After strengthening rapidly, the Japanese Yen (bottom panel) has stabilized has stabilized in the 140-150 range. The 10-year Treasury-JGB spread also stabilized and found support. So did the Nikkei Average after suffering the greatest one-day decline since the Crash of 1987. The Bank of Japan sounded a dovish tone when deputy governor Shinichi Uchida said that the Bank would “refrain from hiking interest rates when the markets are unstable”. In addition, Bloomberg reported that “JPMorgan says three quarters of global carry trades now unwound”.
Is it all over? It’s time to assess the damage from the latest fright by diagnosing what sparked the sell-off.
Even though many market observers focused on the currency carry trade as the source of the mini-panic, I argue that the carry trade unwind was only a symptom of what’s plaguing the markets.
A complacency unwind
Joe Wiesenthal and Tracy Alloway at Bloomberg conducted a series of podcasts that explain the roots of the latest panic. It wasn’t just the unwind of the leveraged Yen carry trade, it was an unwind of a series of trades based on the complacency that the markets were going to stay in a low-volatility stable environment.
Here is a recent
interview with Charlie McElligott, cross-asset macro strategist at Nomura, who pointed out that complacency manifested itself in the form of investors piling into a series of volatility selling products to enhance income. Things weren’t going to end well, it was just a question of when.
A different
interview in January 2024 with Kris Sidial, Co-CIO of Ambrus Group, about the return of the short volatility trade and how investors forgot the lessons of Volmageddon told a similar story of complacency.
A separate
interview in June 2024 with Michael Purves, CEO and founder of Tallbacken Capital Advisors, and Josh Silva, managing partner and CIO at Passaic Partners, on how the dispersion trade is another manifestation of complacency. The dispersion trade consists of investors using equity options to bet on the relative volatility between single stocks and stock indexes. For example, someone might buy volatility in a basket of individual stocks using single stock options while simultaneously shorting volatility in an index like S&P 500 is going to stay relatively low. This works if individual stock volatility is high while index volatility stays low and boring, which it was, until it wasn’t.
All of these derivative trades, including the carry trade, depend on a low volatility market environment. These trades saw a violent reversal when the market consensus suddenly shifted from a U.S. soft landing to pricing in the possibility of a hard landing.
In the space of a few days, initial jobless claims unexpectedly rose to a one-year high. A weaker-than-expected July Payroll report pushed the unemployment rate from 4.1% to 4.3%, which triggers the Sahm Rule as a recession indicator. Moreover, the Bank of Japan took a hawkish pivot by raising rates and tapering its quantitative tightening program. As Joe Wiesenthal put it:
In that moment that the “things are calm and will stay that way” bets get into trouble. So you have the collapsing yen carry trades. And you have the exploding VIX demolishing the short-volatility trades. And you have rising correlations busting dispersion trades. And of course any kind of long stock bets are implicitly short volatility trades, and you get this plunge in the hottest names in the market (like Nvidia and other MAG 7 companies).
In other words, it wasn’t just the carry trade that caused the panic.
Volatility spike = Panic bottom
Here is the good news. The accompanying chart shows the hourly swings in the S&P 500 since 2002. Episodes of hourly swings of +/- 2.5% coincided with market bottoms. The only question is timing and whether the stock market sees a short-term bottom or continues to fall after the initial volatility spike.
There appears to be two categories of bottoms. Sudden panics, usually from unexpected reversals of crowded positions, reverse themselves quickly. Longer term declines occur when the roots of the decline are macro or fundamentally driven, such as the GFC in 2008, the eurozone crisis of 2011, and the COVID Crash of 2020. In all cases, stock prices were higher a year later.
The latest panic appears to be in the first category. Stock prices are poised for a recovery.
Three of the five components of my Bottom Spotting Model flashed buy signals in the last week. The VIX Index spiked above its upper Bollinger Band, which is an oversold signal; the term structure of the VIX inverted, indicating fear; and the NYSE McClellan Oscillator fell to an oversold condition. In the past, the market has bottomed whenever two or more components triggered buy signals.
IPO stocks are turning up on a relative basis, which is a sign of the revival of the market’s animal spirits.
In addition, forward 12-month EPS estimates are still rising. This is a sign of positive fundamental momentum that’s supportive of higher stock prices. Hard landings don’t look like this.
Key risk
For traders, the key risk to the benign V-shaped recovery scenario is a Long-Term Capital Management (LTCM) style hedge fund blowup that threatens the stability of the financial systems. Even if the latest volatility spike caused a hedge fund to unravel, rest assured that central bankers have a well-worn playbook for dealing with financial crises. Flood the system with liquidity, and find one or more partners. Under such a scenario, expect a rally off the initial low, and a re-test of the old low about a month later.
Here is what I am watching. If stresses are appearing in the financial system, it should show up in credit yield spreads. So far, credit spreads have widened, but they haven’t spiked. The financial system doesn’t appear to be in crisis.
Market psychology is jittery, which is a recipe for higher volatility. As an illustration, the 2.3% rally of the S&P 500 in response to a noisy high frequency data release such as initial jobless claims shows the jittery nature of market psychology. While the initial claims report was modestly constructive, continuing claims show a gentle upward path. How will the market react next week if it encounters a disappointing economic report, or if Iran retaliates against Israel?
In conclusion, the recent disorderly risk-off episode can be attributed to the unwind of a series of trades that depend on a low-volatility and complacent environment. Historically, such unwinds have resolved in volatility spikes and higher equity returns soon afterwards. The current environment is supportive of a quick market recovery, though the risk of a LTCM-style blowup could see a longer and more complex market bottom.
Vix at 20 is the first threshold to releverage by algos. People still are in shock so I bet only a small number of hedgies will wade in and in smaller capital. 15 is the major threshold and at that number you will see a lot more into market with price-insensitive long positions. Usually stability breeds instability and market participants all forgot about risk control. It repeats regularly. AI plays and hence semiconductors got decimated. So I am watching this area for quick rebound. The first sign, TSM price action, is very encouraging.
Episodes of hourly swings of +/- 2.5% coincided with market bottoms. FALSE
In all cases, stock prices were higher a year later. FALSE
it has to be the last episode, and you can’t say if this one is the last or the first of a long series