Last week saw a global market sell-off, with risk aversion driving significant losses across equity markets worldwide. As Wall Street braces for another challenging week and substantial losses, concerns about a rapidly slowing U.S. economy are intensifying.

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Japan's Nikkei index entered bear market territory, plummeting 13% - its worst performance since the October 1987 "Black Monday" crash. Panic has gripped the markets, and the term "recession" is on everyone's lips. The fear index (VIX) has surged over 100%, exceeding 50 - its highest level since the COVID-19 outbreak.

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Source: Tradingview

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Catastrophic Jobs Report Shocks Market

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The U.S. non-farm payrolls report for July revealed a growth of only 114,000 jobs, significantly missing the expected 175,000 and marking a sharp decline from June's downward-revised figure of 206,000. The unemployment rate rose to 4.3%, up from the expected 4.1%, contributing to a further bull steepening of the yield curve, characterized by lower front-end yields and steeper curves.

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This unexpected "growth scare" has heightened fears of a potential "Fed policy error," with the market now pricing in the possibility of emergency rate cuts between meetings.

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BOJ Curve Flattening and USDJPY Unwind

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For the first time in years, the Bank of Japan (BOJ) raised interest rates by 0.25%, hinting at potential future hikes. This move led to aggressive flattening of the Japanese 2s10s curve, signaling that the hikes were perceived as restrictive for growth and inflation, negatively impacting Japanese equities.

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Consequently, the Japanese yen appreciated against the U.S. dollar, triggering a chain reaction. Investors were forced to reverse their positions, creating a negative feedback loop of selling and further unwinding. As U.S. economic data disappointed, investors flocked to the yen as a safe haven, exacerbating its rise and disrupting market positions globally.

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Source: Bloomberg, Zerohedge

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1) The Sahm Rule Triggered

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Google Trends indicates a surge in interest in the 'Sahm Rule' following Friday’s disappointing jobs report.

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Source: Google Trends

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Developed by economist Claudia Sahm, this rule signals a recession when the three-month moving average of the U.S. unemployment rate rises by 0.5 percentage points or more from its low in the previous 12 months. With July's unemployment rate increase to 4.3%, the Sahm Rule has been triggered, a precursor to every U.S. recession since 1950.

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Source: BofA Global Investment Strategy

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So, does this mean a recession is imminent? Maybe. However, this indicator joins a growing list of recessionary warning signs.

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2) Yield Curve Inversion Begins to Disappear

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Source: Fred

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When examining the yield curve as a recession countdown, the media often misinterpret the signal, assuming a recession should immediately follow an inversion, which started 25 months ago. However, the inversion itself does not indicate a recession. Aggressive rate hikes by central banks cause the yield curve to invert, signaling tight financial conditions. The curve remains inverted for a period, and only when these conditions persist do they become recessionary. Eventually, the economy slows, leading to late-cycle yield curve bull steepening. Historically, the yield curve steepens just before or during each recession, as growth slows and the Fed is compelled to cut rates.

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The inversion serves as the "warning sign," while the steepening marks the onset of a recession. The initial inversion isn't the signal; it's when the curves un-invert that a recession is approaching, as the Federal Reserve cuts rates rapidly, causing the short end of the yield curve to fall faster than the long end.

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Where do we stand today? We're now at month 25 post-inversion, the economy has slowed, and a rapid bull steepening of the yield curve is occurring, with the market even pricing in the chance of an emergency Fed intermeeting cut. The second half of 2024 could be challenging, with markets pricing in a 78% chance that the Federal Reserve will not only cut rates in September but ease by a full 50 basis points.

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3) Alquant Vega Indicator Signals Risk Since Mid-July

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The Vega indicator, a volatility-based indicator launched by Alquant in October 2018, analyzes the dynamics of various volatility indices. It focuses on the relative evolution of these indices to determine whether their movements indicate underlying panic in relation to the expected short-term market evolution.

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The Vega indicator is particularly effective during periods of genuine market panic, leading to frenetic selling and exceptionally low daily stock returns.

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Since mid-July, the Vega indicator has been signaling increased risk, with early signs of volatility cracks appearing on July 15, when equity indices were at all-time highs. Over the following weeks, the signal intensified, indicating higher near-term volatility. At Alquant, we use the Vega indicator to adopt a risk-off stance and reduce exposure to risky assets.

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As of August 2, utilizing the Vega indicator for the S&P 500 has helped reduce drawdowns by 3%.

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Source: Alquant

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Given its high reactivity, the indicator can also be used to manage exposure to short volatility. Below is a use case with the SVIX ETF (-1x Short VIX Future with 30 days maturity). Using Vega reduced drawdowns by nearly 70%, from -39% to -12% as of August 2, not including a pre-market drop of more than 30% at the time of writing. For an asset that typically exhibits "go up the stairs and go down the elevator" behavior, incorporating Vega can be very valuable for preserving invested capital.

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Source: Alquant

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At Alquant, we offer several investment products that incorporate a range of indicators and follow a strict, rule-based approach. Contact us if you'd like to learn more. You can also explore some of our indicators on our Prisma Platform.

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Disclaimer

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‍This content is advertising material. This content as well as all information displayed on any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.