The Carry Trade

Simply put, the carry trade is the act of borrowing in a currency with low interest rates and using those funds to buy assets with higher rates or anticipated returns (like stocks). The Japanese yen became an “easy” carry trade for big investors because the Japanese yen (FXY) had near zero interest rates. Once the Fed started hiking rates, traders could earn increasing returns by borrowing in yen and buying U.S. bonds. After equity markets bottomed in October, 2023, traders could earn increasing return borrowing yen to buy stocks (at least one analyst thinks the carry trade has been in effect since the rebound from the Great Financial Crisis!). Crypto currencies are even acting like they have been caught up in this massive delveraging. At the time of writing Bitcoin (BTC/USD) is down around 24% in just 8 days and looks like it could soon reverse all its gains since the SEC approved Bitcoin spot ETFs.

The strength in the yen and the presumed unwind of the carry trade has been breathtaking over the last two weeks. The Australian dollar versus the Japanese yen (AUD/JPY) has fallen around 17% in the three weeks since its last peak. AUD/JPY now sits at levels last seen in early June, 2023. AUD/JPY has long been my favorite currency market indicator of sentiment in the stock market. However, the current decline happened so rapidly, that I had no time to adjust my mind to appreciating that AUD/JPY suddenly mattered again in a significant way. After all, the Bank of Japan “only” hiked its target rate from 0% to 0.25%. The hawkish tone of the BoJ on normalizing policy must have traders scrambling to get completely out of the way of future rate hikes.

So what now?

Financial markets are essentially in panic mode. It is near impossible for the stampeding herds to see the other side of this major market disruption. As a contrarian of extremes in financial markets, I am compelled to lean the other way even though market breadth in the stock market still needs to fall significantly to hit oversold levels. Thus, I cannot buy as aggressively as I normally would…”nibbling” is my modus operandi for now (I am also re-accumulating cryptocurrency positions like BTC/USD).

In currency markets, I slipped on my well-crafted trading strategy on the Japanese yen. I gave up on the short GBP/JPY too early, and got overly confident in what looked like the obligatory rebound for USD/JPY side. So, in recent days, I have raced to keep up with new short GBP/JPY positions and have been simply astounded by how fast these positions hit profit targets. This clearing in turn forces me to reload at lower prices as the Japanese yen keeps racing away. Last week, I even dabbled in shares and call options in Invesco CurrencyShares® Japanese Yen Trust ETF (FXY). At SOME point, this non-stop slide in yen currency pairs will end and give way to a (potentially) abrupt and vicious countertrend relief rally. That time will offer a brief opportunity to bail on short yen positions and then step aside to catch a few breaths!

Be careful out there!

Full disclosure: long AUD/JPY, long USD/JPY, short GBP/JPY, long BTC/USD

The post The Carry Trade Sweeps the Sahm Rule Aside appeared first on Inflation Watch.

Source: Sahm, Claudia, Real-time Sahm Rule Recession Indicator [SAHMREALTIME], retrieved from FRED, Federal Reserve Bank of St. Louis, July 31, 2024.

The chart above shows the uncanny consistency of the Sahm Rule. Since 1960, the Sahm Rule has had just one false positive (in 2003) and no false negatives. Thus, the persistent and consistent upward trend in the Sahm Rule since October, 2021 all but locks in a recession signal in the coming months.

Powell Downplays Sahm

The question hung in the air for what felt like an comfortable several minutes while Fed Chair Jerome Powell flipped through his notes: “how worried are you about unemployment rising to the point where it triggers the Sahm Rule, and would that potentially affect how quickly you cut rates?” For a while there, I thought the question caught Fed Chair Jerome Powell by surprise. After he stopped flipping his through his notes he responded by first reassuring everyone he is familiar with the Sahm rule. He even explained the implication of the rule – that a severe downturn in employment is imminent. He also clarified that the Sahm Rule is not really a rule with predictive power, it is a “statistical regularity.” In other words, past performance does not guarantee future results. Powell concluded his response by insisting that the labor market is normalizing and remains healthy. He also reminded everyone that a lot of “received [economic] wisdom” has not worked in this post pandemic business cycle, like the predictions of recession based on the inverted yield curve.

What is the Sahm Rule?

The definition of the Sahm Rule is buried in a policy proposal from economist Claudia Sahm. Sahm sought to create an automatic rule for initiating economic relief payments to take the edge off a recession.

“Automatic lump-sum stimulus payments would be made to individuals when the three-month average national unemployment rate rises by at least 0.50 percentage points relative to its low in the previous 12 months.”

The graph provided by the St Louis Federal Reserve calculates the percentage points used in that rule. Clearly, this rule looks like a very good harbinger of recession.

What are the implications of the Sahm Rule?

While history may only rhyme, I strongly suspect the buzz about the Sahm rule will produce a drum beat synchronous with history’s rhyme. The irony is that, for now anyway, Wall Street will welcome increasing fears of a recession as those worries will act like co-signers to a September rate cut. The predicted near certainty of a rate cut initiated a dramatic market rotation favoring a whole host of rate sensitive sectors over growth, big cap tech stocks. That rotation looked ready to take its next logical step as the iShares Russell 2000 ETF (IWM) surged to a new 2-year high. However, the ETF of small caps faded back to a 0.6% gain and failed to confirm the invalidation of a prior blow-off top. Still, I remain patiently bullish on IWM (a short-term IWM calendar call spread hit my initial profit target as IWM surged intraday).

And then there are bond yields. Lower yields should correlate with an intensifying recession obsession. For now, I am sticking to the presumed trading range on iShares 20+ Year Treasury Bond ETF (TLT). TLT closed right at the top of that range. If TLT breaks out, I will draw a new presumed trading range; I still think ballooning U.S. debt levels and persistently strong economic data provide catalysts for downward pressure on TLT. I bought a fresh round of TLT put options near the close on the assumption TLT will have at least one more fade back to some support level.

The latest recession obsession in the form of the Sahm Rule is sure to produce additional trading opportunities…and surprises to come. At a minimum, the Sahm Rule provides dominant context for each month’s latest job report. Next up – this coming Friday.

Be careful out there!

Full disclosure: long IWM shares and calls, long TLT put

The post The New Recession Obsession: The Sahm Rule appeared first on Inflation Watch.