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WEEK AHEAD
August 12-16, 2024
Last week’s sharp volatility and recovery left our technical indicators tempered but overall unchanged, offsetting the momentum signal by sound fundamental economic indicators. Sowell models continue to support a fully invested position for the time being.
Last Monday's global stock market rout and rebound was first triggered by investor panic from Japan's unexpected stock market quake, falling 12.4%, Japan's worst single-day tumble since 1987.
Investors believe it to be caused by being caught off guard by Japan's central bank raising its short-term interest rates to 0.25% in July, a sharp 8% appreciation of the yen, and causing a sudden unwinding of the Japan "carry-trade" - wherein one borrows in a currency with low interest rates (i.e. yen) and reinvests the proceeds in a currency with a higher rate of return (i.e. USD). As a result of the global contagion effects, U.S. markets led by the S&P 500 fell 3% on Monday, raising recession fears, but by the end of the week, erasing Monday's losses fueled by Japan's follow-up +10.23% market recovery on Tuesday and better than expected U.S. jobless claims, pointing to an encouraging U.S. labor market. Monday was a horror show, but by Friday, it was like someone switched the channel to a feel-good sitcom—complete with the soundtrack that screamed, 'Everything's going to be okay!
The bond market went on a rollercoaster ride, too, stoked by a U.S. flight to quality and a rise in fears of global recession. 30-yr Treasury yields initially narrowed, flirting with 4% on the stock market rout, but by the end of the week, rose sharply to 4.23%, driven by stronger-than-expected economic data. The bond market, as expected, had another volatile week, ending on the opposite side by falling 0.82% on higher yields. However, with overall yields narrowing, 30-year mortgage rates fell to an average of 6.47%, giving existing homeowners refinancing opportunities. Freddie Mac reports that 42% of the mortgage applications are refinanced, the highest since 2022.
Volatility for the week ahead likely remains elevated due to global macro uncertainty, the evidence needed to stabilize Asian currencies, and upcoming bellwether earnings reports from Home Depot, Cisco, and Walmart. As Producer Prices and Consumer Price indices are released on Tuesday and Wednesday, providing the Fed additional confidence alongside Industrial Production, volatility will begin to normalize and constructively focus on fundamentals that have not changed.
P.S. Japan, sitting along the Pacific's Ring of Fire, last Friday issued another alert for a forthcoming "megaquake" warning after a magnitude 7.1 earthquake.
"When we change interest rates that tightens financial conditions and that in turn affects economic outcomes, you know growth, labor markets, and ultimately inflation. But with lags that can be long and variable Milton Friedman famously said. The implication of that is if you wait until gets all the way down to 2%, you've probably waited too long."
— Federal Reserve Chair Jerome Powell, Economic Club of Washington, Jul 16, 2024
The Big Mac Index or Yen Carry Trade
This past year and a half, I have had many friends and family vacation in Japan, to the point that Japan is restricting certain locations from over-tourism. Part of the reason is the amazing fall in the yen, which has created an exchange rate for the dollar not seen in decades. Recently, one U.S. dollar could be exchanged for an incredible 160 yen, meaning a pretty good dinner in Japan might cost you US$20 or less!
But for those needing an everyday reference point, a Big Mac Meal (aka Big Mac Index) in Tokyo costs about 800 Yen. And at today's exchange rate, that translates to about $5.00 US! In Orange County, CA, the same McDonald's Big Mac Meal sells for a whopping US$15.11!! An arbitrage opportunity for the Big Mac Index (i.e., buy Big Macs in Japan and sell them in the U.S.)?
I can see you now searching for flights to Japan. But while you are looking for fares, know that this past week, the market experienced increased volatility that some say was caused by the unusual yen-dollar relationship.
Global markets were rocked as people pointed to the unwinding of the yen carry trade. This trade involves shorting or borrowing yen due to its very low price and investing in higher-yielding assets, like the U.S. money market or bonds and even U.S. stocks. The base case would be to borrow yen at nearly zero and invest in 5% U.S. Treasury bonds.
Yes, I did say borrow, and typically, that means margin. In recent weeks, the Bank of Japan has raised interest rates, and the U.S. dollar has weakened, reversing the yen/dollar conversion ever so slightly. In fact, current data shows that FED rate hikes have worked quite well, creating a near certainty that rate cuts are ahead.
This seems to have sent those Big Mac traders to the exits if they were not covering margin losses on their yen carry trades, which means liquidating assets, including the juicy U.S. stocks they own. This may be the best explanation for the short yet sharp technical downturn in stocks earlier in the week. After the forced short covering, stocks steadied and rebounded.
We are reminded of the dangers of "free money" and how linked our capital markets are here and abroad. Given the hot spots in the Middle East, Europe, and our own U.S. Elections, it seems easy to predict higher volatility going forward, touched off by the slightest event. But, like a good K-Drama, the reveal was short-lived, and data later in the week continued to show underlying strength in the U.S. as U.S. weekly jobless claims dropped, calming fears around the labor markets and pushing equity markets higher.
Time for a Big Mac!!... In Japan, that is!
Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.