Are the markets crashing, or is this just a short correction? That’s a very pressing question for traders after what happened on Monday. It appears there is a bit of a rebound starting on Tuesday. But, is it a dead cat bounce? Or did the markets just have a little panic attack and things are going back to normal?
There have been a lot of dramatic headlines, and even more exaggerated claims on social media. A lot of hypotheses have been put forward as well. Let’s see if we can get under the hood to figure out what’s really going on.
Is It Really Global?
Monday was largely a continuation of the downtrend that started with disappointing data on Thursday, and was compounded by really bad NFP numbers on Friday. As we mentioned in the NFP preview, unexpected weakness in the labor market could lead to worries of a recession resurfacing. The natural reaction would be for global stock markets to fall, and they did. But not all at the same rate.
Japan’s Nikkei suffered the worst single day loss since 1987 (followed by the single best performance ever, leaving it still down since Friday). South Korea’s Kospi was down in double digits. But other Asian indices were down in the low single digits, like the rest of the global markets. In other words, the “flash crash” was largely concentrated in Japan. Let’s not forget that the yen radically strengthened in this period, largely as an unwinding of the carry trade.
So, It’s the BOJ’s Fault?
Not exactly, but the crash in Japanese indices and the USDJPY is a natural consequence of a trap that the BOJ is facing, as we’ve talked about in the past. Raising rates too fast would trigger unexpected consequences as rates rise, so it’s no shock this crash happened after the BOJ surprised the market with a rate hike last week.
It’s not entirely on the BOJ, though. The slower economic data in the US lead to an increase in expectations for the Fed to start cutting. If there is a recession, then the Fed would slash rates (on Monday there was even speculation the Fed would step in for an extraordinary rate cut before September), and destroy any trader caught in a yen carry trade. Investors finally got around to realizing that the carry trade was coming to an end, and started heading for the exits. That flux of capital would naturally shake up the markets.
Is There Something Fundamentally Wrong?
The market’s sudden move (and rebound) didn’t come in response to any major incident, although the conditions tripped indicators that a recession might be imminent. I, personally, have been warning that a recession is unavoidable, but trying to figure out exactly when is the tricky part.
There are some important factors to consider:
Sahm Rule: Has accurately predicted every recession for the last 70 years, and is when the 3-month average unemployment rate rises by 0.5% above the lowest level. But this could be distorted in the current context given the extraordinarily low unemployment rate post-pandemic.
Inversion: Yield curve inversion has accurately preceded a recession for the last 60 years, with the curve inverting sixt to two years before the market crash. The curve inverted mid-2022, so we are close to the time running out for this indicator to be accurate. On the other hand, the yield curve also deinverts, just before the recession sets in. And that happened yesterday.
Liquidity: Market crashes inevitably require a crisis of liquidity. People trying to sell, but no one is buying, since they are afraid that prices will fall further. This causes prices to keep going down. So far, there has been no mention of lack of liquidity, even in Japan. For reference, liquidity problems became evident in the week before the market crash at the onset of the pandemic.
Narrow markets: While stock markets, particularly in the US, have been printing record high after record high in the first half of the year, this has largely been thanks to a relatively small number of tech companies that are focused on AI. This concentration of growth in a few mega-cap stocks that have high valuations makes the market especially vulnerable to a shift in sentiment that can cause a correction.
Markets typically don’t go straight down. Usually they tip over into a correction,then stage a rebound that doesn’t retake the peak. After that, they fall to a new low. And so on. It’s way too early to identify that pattern at this stage. But traders would do well to be on alert, particularly until the current set of uncertainty resolves.