Notes on a classic market panic: Unwinding of the yen-based carry ...

The turmoil in global financial markets on Monday was long in coming but spurred by short-term pressures: the unwinding of the yen-based carry trade, where speculators and short-term investors borrow against the yen to purchase risk assets elsewhere.

As these investors exited their positions in the yen, equity markets plunged and yields fell across the Treasury curve as investors sought the safe haven of U.S. government securities.

With cash most likely moving into the Federal Reserve’s overnight reverse repurchase facility, the central bank will be careful to ensure that financial markets are functioning properly and have sufficient liquidity.

While we do not think conditions are ripe for the Fed to make an emergency rate cut, the case for a supersized 50 basis-point reduction at its next meeting on Sept. 18 has been bolstered by the recent market turmoil.

Should the volatility continue, and we observe weak inflation or jobs data, then conditions for an intermeeting cut would be on the table.

As of now, the Fed is in a wait-and-see mode and will not want to do or say anything that would worsen the panic.

At the time of this writing, the RSM US Financial Conditions Index is just under one standard deviation below neutral, which implies a drag on overall economic activity. With the CBOE’s Volatility Index of the VIX standing above 40, it is likely that investors will capitulate shortly.

The deleveraging of the carry trade will take a few days and catch many speculators and short-term traders off guard, resulting in an extended period of global asset volatility. That is why—along with rising rates in Japan and the next steps in policy normalization at the Bank of Japan—the yen has appreciated sharply, by more than 18%, against the dollar over the past three weeks.

The deleveraging associated with policy normalization in Japan and the one about to start in the United States is part of a regime change taking place among the world’s central banks. The days of low interest rates, low inflation, and easy money that fueled leveraged trades without much risk are ending.

Read more of RSM’s insights on the economy and the middle market.

It is important to note here that the market is not the economy. My proxy for the American real economy is real final private demand—or gross domestic product excluding trade, inventory accumulation and government consumption.

Real final private demand expanded at a 2.6% rate through the end of June, and 84% of prime-aged workers 25 to 54 were employed, which is a multidecade high.

Both of those figures suggest that, despite current volatility in financial markets, the U.S. economy continues to grow even as overall activity cools along with hiring and inflation.

The Institute for Supply Management’s services index in July showed an increase in overall sentiment and hiring in the service sector, which to a certain extent refutes the idea that the U.S is about to or already has fallen into recession. This data should help assuage the panic taking place on Monday across global financial markets that began in the early session across Asia.

The carry trade is a complex element of global financial markets that will not be quickly unwound, and one should be careful about the condition of Japanese banks and the impact on global financial markets as yields on Japanese government bonds rise from their decades-long slumber.

The end of easy money and historically low interest rates is part of the regime change taking place across the international economy.

The current turmoil is likely not the end, with volatility likely in other sectors as well, including private credit, commodities and oil.