The Volatility Curveball

The search for yield gives way to the search for stability

On Tuesday, the Chicago White Sox broke a 21-game losing streak, and South Siders are ecstatic. In professional baseball, you have to go back to 1899 to find a longer string of losses. But their winning game against the Athletics illustrates that reversals happen eventually, and sometimes unexpectedly, as they did in equity markets this past week.

The Volatility Curve Ball

Yesterday was also a good day for global markets. However, over the past week, panic began with a dramatic plunge in Japanese and US equities. Most market commentators agree that there is no single, easily identifiable explanation, and none are sure that this episode of volatility is over. The Bank of Japan had long been expected to normalize interest rates. A weaker than expected US employment report might have fueled stock market gains, not losses, since it could signify lower interest rates sooner. Another factor might have been rumors of war between Iran and Israel. Here is more detail on three possible causes: the US jobs report, the yen carry trade, and unfolding geopolitical events.

1. US Employment

   

   One explanation for the rout was the soft US jobs report for July, which could mean that a recession is at hand—although that does not seem to be the case for now. In fact Claudia Sahm, the creator of the Sahm Rule, says that even if employment levels did cross a line that has indicated a recession in the past, this time might be different because of economic long Covid¹. Her real-time indicator is prescriptive, rather than predictive, and she is urging the Fed to cut rates now. Again, not a compelling reason for investors to run for the hills.

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2. The Yen Carry Trade
   
   By the same token, the Bank of Japan raising interest rates for the first time in 17 years on July 31st, which impacted the yen carry trade, does not mean that Japan is heading into recession either. As my colleague Richard Katz recently wrote:
   

   Even if Japanese stock prices remain weak, it would no more be the harbinger of an economic slump than its stellar rise earlier this year was, as all too many claimed, a sign that “Japan is back.” As I told the Washington Post, ‘Stock prices in Japan have surprisingly little impact on the real economy. That’s because companies are cash-rich and don’t need to use the stock market to finance corporate investments. Moreover, because households invest so little in stocks and share prices, they have little effect on consumer wealth and spending.’

   
   The yen carry trade refers to the practice of borrowing money in the Japanese currency at ultra-low interest rates and reinvesting the money in other markets with higher yields. Large institutions are not the only participants. Dentists and the redoubtable Mrs Watanabe have increasingly engaged in this trading strategy using retail forex platforms.
   
   

   Just how big is the yen carry trade? Some estimates say as much a $1T is in play at any given time. Although still dominated by institutional investors, retail traders are said to make up 10-30% of total volume.
   

   Most analysts are saying that the market was simply readjusting to the new interest rate last week, there were technical issues in play, and that the underlying economic news remains positive—both the US and the Japanese economies remain strong. However, other risks remain. A change in interest rates has spillover effects on the value of the yen itself and on the competitiveness of Japanese companies².

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3. Geopolitics
   
   Concerns about the direction of the US economy and a generational change in Japanese monetary policy were not the only contributors to market volatility this past week. Geopolitical tensions, especially heightened conflict between Israel and Iran, continue to exacerbate overall market uncertainty. I think it is also fair to say that there is a historic leadership vacuum around the world. Ironically, investors’ flight to safety also increases volatility.
   
   

   There are so many political upheavals around the world that they have become difficult to track, as the world is transfixed by a US presidential political drama that is as unprecedented as it is unpredictable. Just one example, the news that after a reign of 24 years, Bangladesh recently ousted their prime minister as protesters stormed her palace³ is not on most people’s radar. Bangladesh is not a small country—it ranks 8th in world population.
   
   

   Slovakia recently witnessed an assassination attempt, and civil unrest is highly visible across the globe from the UK to Sri Lanka. The war in Ukraine has taken an unexpected turn. Taiwan is perhaps the locus of the greatest threat of all for the global economy. A major earthquake or terrorist event could introduce a new source of volatility, as well as new pandemic. Officials around the world have issued warnings about all three gray rhinos. Conflict is as unpredictable as Mother Nature, so these events can be highly impactful when they occur. But geopolitics was not a direct contributor to recent zigzags in risk assets.