Monday’s market rout is a painful but fundamentally healthy correction
The global stock market rout intensified on Monday. Japan led the correction, with the Nikkei 225 index dropping by 12.4 percent—the sharpest one-day decline since the 1987 Black Monday selloff. US equity markets have fallen substantially, too—in particular, the Nasdaq composite has fallen by 13 percent since last month’s peak. European markets, which had lagged behind in the market run-up, have declined less.
What accounts for this market correction? The most important factor has been the perception that the US Federal Reserve is behind the curve, having missed the opportunity to cut the federal funds rate in last week’s Federal Open Market Committee (FOMC) meeting. This perception was reinforced by weaker than expected employment numbers on August 2. Nonfarm payrolls increased by only 114,000 in July, and the unemployment rate rose to 4.3 percent from 4.1 percent in June. The fact that the unemployment rate (on a three-month moving-average basis) has risen by more than 0.5 percentage points from its low of 3.5 percent in July 2023 has heightened fears of an imminent recession, according to the so-called Sahm rule. As a consequence, market interest rates declined substantially with two-year US Treasury yields falling to 3.8 percent, causing the gap against the effective federal funds rate of 5.3 percent to widen the most since the global financial crisis in 2008. Furthermore, the federal funds rate is also far above the policy rate of 3.95 percent, according to the Taylor Rule (developed by economist John Taylor in 1993 to calculate what the federal funds rate should be given current economic conditions). These gaps appear to validate the view that the Federal Reserve is behind the curve.
Having painted itself into this corner, there are no good options for the Federal Reserve going forward. Waiting until the September FOMC meeting to start cutting rates—as implied by the July meeting—could risk having additional weak economic data prolong the market selloff, undermining business and consumer confidence and hurting economic activity. Implementing a rate cut before September could send the message that things are not well, triggering worse fears among investors. Cutting by fifty basis points—instead of the traditional pace of cutting twenty-five basis points per meeting—would also confirm that the Federal Reserve has been wrong in delaying easing for too long. On balance, using the September meeting with more data to make an appropriate cut—of fifty basis points, if necessary—would be the least bad option, minimizing the risk of the Federal Reserve inadvertently feeding into the present market panic.
This “September fifty” option seems to be supported by a close look at the overall economic conditions. The July employment data could be distorted to some extent by Hurricane Beryl and problematic seasonal adjustment factors. The increase in the unemployment rate was caused by a rise in the number of workers entering or reentering the labor force—the prime-age (twenty-five to fifty-four years) labor force participation rate surged to 84 percent—and not by a decline in employment. Furthermore, the Purchasing Managers Index for the important services sector recovered to 51.4 in July from 48.8 in June. In fact, the Federal Reserve Bank of St. Louis gross domestic product “nowcast model” estimates 2.54 percent growth in the third quarter, accelerating from the 1.14 percent pace in the second quarter. Weakening employment numbers warrant close attention to growth prospects, but a recession is yet to become the base case scenario.
Moreover, the global market selloff has also been driven by the normalization of outsized expectations for the high-tech sector and one-way betting for low Japanese interest rates and yen exchange rates. It could, therefore, be regarded as fundamentally healthy. For example, the US “magnificent seven” high-tech stocks, including Nvidia and Apple, have accounted for most of the market price gains over the past year or so, significantly stretching their market valuations. Their recent disappointing earnings reports have triggered the correction, shedding nine hundred billion dollars in market value.
In the case of Japan, investors have expected interest rates to remain low compared to the United States and for the yen to be weak against the dollar. Consequently, investors have borrowed substantially in yen to put on carry trades—investing in higher-yielding bonds, including in the United States and emerging markets. As the Bank of Japan hiked policy rates to 0.25 percent last week—for the second time since 2007—and outlined a plan to unwind its massive bond purchase program, the yen has strengthened by 10.5 percent against the dollar from its thirty-eight-year low of 166.99 yen/dollar in June. The appreciation of the yen has been magnified by short covering on the part of carry-trade investors—and this is expected to go on for some time given the estimated huge carry-trade positions, underpinning the yen in foreign exchange markets. A stronger yen would reduce the profits reported by many Japanese corporations, many of which rely on overseas markets for their profits, negatively impacting Japanese stock markets. To a lesser extent, the renminbi has also recovered to a seven-month high of 7.13 yuan/dollar due to short-covering of yuan-based carry trades.
On balance, the sharp equity market selloff may be painful to investors, but it could turn out to be a timely and healthy correction. Meanwhile, it is important that the Federal Reserve uses its long-planned review of its monetary policy operating framework to learn from its recent mistakes. (It has been behind the curve twice: keeping the federal funds rate too low for too long in 2022, and too high for too long now.) Going forward, the Federal Reserve must adopt a forward-looking policy framework instead of being fixated on current economic data.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s Geoeconomics Center, a former executive managing director at the Institute of International Finance and a former deputy director at the International Monetary Fund.
Data visualization created by Alisha Chhangani.
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