Have you ever thought, “What a boring month this has been”? Fortunately, July was far from being classified as such. We could even title this month “The Return of Volatility,” as the carry unwind created some notable movements in the market. In other words, do you see the performance of JPY and CHF? That’s what is causing the risk assets to decline. We’ll delve into that in a moment.

As we mark the second anniversary of this newsletter, I want to take a moment to reflect on this journey, and celebrate the milestones reached so far. What began in July 2022 as a modest effort to keep track of my market thoughts, has grown into something far more significant: it’s not just a newsletter anymore; it’s become a valuable resource for macroeconomic analysis and a trusted reference for many of you.

Looking to the past Portfolio Updates, what is very clear to me is that in these two years, the depth and sophistication of the analysis have evolved at an astonishing pace. Initially, my insights were rudimentary, but the pressure of delivering value to an increasingly professional readership, coupled with the invaluable feedback and perspectives shared by friends on Twitter, has catalyzed an exponential growth in both my knowledge, and the newsletter’s content.

Each Portfolio Update reflects a growing depth of understanding and a more nuanced perspective, and it’s been only possible because of the high standards you hold.

I am very grateful for the role that you and the broader community have played in this evolution: thank you for the ongoing support, and for challenging me to improve every day.

Here’s to the next chapter.

United States

As usual, let’s start with the United States. On Wednesday, three days ago, the Fed decided to leave rates unchanged at 5.25-5.50% once again.

The statement now says that the Committee is attentive to risks on both sides of its mandate, which is quite a change from June’s “highly attentive” to inflation risks. The statement also mentioned there has been “some further progress” towards its inflation goal, whereas in June it said there had been “modest” progress. And it now states that risks to achieving its employment and inflation goals continue to move into better balance, whereas in June it said it was moving “towards” better balance. However, the Fed reiterated that it does not expect it will be appropriate to lower rates until it has gained greater confidence that inflation is moving sustainably towards the target, suggesting that the Committee still wants to see favorable data before pivoting to rate cuts. This last point is why my initial reading of the statement was a solid “no cut in September” (link), although the presser quickly confirmed otherwise.

Indeed, later at the presser, Powell revealed that there was a real discussion about the case for reducing rates at this meeting, even though he later said that “overwhelmingly” policymakers felt it was not the time yet. Powell also noted that the policy rate is clearly restrictive, and it is coming to the point where it will be appropriate to start rate cuts and dial back restrictions to support the continued progress of the economy.

Interestingly, he also added that the Fed doesn’t need to be 100% focused on inflation given that upside risks to prices have decreased while downside risks to the employment mandate are real now. In other words, Powell reads my Twitter account: “Under the current regime, growth and the labor market are more important than inflation. And for both, the risk is skewed to the downside.” (link)

He also added, of course, that the Fed is balancing the risk of going too soon against going too late, and I would argue it’s better to be slightly late than too early. Regardless, when asked about the prospects of a 50bps rate cut, Powell said it was not something the Fed was considering right now.

Now, you need to understand that the Fed’s modus operandi is very predictable, as long as you listen to them: aside from some extraordinary cases (e.g., bank failures in 2023), they literally tell you what they are going to do and then follow those plans. This is a little secret that people who follow central banks very closely, like me, don’t want to tell you. Knowing this, and seeing what happened at the FOMC, you’d expect traders to price in between 25 and 75bps of cuts by the end of 2024.

Of course, this is not the case.

As of now, traders are pricing a 70.5% chance of the Fed cutting 50bps in September already—and this is crazy given Powell literally said he’s not going to cut 50bps at the presser. But what’s outstanding is the pricing for December: 11.8% for a 150bps cut, 45.9% for a 125bps cut, and 34.9% for a 100bps cut. In other words, the market is pricing a 92.6% chance that the Fed will cut at least 100bps this year. Knowing there are just three more Fed meetings in 2024, this implies a scenario where the Fed cuts 50bps in September, followed by two additional 25bps cuts in subsequent meetings.

I’m sorry, but barring an apocalypse or extreme economic deterioration, this is pure fantasy, and I’m taking the other side of the bet without even thinking about it.

For this pricing to make sense, a severe recession is needed. Yes, this is the third consecutive year the recession narrative comes back, but maybe the third time’s the charm? I honestly don’t think so.

Slowdown? Yes. Recession? No. But we’ve been saying it in this newsletter for a while now: Q2 and Q3 were expected to be slower. In the US, consumer spending accounts for about 70% of the overall metric, and real retail sales have been slowing down for a while, with four out of five of this year’s releases showing negative YoY growth rates. The implications are obvious: consumption leads employment (and corporate earnings), and the lower the consumption, the higher the unemployment.

However, despite the current panic, my argument is that this situation is temporary, for a few reasons. First of all, long-term interest rates are falling amid the flight-to-safety, with the 10Y and the 30Y down 70bps and 54bps, respectively, since July’s high. This decline, which just extends the drop that started in late April, will likely translate to more housing activity: housing permits and starts will stabilize, and eventually, so will units under construction, which is expected to happen in late Q3. If anything, this is positive for growth. Then, if we add to the picture the statistical distortions currently reflected in the unemployment rate, it’s easy to see why I don’t really buy the recession narrative.

I said it recently (link), and I’ll say it again: the declining growth trade was two months ago, not now. On top of that, don’t you think that if the currently priced scenario were realistic, credit spreads would be higher?

Europe

In the previous Portfolio Update, we were left with the French elections yet to happen, and European equities falling hard. If you remember, my argument was that equities were pricing in a political risk that didn’t actually exist, leading me to go long. This prediction largely came true: the political risk did not materialize, and for most of this month, European equities, particularly French banks, rallied. However, this rally was short-lived. Indeed, as soon as the market began pricing in a BoJ rate hike, equities worldwide started to decline, including European ones.

Regardless, this month we also had the ECB meeting, where they chose to maintain current rates after the 25bps reduction in June. As I suggested in April’s Portfolio Update, “the ECB may opt for a different approach, where rate cuts could be followed by periods of pause”. In their policy statement, the Governing Council reaffirmed their commitment to keeping policy rates sufficiently restrictive to achieve their goals, emphasizing a data-dependent approach without pre-committing to a specific policy path. During the follow-up press conference, Lagarde highlighted that the discussion was balanced, and the ultimate decision was unanimous.

She also stressed that the ECB is data-dependent but not specifically data point-dependent. This choice of words, echoed by Powell last week, emphasizes that we shouldn’t focus too much on a single print, but rather on the trend. Remember: monetary policy is not supposed to be predictive, but reactive.

Looking ahead, Lagarde suggested that the September meeting is “wide open.” Current market pricing indicates 70bps of cuts, translating to 25bps cuts in September, October, and December. However, I caution against assuming this will actually happen. The Eurozone is not in a recession, so it is misguided to expect the ECB to follow a traditional recessionary playbook. Additionally, Bloomberg reported that ECB officials are considering if only one more cut is feasible in 2024, and with lingering inflation pressures, officials are less confident about the likelihood of two further cuts.

In summary, do not assume that the ECB will cut rates in September, and certainly not that it will cut three times this year.

United Kingdom

In July, the BoE joined the party and cut rates for the first time since March 2020 to 5.00% from 5.25%. The decision to ease policy was made via a 5-4 vote, with dissent from Pill, Greene, Mann, and Haskel. Notably, some members who opted to cut rates viewed the decision as “finely balanced”, while also observing that “inflationary persistence had not yet conclusively dissipated, and there remained some upside risks to the outlook”. For the dissenters, they preferred to keep policy steady, wanting stronger evidence that upward pressures on inflation would not materialize.

In terms of guidance, the MPC emphasized that rates must remain restrictive for sufficiently long until risks to inflation returning to target had dissipated further. Alongside the statement, Bailey stated that policymakers need to be careful not to cut rates too quickly or by too much. The accompanying MPR showed that 1, 2, and 3-year ahead inflation forecasts were revised lower, with the 3-year projection at just 1.5%, implying there is further scope for the MPC to lower rates.

At the follow-up press conference, Bailey was tight-lipped about the path of rates or commenting on the market curve, and his main takeaway was stressing the upside risks to inflation and the cautious approach taken by the MPC. Overall, despite an initial dovish repricing in the wake of the announcement, the lack of signals for further reductions saw BoE pricing move in a hawkish direction.

While there was some surprise regarding the decision, I believe it makes perfect sense. Look at it this way: if they hadn’t made the cut now, it would have been September, and it September was almost a given, then why delay? Inflation is not expected to decline significantly further, but it’s also unlikely to surge above 3% anytime soon. And with the ECB having cut rates already, and the Fed ready to follow soon, cutting seems relatively low-risk.

Overall, this doesn’t change much. Another cut in September seems unlikely, shifting the focus to November, which will largely depend on the government’s first budget announcement on October 30th. The key takeaway is that with rates actually coming down, even if this doesn’t immediately impact mortgage rates, it could still boost overall market sentiment. And with inflation no longer a pressing UK-specific issue and the potential for further rate cuts ahead, there’s a solid case for a bullish outlook on valuations.

Japan

It finally happened: the yen stopped depreciating so much and so fast. One might think that the reason for this is just rate differentials, but that would be a gross underestimation of the drivers at play for this currency. Indeed, JPY pairs have been quite indifferent to rate differentials for a while now.

What really happened, and had incredible consequences for all risk assets worldwide, is that the carry trade has to be unwound now.

Let’s start from the basics. To oversimplify, when you hold a long position in a currency, you earn the currency’s central bank interest rate. Conversely, when you hold a short position in a currency, you pay that currency’s central bank interest rate. If you go long on a currency with a high interest rate and short on a currency with a low interest rate, that net difference is your profit. Essentially, this is the carry trade. These kinds of trades, which are heavily one-sided, tend to be self-reinforcing when they reverse: exiting them requires buying back the previously-borrowed currency and selling other assets, which strengthens that currency further and forces more selling in other markets.

In 2022, most of the world exited the low interest rate environment and began hiking rates. However, one central bank was a clear outlier: the Bank of Japan. As interest rates in other G10 countries started to rise, it became increasingly profitable to borrow in JPY at negative interest rates (i.e., you were effectively getting paid to borrow yen) and buy other currencies, mostly dollars, to invest in risk assets: not only were you gaining from asset price appreciation, but you also got paid on both sides of the carry trade. As you can imagine, a significant portion of the equity market movements over the past two years was funded this way.

In April, the BoJ hiked rates for the first time in a while, bringing the interest rate to 0.00%. While this reduced the profitability of the carry trade, you were still borrowing yen for free and getting paid to buy other currencies. However, as the market expected other central banks to cut rates soon, the BoJ’s hint at a new hike in July, followed by the actual hike, shook the markets. The leverage funded through this process had to be taken out quickly—in other words, a rapid de-grossing.

As the carry trade unwinds, traders have to sell their positions, which means they need to buy yen and sell dollars. Guess what happened? The yen appreciated substantially, and the dollar declined. These dollars were used to buy assets, mostly stocks. Guess what happened? Stocks have been going down since. The issue is that with assets declining and uncertainty rising, you have to park your money somewhere but don’t want to hold risk. So, you buy money market instruments. Guess what happened? The price of these instruments surged so much this week that the implied rate curve stopped making any sense, as I explained in the previous sections.

In other words, I believe the price action characterizing this month in global markets has nothing to do with expectations on rates or growth; rather, it’s 100% about adapting to the fact that the cheapest way of borrowing money is not as profitable as before. You may disagree, but the outcome would be the same: short the spikes in G10 STIR and enjoy the ride.