Market Pulse: August 5, 2024

This is a moment for the Fed.

A matter of days ago Fed policy was considered to be very appropriate, low risk and something that could be executed without a sense of urgency. But in short order Fed judgment is being second guessed and there are deep and growing concerns they missed the turn in the labor market and as a result are now chasing, not leading the economic narrative.

In the middle of last week Fed Chair Powell described the labor market as “strong but not overheated.” After the jobs data on Friday the Fed’s opinion seemed overbaked to many market participants. While payrolls missed the estimate, they were hardly a disaster. But some/most of the other July labor market data was weak, and that just piled on to the myriad of already suspect reports. Maybe the slip in the previously solid payrolls took the blinders off market participants, but in any case, the current state of the labor market does not need the payrolls to be considered troubled. It is not, as Chicago Fed President Goolsbee suggests, a matter of one month’s numbers.

At 4.3% the Unemployment Rate (UER) is historically low, but it is nine tenths off the low and that is not a good spot to be. The Household Survey, the source of the UER, is often chided as being the less reliable than the Establishment Survey; but maybe we should ask Powell. Just last week, when answering a press conference question on labor market conditions and Fed policy, he said, “…we're prepared to respond if we see that it's not what we wanted to see, which was a gradual normalization of conditions. If we see more than that, and it wouldn't be any one statistic, although of course the unemployment rate is generally thought to be a single, a good single statistic…”

The current condition of the labor market did not result from one number, also notably weak, over the longer run, are: • The number of Unemployed is up 25.7% so far in 2024. • Continuing Claims are 40% above the cycle low. • Hire, as reported by JOLTS, are down 22% in the last two years. • Etc.

Now it is a matter of the rock and hard place for the Fed:

• As of July 31, the Fed considered the labor market to be “strong”. To change that view because of “one month’s number” released on August 2, makes the Fed seem reactionary. So, if the Fed’s policy attitude gets notably dovish, then we will wonder, “what took them so long?” Additionally, another Powell pivot will make the Fed appear to be chasing, and the more they do, the more they will feed the beast, reinforcing the narrative that the Fed is indeed late and trying to catch up. Fed credibility takes a hit.

• However, if the Fed stands pat on their policy stance, “nothing to see here folks”, then they will look a bit like the old dog that can’t learn a new trick. In the current mood the market will highlight every weak number; bad news for the economy will certainly be bad news for the markets and yet the Fed is reluctant to act. Fed credibility takes a hit.

 

A Carry Trade refers to a position that is funded by a low interest currency, such as the Yen, with an investment in a higher yielding asset, such as sovereign debt of another country or a stock index. At the end of every Carry Trade, the final step in the transaction, is to buy back the short position in the funding currency. Because the final step of a Carry Trade is to repurchase the funding currency, the optimal case is that the currency in question is weaker at the end of the trade than it was at the initiation of the trade. A sudden and sharp rally in the funding currency is the sort of thing that ruins an otherwise successful trade. The greater the number of positions in a particular trade, the bigger the crowd trying to fit through the exit at the same time. It is likely some positions in the highest of high-flying stocks in the Nasdaq were funded by borrowing Yen in the latest year.

It can be said that the first appearance of the Yen Carry Trade was back in the mid-nineties. An article in the February 28, 1996 Wall Street Journal discussed a “complicated bet” that had gone bad for some hedge funds. “Here’s how it all began,” explained the WSJ. “Last year, the smart money bet heavily that a weak US economy would force the Federal Reserve to slash interest rates while the Bank of Japan was busy printing yen to refloat that economy. Presto: Bonds would rally, the dollar would go up, and the yen would weaken. That was the bet, and it worked, for a while. Some hedge funds pumped up their wager by borrowing yen at near-zero interest rates, converting the yen to dollars and then investing those greenbacks in higher yielding US Treasury debt. As they happily collected the interest “spread” from the big gap between Japanese and US interest rates in this so-called carry trade, the hedge funds sat back and waited to repay their yen-denominated loans with ever-cheaper yen….”

That trade did not end well; at the end of the day, bonds prices fell and Japanese interest rates rose and the dollar weakened. As the WSJ wrote, “Oops.”

Famously, the Yen Carry Trade was back in vogue a couple years later. Borrowing in Yen once again funded a long Treasury position, among other things, throughout most of 1998. The position benefited from the Asian Contagion and Russia default/devalue. The Yen cooperated, weakening notable most of the year. The problem was that when some positions liquidated, others followed on their heels. The Dollar/Yen moved from a peak of 147.66 in early August 1998, down to 111.85, less than two months later.

Another time when the exit from a Yen Carry Trade was way toooooo crowded.