Financial markets remain jittery after a massive sell-off on Monday as analysts identify a “yo-yo pattern” of volatility across the world.
What caused this week’s rout?
Monday’s meltdown was triggered by two main factors.
Markets were initially spooked last Wednesday when Japan’s central bank raised interest rates. Although relatively small, it was only the second increase since 2007 and drove up the yen, forcing investors to rapidly unwind their carry trades – which involve borrowing in a low-interest-rate country to fund investments in higher-returning assets elsewhere.
Then last Friday, fears of a US recession surfaced in the wake of weaker-than-expected jobs data showing one of the weakest months for non-farm payroll growth since the Covid-19 pandemic.
Traders since piled into bets that the Federal Reserve will have to aggressively ease monetary policy to stave off a downturn in the world’s largest economy.
The VIX index, a so-called “fear gauge” measuring US stock market volatility, hit its highest level since the start of the Covid-19 pandemic in 2020.
Meanwhile, investor sentiment around US tech stocks has dampened due to their high valuations and worries that artificial intelligence has become over-hyped.
Expectations of an attack on Israel by Iran following the assassinations of Hezbollah and Hamas officials have brought up further risks.
Where are we now?
Markets have simmered down since Monday’s sell-off. In the US, Institute for Supply Management data showed a rebound in services sector activity in July from a four-year low.
Elsewhere, deputy governor of the Bank of Japan Shinichi Uchida played down the chance of another rate hike in the near term while markets are unstable.
But few analysts have gone so far as to argue the market has bottomed out, with investors remaining cautious and looking for further clues on the US economy.
The FTSE 100 dropped as much as 1.2 per cent on Thursday in a sign that the UK market remains nervous. The fall came after JP Morgan raised the likelihood of a US recession this year to 35 per cent from 25 per cent, with 45 per cent odds that it will come by the second half of next year.
New figures on US unemployment benefit claims last week published this afternoon were therefore in sharp focus as investors hunt for clues on the trajectory of the economy.
The data showed slightly fewer new claims than economists had expected, easing fears of a recession. UK and European markets immediately pared some of their losses made earlier in the day.
What about the UK?
JP Morgan warned on Thursday that around a quarter of the global carry trades that partly caused the recent mayhem have not unwound, meaning further risks if the yen grows stronger.
Matt Britzman, senior equity analyst at Hargreaves Lansdown, said global markets had settled “into a yo-yo pattern as volatility remains high”.
The pound is set to post its fourth straight weekly decline after falling 0.9 per cent against the dollar since Monday, which would mark its longest losing streak in nearly a year.
Still, the FTSE 100 has proven more resilient than New York’s S&P 500 in recent days. Unlike most other peers, the London’s blue-chip index remains comfortably above its 200-day simple moving average, a metric used by traders to determine long-term market trends.
Russ Mould, investment director at AJ Bell, said the lower volatility was because the UK market is cheaper and earnings expectations are lower. The S&P 500 has gained 78 per cent over the last five years, compared to just 11 per cent for the FTSE 100.
“The UK is also less exposed to the most heady, and potentially expensive, parts of the US market such as AI, semiconductors and technology,” Mould added.
“That might help the UK if things get tough, but if the world’s biggest economy does go into recession, that could make it harder for UK equities to make much progress – pending any policies that are outlined by either the new government or the Bank of England.”
Uncertainty remains over the Bank’s interest rate path after it lowered borrowing costs for the first time since March 2020 late last month.
The Fed is considered a trendsetter in Western monetary policy, with money markets pricing in a 63 per cent chance that it will cut rates at its next meeting in September to avoid a recession.
Meanwhile, markets are giving a 48 per cent chance that the Bank of England will make a 0.25 percentage point cut next month.
“Will the Fed back away from interest rate cuts to avoid further cutting the dollar-yen rate differential and further provoking yen-dollar volatility?” Mould said. “Or will that box in the US central bank just at a time when recession worries are gathering Stateside?”