Renewed Recession Fears Send Shockwaves through Global Markets

Global stock markets plunged on Friday after the US released disappointing jobs data, and the selloff continued on Monday. US and global bond yields also fell sharply, as bond markets priced in additional rate cuts in the near term. On Monday, the news sent shockwaves through Japanese markets, which were already reeling from the surging yen. Japan’s Nikkei 225 fell nearly 12.5% on Monday, pushing its recent losses above 25.0%, before rebounding 10.0% on Tuesday. By comparison, the S&P 500 is down almost 8% from its recent highs. (See table.) Volatility as measured by the VIX Index surged on Monday, briefly reaching its highest point since the start of the COVID-19 pandemic. On Tuesday morning, US stocks were reversing some of Monday’s losses, while European stocks were mostly flat.

These wild swings in the market appear to have been sparked by renewed fears of a US recession, which would have serious consequences for the global economy. As US yields fell and the Japanese yen kept rising, the unwinding of the so-called carry trade in which investors borrow at low interest rates in yen to invest in higher yielding currencies elsewhere caused a spike in volatility. According to Friday’s jobs report, the US unemployment rate rose to 4.3%, triggering the so-called Sahm rule (graph 1). This rule, created by American economist Claudia Sahm, states that when the 3-month moving average of the US unemployment rate is at least a half a percentage point higher than its 12-month low, a recession is already underway. After the Federal Reserve (Fed) held rates steady on Wednesday, investors are worried that US monetary policy is overly restrictive given current economic conditions. Some observers even called on the Fed to make an emergency rate cut before its September meeting or to cut by at least 50 basis points when it does meet. But indicators like the Sahm rule that are based on historical observations have important limitations. In a recent interview, Claudia Sahm even said the rule may not apply in the current circumstances. While the signal is concerning, we don’t believe the US is in the early stages of a recession.

Equity markets have been reacting positively for months to falling government bond yields, but the positive stock–bond correlation has completely reversed in recent days. Investors now seem to think that even drastic interest rate cuts may not be enough to keep the economy and earnings on track. Elevated US stock valuations are also behind the market selloff, as the S&P 500’s average price-to-earnings ratio is near a record high (graph 2). Buoyed by the recent enthusiasm for artificial intelligence, the S&P 500 has become increasingly concentrated in a small number of technology companies, whose earnings were not as strong as some analysts had anticipated. Many commodity prices and most cryptocurrencies are trading lower as well. The price of West Texas Intermediate is down more than US$5.00 per barrel since the start of the month.

Losses have been especially deep on the Japanese stock market, which has also been rocked by US recession fears as well as a surging yen. Japan’s currency is up nearly 12%, from more than ¥161/US$ to ¥144/US$. While the yen often rises alongside risk aversion, its current ascent has been amplified by its recent weakness (graph 3). The Bank of Japan also increased its policy rate to 0.25% and shifted to a more hawkish tone, indicating it will continue to make its policy more restrictive. A strong yen will hurt the competitiveness of Japanese companies amid already tepid global demand. European and Canadian stocks were also down, but not as much. The Canadian stock market was closed on Monday, so it avoided the worst of the volatility. But it was down more than 1.5% on Tuesday morning.

Recent economic data and market reaction will greatly complicate the work of central banks. Markets are already pricing in a nearly 50 basis points cut by the Fed in September—up from 25 basis points a week ago. Market pressure could also ramp up the political pressure given that the US is in the midst of a presidential election. Both the election and escalating tensions in the Middle East could mean more market volatility as well. The S&P 500 is especially vulnerable given its high stock prices, and a correction seems likely if economic data continues to disappoint. Financial stress and risk aversion can make restrictive monetary policy even more painful, putting the brakes on the economy. That’s why central bankers need to pay attention to recent market movements and be ready to respond forcefully if needed—a tall order when inflation remains a risk. Recent news has removed any remaining doubt that the Fed will begin cutting interest rates in September. But we continue to believe the US economy will avoid a recession. That said, we’ll need more information before we know whether an outsized cut is in order.