get into serious trouble due to the sharp market moves, or because firms respond to the tightening of financial conditions by cutting back on investment and headcount. And history suggests that if the US were to experience a hard landing, it would be rare for the UK not to suffer a major slowdown too.” However, UK equities have not risen to anything like the frothy levels in US markets post financial crisis, which may soften any potential fall. 

These developments hint at a new risk environment with new world alliances forming, which could have long-term implications for global trade patterns, investment decisions, and economic policies, further contributing to market volatility and uncertainty