The CIO’s Take:
Sahm rule signals a downturn
If nothing else, the last couple weeks have certainly tested the resolve of those buying into the current bull market for US stocks. In recent editions of Perspectives, we’ve investigated some of the factors, from mixed feelings on Q2 earnings to an unwinding yen carry trade—the latter of which we’ll discuss further a bit later. Another suspect you might have heard cited recently is the so-called ‘Sahm rule’ relating US unemployment to economic contractions. Updated based on July’s weaker-than-expected jobs number, it suggests we’re already in a recession (see below).
Named after former Fed economist Claudia Sahm, the ‘rule’ is super-simple to calculate: Has US unemployment risen more than half a percentage point in the last twelve months? If so, we’re already in a recession. As the plot above indicates, the Sahm rule has correctly IDed every recession over the last fifty years—so the fact that it’s been triggered has stoked fears of a hard landing.
Not so fast, Sahm says
So, should we be worried? It turns out that in this case, Dr. Sahm, herself, disagrees with her namesake rule. When she originally designed the indicator for the Fed, it was built to automate the process of sending out stimulus checks in a recession, softening the blow on American households. But because it’s a simple measure, it doesn’t account for situations in which unemployment rises not due to layoffs, but because more Americans come out looking for work before hiring has a chance to catch up. That’s what Sahm believes is happening now.
Yield curve suddenly ‘uninverted’
Ironically, some readers may have noted that another recession indicator, the well-known inverted yield curve, happened to ‘uninvert’ last week. That feels like a big deal, since the curve has been inverted—in other words, yields on 2-year Treasuries exceeded those on 10-year government bonds—for over two years now. Unlike the Sahm rule, however, which is meant to tell us when we’re already in a recession, the inverted yield curve is a forward predictor, and the pain doesn’t usually begin until the yield curve inversion corrects itself: exactly what we’ve just observed.
Don’t rule out a soft landing
Should that worry us? Maybe not. The reason a yield curve inversion typically reverses just before a recession begins is that the Fed slashes rates knowing recession is nigh, sending the front end of the yield curve lower than the long end. The median trader, betting on at least one half-point cut this year, clearly sits in the camp worried about a recession in 2024, but we believe they’re overestimating the Fed’s urgency to ease. We believe the odds of a soft landing are still higher and aren’t reading too much into technical indicators easily fooled by post-pandemic weirdness in the data.
Yen carry trade coming undone
Last week, we touched on one of those other theories on what’s driving the risk-off in financial markets: the “unwind” of the yen carry trade. What does that mean? When a trade goes wrong or suddenly becomes much riskier, investors employing it will start reducing their exposure, liquidating or “unwinding” the positions they’ve taken on. That’s happened countless times before: to currency speculators, equity short sellers, arbitrageurs, and hedge fund strategists. Here, we’ll dig a little deeper into what the yen carry trade is, and the implications of its unwinding.
Understanding carry mechanics
The idea behind a “carry trade” is extremely simple: borrow at a low interest rate in one asset and invest the proceeds into something with a higher yield, extracting the ‘spread’ between the two assets. The yen carry trade is something traders have been engaged in for as long as the yen’s yield (i.e., Japan’s interest rate) was so low, borrowing yen, converting them to another currency, like USD, and investing them in something with a more attractive return, like US Treasuries… or, maybe, Magnificent 7 stocks!
Facing bad conditions recently
That trade works, as long as currencies don’t move too much—remember, at some point those dollars are converted back to yen to pay off the yen-denominated loan—and as long as the asset purchased really does yield more. What we’ve seen the last couple weeks is a perfect storm: likely sensing the yen was too weak, the Bank of Japan has been intervening, causing yen to strengthen, they also shocked markets with a rate hike, and the US economy looks weaker as the Fed is closing in on cuts. All of those things led the yen to rise sharply against the dollar (see below).
Meanwhile, US stocks are tanking, so anyone long equities with their borrowed yen is feeling the trade getting riskier. Many more who did something safer—like buying bonds in a higher-yielding currency—probably did so with leverage, trying to amplify what would be a much larger spread. Of course, that means the outsized move in the yen has them sweating potentially huge losses. Leverage is a double-edged sword. In either case, the carry trade has become a scary trade, and those with positions have been unwinding them.
How big a problem is it?
There’s really no data to tell us how big the yen carry trade is. One potential proxy is the size of short sales in the yen, and judging by those positions, the trade is about as big today as it was just before a similar unwind in 2007, when the subprime market imploded. The same data suggest that foreign banks in Japan are smaller players, and that positions of speculative traders, like hedge funds, have increased this time around. It’s likewise hard to tell where exactly the borrowed funds have been invested, but Japan’s balance of payments shows a surge of investments into US assets.
Where has it hit hardest?
We’ve witnessed one implication of the carry trade unwinding: a rally in the yen as traders buy it to repay their loans, and big losses in anything those traders have liquidated on the long side of their carry portfolio. In part, that might have been to blame for steep losses in US tech stocks, though we suspect carry traders weren’t doing too much of that particularly extreme speculation. A more likely destination for carry trade longs were high-yielding emerging markets currencies, many of which—like Mexico’s peso—have seen a spike in volatility since the trade started unwinding.
Expect further yen strength
Of course, a big part of fears surrounding the carry trade stem from growing concern we just discussed over a potential downturn in the US economy. So, to the extent those fears are misplaced, currency traders’ jitters should stabilize, minimizing further damage. As for the yen, it seems clear to us from the chart above that it’s trading far lower against the dollar than it has in a long time, and we believe Japan’s economic recovery and a pivot in Fed policy will keep the still-undervalued yen strengthening—though hopefully with a little less volatility!
Price cut on 30-year loans!
Falling stocks and rallying Treasuries tell us pretty clearly: investors are in a flight to safety. That sentiment, not surprisingly, spills over into other asset classes. Mortgage-backed securities have predictably followed the rally in fixed income markets, as investors react to the prospect of both declining US interest rates and a cooling economy, reflecting mortgage rates on the decline, a joyful reminder to homebuyers—not to mention the estimated 4 million American households with mortgages locked at rates of 6.5% or more—that Fed policy can kick in before the cuts begin.
Biggest drop in two years
So, what exactly does the data say? Freddie Mac’s weekly survey recently showed the 30-year fixed-rate on conventional mortgages falling more than a quarter-point from the week prior, hitting 6.47%. Similarly, the Mortgage Bankers Association of America reported the latest 30-year fixed rate at 6.55%, a drop from the previous reading of 6.82%, representing a 15-month low (see below). Considering how high rates got since the Fed started hiking in 2022, many will look at the plot and wonder whether we’re seeing the start of a trend in the other direction.
Decline could continue, but…
There is reason to be hopeful this represents the first leg of a bigger move down in mortgage rates, but there are at least a couple caveats. Weak economic data and dovish messaging from the Fed that a pivot is coming in September have led rates lower, but the market is pricing in an awful lot of easing; if it doesn’t materialize—or comes to less than traders expect—the decline in mortgage rates will naturally stall. There’s also a risk premium associated with mortgage loans, and plenty of volatility in the secondary market, neither of which is guaranteed to subside anytime soon.
Supply still keeping sales light
Regardless of whether this fall in mortgage rates has room to run, those looking to refinance loans they took when rates were higher will likely jump at the chance. Indeed, the Mortgage Bankers Association also reported refinancing applications hitting a two-year high. For those trying to find a loan for a home purchase, conditions are obviously better now, too, though with the supply of homes for sale still tight, it might not make a huge difference—so don’t expect a big jump in activity even if mortgage rates continue creeping down.
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