Stocks were smashed globally this week after the surprise Bank of Japan rate hike caused a tectonic shift in the Japanese yen carry, and the US labor report triggered a recession warning. This caused risk assets to unwind as the yield curve made a potentially huge shift, crushing everything from mega-growth to small-cap stocks.
This marked a significant pivot point in the market and likely suggests that the trades of the past 18 to 24 months are over.
Recession Risk
The biggest news came from the labor report: the unemployment rate rose to 4.3%, above estimates of 4.2%. This triggered the Sahm rule, which historically suggests that a recession follows when the unemployment rate’s 3-month moving average rises by 0.5% above its lowest point over the past 12 months.
Additionally, the rising unemployment now permits the yield curve to steepen, which the yield curve has attempted to do on a few occasions. Still, the unemployment rate has been so low that every time the ten minus the 2-year got to around -15 bps, it stalled out and reversed. That changed on Friday, with the yield curve steepening and rising above that resistance level, and it is probably on its way back into positive territory.
Additionally, the 10/2 18-month forward curve rose to a positive 50 bps on Friday, reaching a new cycle high; the 10/2 18-month forward tends to lead the 10/2 spot curve, and both tend to lead the unemployment rate, so the events on Friday mark a significant shift in the bond market. The two signals suggest that the odds of a recession have increased further.
Also, breakeven inflation expectations traded to new cycle lows on Friday. This is the first time the 5-year breakeven inflation expectations have fallen below 2.05% since January 2021. Falling breakeven inflation expectations indicate that the market foresees lower inflation rates in the future and slower economic growth. Since the early 2000s, the 5-year breakeven inflation expectations, basically the 5-year Treasury Rate minus the 5-year Tip Rate, have done an excellent job of predicting the direction and timing of when it was time for the Fed to cut and raise rates. If the trend in breakevens continues, it will send a clear warning about growth expectations and that a rate-cutting cycle is coming.
Stocks Smashed
High-yield credit spreads increased sharply, with the CDX high-yield index rising to 369, a reasonably low reading historically speaking but a level that is likely to climb if recession fears continue to build. Rising credit spreads and falling Treasury rates are not a good combination and are not bullish for stocks of any kind, especially small-cap stocks.
Small-cap stocks tend to trade with credit spreads, so they were smashed this week, falling nearly 7% and giving back much of their July gains. When overlaying the inverted IWM ETF with the CDX high-yield credit spread index, it is clear that the IWM trades with credit spreads. The gamma squeeze initially sending the small caps higher is now well behind us.
Of course, the S&P 500 current earnings yields trade with the CDX high-yield credit spread index as well. So, in the end, rising credit spreads will continue to unwind the equity market bubble that has formed since October 2023.
Yen Carry Trade
On top of this, the bad news is now the bad news, and anything suggesting the Fed will cut rates in the future or strengthen the case for rate cuts will weaken the dollar versus the Japanese yen. A strong yen will work to unwind the carry trade. The Bank of Japan increased interest rates in a surprise move this past week, and with rates falling in the US, the interest rate differential is narrowing, sending the USD/JPY lower.
The yen carry trade was one of the biggest drivers of the equity market rally since the Nasdaq lows in the winter of 2022. The more interest rate spreads collapse, the more likely the yen will strengthen versus the dollar, and the more the trade will unwind.
Fundamentals Not There
This past week, many significant events pointed to the trade of the past 24 months ending. That means there will need to be an unwinding process of this giant bubble formed in the equity market over that period.
Earnings and fundamentals will not save this market for the most part because stocks have significantly overvalued historically. Earnings estimates for 2024 have been unchanged for two years, and the PE ratio has risen to 22 times 2024 estimates of $241.96 versus 14 times 2024 estimates in the fall of 2022.
The past week’s events are critical and not only a considerable pivot point but, more importantly, mark the end of the bull market.
Source: seekingalpha.com
