Evaluating the Causes of Recent Market Volatility

We’re only human Measures of economic policy uncertainty have eclipsed the pandemic. The largest increases are due to trade policy uncertainty and where the US will end up with regard to tariffs. Why do we care? A top 10 list 1. A “wait and see” mentality emerges. Large, hard to reverse spending decisions by firms and households are put on hold. That acts as a drag or tax on economic activity. 2. Business investment feels the bulk of the effects and contracts. 3. Credit conditions tighten, especially for those most exposed to tariffs, which further constrains investment. Even firms with plans to invest can be hobbled. 4. The banking system becomes less stable. Loan defaults pick up as the economy slows. Consumer delinquencies are already on the rise. 5. Unemployment rises as growth slips to levels that no longer enable the economy to absorb those entering the labor force. What is unknown is whether that weakness will cause a further slowdown in wage growth given the stagflationary effects tariffs. Workers tend to demand compensation for the escalation in the cost of living due to tariffs. 6. Consumer spending skips a beat. Job losses confirm fears and and trigger a larger blow to aggregate incomes and spending. 7. Financial market volatility soars and asset prices fall. People lose retirement savings and feel poorer, companies can't raise money by selling stock and loan losses accelerate. Confidence among consumers and busineses further falters. 8. Monetary policy becomes less effective as fear prevents firms and consumers from reacting to stimulus once it starts. 9. Contagion. Foreign firms and governments perceive the US as an unreliable and less predictable partner. Supply chains are reconfigured to reduce their dependence on US markets. 10. If left unchecked, sustained periods of uncertainty can trigger a breakdown of economic and political systems. Five things can help mitigate and derail bouts of uncertainty from becoming a vicious global cycle: 1. Strong institutions. They create confidence that rules won’t arbitrarily change, and work to counter the “wait and see” behaviors that curb growth. The judiciary plays a key role. 2. Clear communications by the Fed. That and a lack of political interference tempers uncertainty regarding the trajectory of inflation. 3. Automatic fiscal stabilizers, which provide immediate, predictable government response without political gridlock that can worsen a crisis. 4. Well capitalized banks, which prevent larger credit crunches from taking root. 5. International cooperation, which limits contagion. Bottom line Bouts of uncertainty trigger fight or flight reactions. That has resulted in a toxic mix of panic and paralysis. Expect whiplash, as the surge in activity ahead of tariffs borrows from growth later in the year. As for national security, that could be shored up with a targeted & strategic approach to industrial policy. Break bread not ties when possible. Be kind; pay it forward.

I remain quite concerned with recent movements in #asset prices and am not mollified by the arguments that short-term trade position unwinding is the major motivator for what we see. Trade position unwinding of this type seems to be a relevant factor but we have seen such trade unwinding in other events and asset prices, in general, have not behaved like that. In light of recent market developments following President Trump's "Liberation Day" tariff decisions, I continue to entertain the view that financial markets are increasingly showing signs of more structural and lasting shifts. Notably, US Treasury #bonds, traditionally viewed as the ultimate #safe-haven asset, have been displaying behavior reminiscent of riskier #securities. Unlike previous episodes of global uncertainty—where Treasuries consistently rallied—recent days have seen simultaneous declines in Treasuries, equities, and other traditionally risky assets. This divergence from historical norms suggests some reassessment by global investors of the underlying safety and reliability of #US government #debt. If that continues, the implications of these movements extend well beyond short-term #volatility. Persistent fiscal deficits and unpredictable tariff policies are exacerbating doubts about the US's commitment to disciplined economic management, potentially undermining long-term investor confidence. Of that, I have no doubt. This erosion is reflected clearly in #Treasury #yields, particularly at longer maturities, and the noticeable retreat of foreign investors from US assets. Given the pivotal role US Treasuries play as global financial benchmarks and collateral, these structural shifts could indicate a more lasting recalibration of market sentiment and risk perceptions surrounding US debt and assets more broadly. How structural and deep this recalibration is I do not know. My bottom line for now: something more structural is happening in the market but I do not know the extent of it. As a wise man once said: when facts change, I change my point of view. So, nothing is written in stone.

The stock market experienced a significant correction last week, and that may have just been the beginning of the market carnage. Overnight, Nasdaq futures dropped as much as 6%. The crypto market is also experiencing its own crash. Theories abound about the causes of this market turmoil. Some suggest it’s due to the unraveling of the yen carry trade, others point to job figures and yield curves indicating recession risks, and then there are deep geopolitical concerns over the Iran/Israel situation. It is likely that the market reaction is a culmination of these events, each increasing the risk premium in equities. Individually, these factors might not have caused such a severe downturn, but their combined impact is quite potent. While most understand recession and geopolitical risks, the Japan carry trade is a bit more complex. In the spirit of learning, here’s a deeper look into the trade: Japanese interest rates have been historically low, creating an arbitrage opportunity where traders borrow yen at low rates and invest in higher-yielding assets abroad, such as U.S. Treasuries. Recently, however, inflation concerns led the Bank of Japan (BoJ) to raise interest rates. Meanwhile, U.S. rates have been decreasing, and further cuts by the Federal Reserve are anticipated. This effectively negates the arbitrage opportunity. The process unfolds as follows: Higher Japanese Interest Rates: Investors seek to close their carry trade positions. Selling Investments: To repay Japanese loans, investors sell off investments outside Japan. Increased Yen Demand: This drives up the value of the yen. Short Squeeze: Short sellers face pressure as the yen appreciates further. Global Margin Call: As asset prices fall and market volatility increases, lenders and brokers around the world may simultaneously demand additional collateral from borrowers, exacerbating market declines. In addition to the yen carry trade, the U.S. job market also plays a crucial role. Weak job and PMI figures last week signal are flashing recession, further impacting market confidence. Geopolitical risks, such as the Iran-Israel conflict, contribute to market volatility by potentially disrupting global trade and impacting oil prices, adding another layer of uncertainty. In summary, the current market correction appears to be the result of a convergence of these factors, each heightening the overall risk environment and contributing to the ongoing volatility. There will be a flight to safety that includes treasuries, precious metals, consumer staples and stable dividend stocks. Rotation will increase their prices. Cash is usually king, and it would be wise to have a good chunk on the sidelines to take advantage of opportunities that such market meltdown always provides.