Soft-Landing Narrative Coming Under Fire
On August 5th, the VIX, or volatility index, spiked making a six-standard deviation move as fear of a U.S. recession led to a surge of risk-off trades. In equities, there was a sharp reversal of crowded positions mixed with a shift in the fundamental economic backdrop highlighted by a soft July U.S. employment report. At the same time, the dramatic unwind of the yen-carry trade acted as a global margin call and exacerbated price swings.
The yen-carry trade is the strategy of borrowing cheaply in the lower rate yen and deploying that capital in higher-yielding assets elsewhere to profit from the difference. The Bank of Japan made some notable policy moves, hiking rates and cutting back on its domestic bond purchases of government bonds (JGBs). This prompted a massive rebound in the Yen and triggered the most severe selloff for Japanese stocks and bonds in decades. Once the Yen began to rally on the heels of higher rates and cooler global growth, the carry trade unraveled as traders borrowing Yen faced margin calls. Carry trades help finance growth in assets such as U.S. equities, and act as a liquidity drain when the flow of capital is reversed.
More market participants are questioning the trajectory of global growth with weaker employment and manufacturing data shaking investor confidence in the ability of the Fed to achieve a soft landing for the U.S. economy. U.S. Treasuries rallied sharply at the start of last week and U.S. Dollar-denominated money market fund assets hit a record high in the wake of the market upheaval. Recent favorable inflation data have supported claims that the U.S. economy no longer has an inflation problem, and that the Fed’s dual mandate of price stability and full employment are no longer at odds with one another. This has led markets to price in the Fed beginning to cut interest rates at next month’s meeting. Given this broader environment, we expect agency mortgage-backed securities (MBS) to continue to perform well. In a turbulent, dislocated market, agency mortgage bonds are poised to benefit from increased investor demand for safe-haven securities; and while MBS have risks, they’re not related to credit. This provides them with an opportunity to outperform in a slowdown when there’s a flight to quality, which Edge has exposure to via funds and individual securities.
We remain cautious about the backdrop for equities given the re-emergence of hard landing risk in the U.S. economy, election uncertainty, and elevated geopolitical risks. Many market participants now fear that the Fed may have left rates too high for too long. It is possible for further bouts of volatility given the headwinds of negative earnings revisions, weakening economic activity, and impending Fed rate cuts already being priced into stocks. Also, while the inflation picture of recent months may appear favorable, it’s likely to stabilize well above the Fed’s 2% target. With a defensive equity allocation and healthy cash position, we will look to deploy excess capital into any broader downturn.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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