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By Cboe

In the most recent Federal Reserve Open Market Committee (FOMC) meeting at the end of July, the committee decided to maintain the target range for the federal funds rate at 5.25% to 5.50% and to continue reducing their securities holdings.

An Economy In Flux

Though the FOMC cited recent signs of an improving economy as the basis for its policy decision, the release of the July 2024 jobs report on Friday, August 2nd, upended market sentiment. As detailed in the report, U.S. employers added just 114,000 jobs in July – 35% fewer than expected – and unemployment, now at 4.3%, is the highest since October 2021. This incoming data initiated many conversations about the Sahm rule, which posits that if the jobless rate, based on a three-month average, is a half percentage point above its lowest point over the previous 12 months, the economy has tipped into a recession. Friday’s jobs report technically meets the Sahm rule's criteria. The jobless rate in July rose from 4.1% to 4.3%, ticking the three-month average more than a half point above the 3.6% average one year ago.

Against this backdrop, the sell-off on Friday was driven by the belief that the FOMC has delayed in reducing rates and a recession is nearing. Interestingly enough, Claudia Sahm, the economist for whom the Sahm rule was named, wrote in a recent post that clarified the interpretation of the statistic, stating, “A recession is not imminent, but the risks of a recession have risen.”

The Interconnectedness Of Markets: The Japan Carry Trade Effect

While the jobs report shifted market sentiment on Friday, the Bank of Japan's recent action to raise its benchmark rate from 0.10% to 0.25% was part of the impetus for the drawdown in U.S. equity markets on Monday. How was this possible? Because of the yen carry trade.

Macroeconomic conditions determining the relationship between Japan and the United States have shifted. Since early 2023, the Federal Reserve has increased interest rates, while the Bank of Japan has kept its rates close to zero. This difference made the yen less attractive, allowing investors to borrow cheaply in yen and invest in higher-yield assets, such as U.S. equities – particularly “Magnificent Seven” companies. This practice, known as the carry trade, pushed the yen's value down further. A weaker yen boosted the earnings of Japan's export-driven companies as their foreign earnings became more valuable in yen.

With the Bank of Japan enacting tighter monetary policy, traders are forced to close their positions due to the appreciation of the yen; causing a sharp market decline. Japan's stock market, led by export-oriented companies, has been particularly affected, as these companies benefited from a weaker yen both through competitive pricing and higher reported earnings from abroad.

The Possibility Of Future Rate Cuts

While many market participants and individuals have been calling for a rate cut, recent occurrences have raised the decibel level of those voices. In the press conference following the recent FOMC meeting, Federal Reserve chair Jerome Powell signaled the possibility of a rate cut by stating, “A rate cut could be on the table in the September meeting.” However, Powell also tempered expectations by saying he “can imagine a scenario in which there would be everywhere from zero cuts to several cuts” over the remainder of the year, “depending on the way the economy evolves.”

With the adverse change in market sentiment and Monday’s U.S. equity drawdown, Chicago Federal Reserve President Austan Goolsbee intimated that the Federal Reserve would react to signs of economic weakness and indicated that interest rates could be too restrictive now. Based on the CME Group’s FedWatch, there is a growing probabilistic belief that a rate cut will occur in FOMC’s September 2024 meeting.

Managing Volatility Stemming From Uncertainty

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Much uncertainty remains in the current U.S. economic landscape, with potential developments on the horizon capable of shifting market sentiment either way. Index options can provide investors with the tools to mitigate or capitalize on volatility stemming from uncertainty for the benefit of their portfolio.

Featured photo by Etienne Martin on Unsplash.

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