Storm Has Passed

The US stock market is rebounding decisively from a roughly -10% correction. The event unfolded quietly at first during the last half of July, then crescendioed rather loudly in the first few days of August. We saw the VIX Index, which measures fear among options traders, briefly skyrocket above 60, the highest since 2020. Volatility jumped in the bond market as well. Treasuries rallied hard as fearful traders ran to the traditional safe-haven play.

But the fever quickly passed. The S&P 500 regained its footing and has retraced about 70% of the correction. The VIX is back down to 15, considered normal. And that incredibly sharp rally in bonds is fading. Investors are left to wonder, was that just a temporary lull in the rally, or was it a precursor to a more volatile time ahead?

The correction had three proximate causes. First, a number of mega-cap tech & internet stocks have run so far, so fast this year that Wall Street is beginning to take some profits. Another way to say that is, these stocks had become over-valued. Second, the July jobs report, released on August 2nd, suggested that the labor market is finally weakening. Nationwide, employers added just 114,000 new jobs vs. 175,000 predicted by economists. The unemployment rate ticked up to 4.3%. At the same time, a Dept. of Labor report showed a spike in weekly new claims for unemployment insurance. That really got traders’ attention.

And finally, Barron’s explains that part of the volatility was due to an unwind of the Japanese yen “carry trade.” International investors have been borrowing yen cheaply and investing that money in the US stock market. That trade only works because of a huge difference in prevailing interest rates between the two countries. So when the Japanese Central Bank recently raised rates, coincident to a down-shift in US rate expectations, that trade sort of blew up.

So why the quick turnaround? Well, the carry trade is obviously a very temporary headwind. And the up-trend in jobless claims has since been reversed. We’re also hearing that that the unemployment rate didn’t rise because of corporate layoffs, but rather because of an influx of immigrants looking for work. So there is a collective sense that maybe the market’s initial reaction to these events was overdone.

In addition, our sense is that investors are absolutely certain that the Federal Reserve will begin lowering interest rates next month. We all read this week’s inflation reports with relief. The Consumer Price Index (CPI) drifted down to a 2.9% annual rate, the lowest since March 2021. And 90% of the monthly gain in prices was due solely to a ridiculously contrived component of the index which attempts to measure the cost of rent. The Federal Reserve monitors Core CPI, which fell to a 3.2% annual rate. If you strip out rent, however, it drops down to just 1.8%. This is a big deal since is suggests the Fed has already met its 2% inflation target. The time has come to cut rates, not because the economy is falling off a cliff, but because rising inflation is no longer a risk.