Let the Games Begin
We haven’t done this in a while, but it’s time to dive into economic data and make sense of financial markets. After a long stretch during which mostly nothing “really important” happened, the waiting is over. Let the games begin, and I don’t mean the Paris Olympics.
For those who don’t want to read past this paragraph, let me give you the tl;dr version now:
Last week, a Fed-induced run-of-the-mill worry that the U.S. economy is slowing down ran headfirst into a wild global margin call on hedge funds that started in Japan.
The economic slowdown is probably real, but the degree to which we should worry is up for debate. The global hedge-fund margin call was super-duper real and very painful.
Like all “forced selling” events, if you’re in charge of your emotions and not forced to sell with every naïve hedge fund out there, then at a minimum, time is on your side, and this may even turn out to be a time during which opportunities are revealed.
But option-selling strategies definitely had a very bad day on Monday when volatility doubled overnight. We had warned you of engineered-yield strategies back in March here.
Last Year’s “The One Chart That Matters” (Post-COVID Edition)
For a while, the only chart that mattered was the one tracking U.S. inflation. In June 2022, that chart spiked up to 9% inflation, which was a real shock to the system (and to everyone’s wallet). That’s basically behind us. We may be stuck closer to 3% than 2%, but the “inflation emergency” is over, at least as far as monetary policy is concerned. So the interior designers at the Fed are ripping the old wallpaper and replacing it with this year’s version of “the one chart that matters.”
New Year, New Look (Summer 2024 Edition)
The one thing that makes inflation go down is a cooler economy (at least, that’s the main lever over the short term. Innovation and productivity gains are the long-term lever). And nothing cools the economy quite like a slowing job market. So yes, the U.S. economy has created fewer jobs recently, and unemployment has started to creep up. We’re up to 4.3% unemployment at the last read. It’s still low but definitely rising. The Fed, and everyone staring at this chart, is worried because — as you can see below — history tells us that unemployment rarely rises just a little. It tends to snowball. That was the start of the conversation in markets last week after the Fed came out and roughly said, “Hey, we should start reducing interest rates soon because we don’t want to wait so long that we’re blamed for a big rise in unemployment.” Many headlines warning of doom for the U.S. economy ensued. That was punch to the chin #1.
Now onto the second layer of this oh-so-long week in markets and economics. Once unemployment figures were released, everyone looking for doom went to something called the Sahm Rule (named after former Fed economist Claudia Sahm). The idea is that the Sahm Rule is an early indicator of recession, long before the National Bureau of Economic Research (NBER) gets around to calling the official start of a recession. And sure enough, the Sahm Rule was triggered by the last unemployment report (The graph below is through July 2024, post unemployment report). This added to the general sense of angst, even though Claudia Sahm herself will tell you that the statistic she designed is not really a “rule” but an indicator of trouble at best. In other words, “recession maybe,” not “recession guaranteed.”
The Widow Maker Meets Volmageddon 2.0
And then there is Japan, which is where the real trouble started.
They’ve called Japan the “Widow Maker” because its markets have often behaved in unexpected ways, which makes it extra shocking that hedge funds would bank on Japan submitting to their naïve assumptions.
We’re going to keep this simple, but basically, interest rates in Japan have been very low relative to other places like the U.S. In fact, interest rates have been negative there for a while. So if you’re a clever (but not clever enough) hedge fund, you could borrow money in Japan for very little interest, and then use that money to go buy things that seem like good investments. If conditions stayed as they were, you could pocket the difference between the cost of funds borrowed in Yen and whatever you made on the investments you made with the borrowed cash.
Except that last week, the Bank of Japan decided to flip the script by raising interest rates, and in fact, make them more positive than they had been in a very long time. When that happened (along with rates falling in the U.S. because of the recession fears we just discussed), the Yen appreciated a lot, and hedge funds started getting calls from their lenders that they needed to pay down their loans or come up with more cash. They call that a margin call, except everyone in hedge-fund-land got the same margin call at once. Yikes.
Since coming up with cash takes time, hedge funds did the next obvious thing: dump stocks to come up with Yen in a hurry. Every “smart” trade got hit, from U.S. tech stocks to European stocks to Japanese stocks. Japanese stocks were a natural victim since they were the fastest way to get good Yen on hand to turn in to the lenders and make the margin calls stop. This has not been a pretty process.
Volatility jumped like it hadn’t in a very long time, making Monday, August 5, 2024 the unofficial date for Volmageddon 2.0, as you can see from this graph (through Monday).
Now stocks fell a bunch, some more than others. But let me remind you of a piece I wrote back in March, warning of what I called “engineered yield” that is created by selling options. Well, when volatility jumps, the value of options jumps too. This means that those option-selling strategies had a very bad day on Monday, proving yet again that the “high” income from selling options is no free lunch indeed.
Where does that leave us?
Yes, the U.S. economy is probably slowing down. That’s not a great headline, but the reality is that the super-hot economy of 2021-2023 was kind of killing us too, with inflation nearing 10%. And the signals that we are entering a recession should never be dismissed, but it’s a long way from one signal to having certainty about anything in this world.
Now, as far as markets are concerned, last week was the latest reminder that you should always test your assumptions, test your comfort with downside risk, and avoid being a forced seller like the plague itself. Oh, and products that sell options to generate higher yield feel great until we get a day like Monday. But you knew that already, because of our newsletter from a few months ago. If you want to go back and revisit, it’s here: Beyond the Reef.
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