Charts of the Week: Summer Storms

Financial market volatility in Japan and the US The recent wave of global financial instability can be seen in a number of markets but the sharp spike higher in equity market volatility offers some neat context. Japan’s volatility gauge, for example, bolted up to multi-decade highs on August 5th while the US gauge (the VIX index) rose to its highest level since the onset of the pandemic in mid-March 2020.

The US economy and the Fed Last week’s disappointing US employment report and the recession alarm bells that this report has triggered was one of the catalysts for this instability. That said, prior to that report there had been a steady drumbeat of weaker than expected US data over the previous two to three months. As chart 2 below equally suggests the Fed may have been a little slow to respond to this unexpected weakness. Financial markets are certainly now anticipating a steeper decline in policy rates by the Fed over the next couple of years.

The BoJ and the carry trade While the US dataflow and Fed policy have been influential the role of the Bank of Japan in this saga should not be understated. Last week’s decision by the BoJ to lift its policy rate, which was unexpected by many market participants, has narrowed interest rate differentials with other major economies and the US in particular (chart 3). And that in turn has had ramifications for the so-called carry trades where investors borrow in yen and invest in higher yielding assets in overseas markets. The profitability of this trade has certainly now declined and that’s had reverberations for global financial flows as Japanese investors have repatriated their funds. Against that backdrop more recent remarks from BoJ Deputy Governor Uchida about potentially delaying any further normalization in Japan’s monetary policy has perhaps understandably been welcomed by investors.

US technology companies and equity markets Also worthy of some mention is technology. There has, as chart 4 below indicates, been much optimism in financial markets about the profitability and broader productivity-related benefits that might stem from investing in and harnessing Artificial Intelligence. And that optimism had been reflected in somewhat lofty valuations for many large technology companies. These narratives, however, are now being more actively challenged in financial markets. And if these challenges now morph into more deep-seated concerns, this could generate negative spillovers for the world economy.

US banking conditions and financial balances That said the feedback loops between financial conditions and the real economy may not be that big. Private sector financial imbalances in the US economy, for example, are not that acute. It’s been notable this week too that the latest survey of US Senior Loan Officers from the Fed did not suggest any material pressure on households or companies to further deleverage balance sheets (see chart 5).

Supply chain pressures and monetary policy Finally, it may also be worth bearing in mind that other recession forces are not as acute at present as they were two to three years ago. Monetary policy has already been pulled into the restrictive zone and is now moving to more accommodative territory in many major economies. With inflationary pressures subsiding there is also scope for further easing in the period ahead. The supply side pressures that were doing so much to generate inflation, in the meantime, have also normalized (see chart 6).