Recession of Reverse Carry Trade? Who dominants the market?

U.S. stocks experienced a "big fall rebound" on Monday, further bringing this discussion to investors - whether the U.S. economy is "starting to slow down" or "in recession"."into recession"?

Some of the recession predictors have already been triggered in terms of economic data, but due to the unique nature of the current economic cycle, it is also not possible to simply apply historical experience.

What is a recession?

An Economic Recession is a severe, widespread and prolonged downturn in economic activity.The U.S. National Bureau of Economic Research (NBER) considers the depth (depth), breadth (diffusion) and duration (duration) dimensions of economic activity when identifying a recession.Specific indicators examined include:

• Real personal income after transfers

• Non-farm employment

• Household Survey Employment

• Real personal consumption expenditures

• Real Manufacturing and Trade Sales

• Industrial Output

According to these indicators, the current U.S. economy is closer to a growth slowdown than a recession.That is, it is still in a growth phase, just at a slower pace.The specific performance is as follows:

• INCOME AND CONSUMPTION: The year-over-year growth rate of disposable personal income slowed slightly from 4.0% at the beginning of the year to 3.6% in June, while the year-over-year growth rate of personal consumption expenditures rose from 1.9% to 2.6%, both of which remained relatively stable.

• Employment: The job market is still growing, despite the lower-than-expected 114,000 new non-farm payrolls in July.

• PRODUCTION: Industrial output grew at a 1.6% year-over-year rate, showing some improvement.

Some indicators pointing to recession

To predict a recession, the market usually refers to the following indicators:

• GDP growth: Two consecutive quarters of negative GDP growth is usually considered a "technical recession".However, real GDP in the second quarter of 2024 was 2.8% YoY, which is higher than market expectations and does not meet the definition of a technical recession.

• U.S. Bond Yield Curve: the current inversion of the yield curve has persisted for almost two years, that is because the Federal Reserve has been keeping interest rates higher, and as expectations of interest rate cuts intensify, yields at the short end are expected to fall, thus easing the inversion.However, private sector investment remains resilient and has not contracted significantly.

• Sahm Rule: When the three-month moving average of the unemployment rate rises by 0.50 percentage points or more relative to the previous 12-month low, it indicates that a recession is about to begin.The current lift in the unemployment rate has triggered the Sahm Rule, but with the combination of high growth + low inflation, the value is still unstable at this point and the rule may be invalidated.

  

Factors that could lead to a recession

Historically, the U.S. has experienced 18 rounds of recession, and the main triggers include:

• Monetary tightening: the Fed's sharp interest rate hikes could lead to an economic slowdown or even recession.The current Fed rate hike cycle is nearing its end, and the market expects a possible rate cut in September.

• Fiscal Spending Cuts: Significant cuts in government fiscal spending could lead to an economic slowdown.Fiscal spending cuts are currently limited, with the IMF projecting the U.S. structural deficit rate to remain close to 6.7% in 2024.

• High leverage: High leverage levels could lead to financial systemic risks.Current private sector leverage is relatively healthy.

• Stock market crash: A sharp fall in the stock market could trigger a recession.The current stock market is volatile, but there is no systemic risk.

• External shocks: e.g., international trade disputes, geopolitical risks, etc. could lead to a recession.The risk of external shocks is currently manageable.

Impact of reversal of Carry Trade

The yen has always been an important lending currency for Carry Trade due to its low interest rate, but recently, the reversal of Carry Trade has been mainly affected by the following factors:

1. Appreciation of the yen: the Bank of Japan to raise interest rates and reduce the size of asset purchases led to the appreciation of the yen, increasing the financing cost of the Carry Trade.

2. Expectations of U.S. economic slowdown: U.S. retail data and employment data fell short of expectations, triggering fears of recession, leading to the depreciation of the U.S. dollar and U.S. bond yields fell, further compression of the interest rate arbitrage trading revenue space.

   

   Changes in market sentiment: Risk aversion rose and investors closed out their positions in interest-hedging transactions, leading to increased market volatility.

As a result, there has also been a certain impact on market liquidity, which has been manifested in the form of significant market volatility, a sharp fall in asset prices, and an increase in financing costs.

• Losses on the asset side: for example, the fall in the prices of U.S. stocks and U.S. bonds led to a reduction in investors' returns on the asset side.

• Rising financing costs: the appreciation of the yen makes it more expensive to borrow yen.

• Market panic: investors have been selling assets in a panic, further exacerbating market volatility