“I don’t focus on what I’m up against. I focus on my goals, and I try to ignore the rest.”
― Venus Williams
Unemployment and the Sahm Rule
Last Friday, August 2, we received employment data from the Bureau of Labor Statistics for the month of July and there were some misses of expectations which made the headlines. In particular, the Nonfarm Payrolls report showed that the U.S. added 114,000 jobs in July, but that was well below the expected 170,000 and the second month of declining numbers. Meanwhile, the unemployment rate increased to 4.3%, the highest it has been since October 2021 and the fourth consecutive month it has increased. Now a 4.3% unemployment rate is still low relative to the historical average, but it isn’t the level that people are concerned about, so much as the direction. One result of this number was that it triggered the Sahm Rule, an economic indicator which has received some press for the last year or two. The Sahm Rule is simple. It takes the 3-month moving average of the unemployment rate and compares it to the low in the unemployment rate in the last 12 months. If the difference is half a percentage point or more, then the U.S. is already in a recession. At least historically. The track record for predicting recessions going back to 1960? A perfect score, 100%.
The Sahm Rule Indicator
Now that’s a scary narrative. However, there’s more to the story. Believe it or not, the Sahm Rule Indicator was not developed to induce investor panic when it reads 0.50% or more. Recessions are officially declared by the National Bureau of Economic Research (NBER). Due to the method by which recessions are determined by the NBER, we only know we are in a recession months after it has started. The Sahm Rule was created to provide an earlier signal of recession and to indicate that monetary and fiscal policy levers should be pulled to avoid a runaway increase in unemployment. Another important fact that isn’t always communicated when the Sahm Rule is spoken about is that it was created in 2019. This means that the U.S. has experienced exactly one recession since the creation of the Sahm Rule Indicator and that is the 2020 flash recession created by the pandemic shut downs. Unemployment skyrocketed from 3.5% to 14.70% in two months! That is hardly a standard recession and is likely not a useful measuring stick. So, in essence, this is the first time any central banker or fiscal policy maker has had the opportunity to make use of this indicator. The Fed, and anyone else paying attention is aware of the Sahm Rule and its current level. What remains to be seen is what actions will be taken.
What is the Yen Carry Trade?
Moving on from employment to currencies, there have been abundant headlines recently about the Japanese yen and how it’s driving at least some of this market volatility and there is almost certainly some truth to that. You might be asking why or how the relative value of Japanese currency could upset global markets. It’s a good question and requires somewhat of a technical answer. In the simplest terms, there is a trading strategy used by hedge funds and institutional investors to borrow in yen and then buy risk assets, like stocks, with the leverage they gain. This is known as the “yen carry trade.” It’s a complex trading strategy and I won’t bore you with the details more than is necessary.
This trade has been a popular one for a couple of decades now as the Bank of Japan (BoJ) has held interest rates near zero for most of the 2000s. In fact, the BoJ even had a negative interest rate policy from 2016 until this year and it was big news in the financial press when Japan finally ended its negative interest rate policy. The fact that Japan had low interest rates relative to other countries, like the U.S., meant that sophisticated investors could borrow in yen and pay lower interest than they would to borrow in, say, U.S. dollars (USD). They could then convert their yen back to USD and invest. If rates stay lower in Japan than the U.S., then there is a favorable trade to be made. However, the exchange rate matters too. To pay off the borrowed balance, which is denominated in yen, those investors need to convert back to yen. As the yen strengthens compared to USD the exchange rate becomes less favorable and the margins of profit on the strategy shrink. This strategy could also result in losses, so a rapid change in the exchange rate could lead to a rapid reversal of this trade. Now that we have a base understanding of the strategy, we can examine the current landscape.
The yen has been weakening vs. the U.S. dollar (and other currencies) since 2021. In recent months, the Bank of Japan has been defending their currency value and stepping in as a buyer when the yen has weakened too much for their liking. All the while they have been warning the markets that they would do so. Regardless of those warnings, when the BoJ increased rates from 0.1% to 0.25% on July 31 it caught at least some market participants by surprise and likely caused many carry traders to take a hard look at their strategies. Of course, 0.25% is still a much lower rate than 5.5% on a loan. However, it isn’t necessarily the interest rate that caused a stir, but rather the effect the interest rate has on the relative value of the currency. If those traders are worried that their margins might turn quickly negative if the yen continues to strengthen rapidly, then they might choose to back out of that trade. That means selling those risk assets, like stocks, to raise cash to convert to yen and pay off their loans. The market abhors negative surprises and the one from the BoJ may have caused a sharp reaction from carry traders which then had knock-on effects for other market participants and intensified the sell off.
USD to JPY Exchange Rate
The follow up question is whether we will see more of the same and that will depend on the price of the yen. If the yen makes rapid advances relative to the USD and other currencies, then it’s possible. Then again, the market prices in new information quickly and this surprise has already occurred. The next Bank of Japan interest rate decision isn’t until late September and BoJ Deputy Governor, Shinichi Uchida, signaled a pause on rate hikes citing market volatility as a reason. As of the time of writing, the yen was still slowly retreating from those rapid gains.
Remaining Calm in Tumultuous Market
When surprises occur, the markets can have a big reaction and stock prices tend to fall much faster than they climb. Big dips are an inevitable reality of investing and when those dips get big enough, we give them names such as corrections and bear markets. Corrections are defined as a 10% decrease from the most recent high in a particular security or index, while bear markets are defined as a 20% decrease from the most recent high. Dips of 5% or more can be scary for investors, but they are common occurrences. In the last 10 years, the major U.S. indexes (the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite Index) have experienced two bear markets, four corrections outside of a bear market, and a dozen or more 5% drops. The tech-heavy Nasdaq is often more volatile than the other two indexes and is technically in a correction this week. As you can see in the chart below not every 5% drop leads to a correction and not every correction leads to a bear market.
Since the bottom of the bear market in the S&P 500 on October 12, 2022, we have had a period of relative calm. Since that time, we have seen seven days in which the S&P 500 pulled back 2% or more in a single trading session. That’s about 1.5% of all trading days. If we look back to the beginning of 2000, the longer run average for that kind of volatility is 4.41% of trading days. When we get used to a steady upward march in the value of our portfolios, a sharp reversal can be an uncomfortable wake up call. It’s important to remember that no one can call the top or bottom of a market with consistent accuracy, but remaining invested has paid off in the past.
As of today, this economy is still in growth territory. Yes, there are signs of slowing growth, but that’s different than contraction. In an earlier article on stagflation, I used the analogy of a car to make a distinction between disinflation and deflation. The analogy works here too. Slowing growth is like a car decelerating while still moving forward whereas a contraction would be throwing the car in reverse. Recent data has shown a trend of growth slowing (deceleration), but we aren’t obviously in contraction. The ISM Services PMI, a measure of the services side of the U.S. economy, bounced back into expansion territory on Monday. Unemployment may be all the way up to 4.3% from the recent lows of 3.5%, but the long-term average is 5.69%. The economic data calendar was light this week, but we did see initial jobless claims come in below expectations and down from the prior week which may have helped push back on the concerns about employment. Next week we have some inflation data coming out on Tuesday and Wednesday and the market won’t want to see inflation go in the wrong direction. However, with all the chatter about slowing growth, inflation data may take a back seat to the growth data and the most substantial growth data we will see next week is retail sales on Thursday. With minimal new data to drive the narrative, markets may struggle to find direction, so don’t be surprised by ups and downs.
As we all know, the headlines will always lean into sensationalism. The idea that unemployment is spiking or that a complex trading strategy is causing market turmoil is going to get clicks. However, the catalyst for a turn in a market cycle is rarely the one everybody’s talking about. Black swan events often kick off a bear market and, by definition, they cannot be predicted. They will occur and investors must expect them and invest accordingly. That is easier said than done to be sure, but being an investor requires grit and it is, by nature, an optimistic pursuit. Days like Monday are a good reminder to check on your investment policy at regular intervals. I discuss this with clients at each meeting. What has changed in your life? What changes are you expecting? Are we on the right path or do we need to change our approach? Plan for the unexpected so you can act on your plan instead of reacting to the uncontrollable. Are you a high-risk investor still saving money? Then a correction could present a buying opportunity. Are you about to retire or living in retirement? Then perhaps a lower risk strategy is warranted to limit portfolio volatility. Having sufficient cash reserves and a well-planned cash flow can make corrections less scary when they occur. I like silver linings and one positive sign from the recent market volatility was that we saw obvious safe-haven demand in U.S. treasuries and bonds on Monday. Essentially, when stock prices were falling, bond prices were climbing. This shows that U.S. treasuries are still the world’s safe-haven asset and that the inverse correlation between stocks and bonds may be re-emerging after almost two years of largely moving in the same direction. There are no guarantees in investing and time will tell if this trend is sustained, but this inverse relationship can help limit the downside risk of market volatility in a portfolio containing both stocks and bonds.
Disclosures
The information provided in this material is for informational purposes only and is not intended as investment advice. The views and opinions expressed in this document are those of the author and do not necessarily reflect the official policy or position of [Your Firm’s Name]. Any forward-looking statements or projections are based on current market conditions and subject to change without notice. Any discussion of markets, trends, or investment strategies in this document is based on the author’s interpretation of available information at the time of writing. This information is subject to change, and there is no guarantee that the interpretations are accurate or that the strategies discussed will be successful. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. Any references to particular securities or strategies are for illustrative purposes only and should not be construed as an offer to buy or sell any financial instrument. The explanations provided on the Yen Carry Trade and the Sahm Rule are simplified for educational purposes. These concepts involve complex financial mechanisms that can vary significantly based on individual circumstances and market conditions. Readers should consult their financial advisor for a more detailed and personalized analysis. The information in this document is based on current market conditions, which can change rapidly. There is no guarantee that the views expressed will be proven correct or that any strategies discussed will be effective. Investments should be based on an individual’s goals, risk tolerance, and financial situation, and should be discussed with a financial advisor.
