arsonists and firefighters

The first Japanese interest rate hike in decades touched off a monetary earthquake that shook markets in August as traders raced to repay Yen loans by liquidating dollar-denominated assets all around the world. Beginning in late July, the increasingly frantic unwinding of this Yen “carry trade” created a classic Crisis Sequence in the VIX which led to timely long volatility exposures that helped TCM Risk Managed Indexing portfolios (Tactical Beta +2.9% Aug) sidestep the most intense phase of the “mini crisis” between August 2 - 5 (chart).

*Return comparison, Nov 2023 - Aug 2024. Source: TCM, barchart.com. Click for larger image. Please refer to Tactical Beta fact sheet for full return history*

Just days after playing arsonist, the Bank of Japan once again turned firefighter with assurances that the pace of future hikes would be measured, a move that ignited a sharp rally into Fire Fed Chief Powell’s widely anticipated speech on August 23rd that strongly hinted at a fresh round of interest rate cuts.

Rising over 300% in response to a relatively modest 7.2% decline for the S&P 500 between Aug 2 - 5, the reaction to August’s mini-crisis was proof that the VIX is not dead. If anything, the proliferation of new products for hedging discreet short term risks (e.g., “O DTE” options) has made the VIX with its 30 day outlook a purer indication of concern about complex issues that are not easily solved- AKA, market crisis periods. For addressing such risks, we continue to believe that the VIX is the best tool for the job.

rate expectations

While the fire brigade managed to keep the fallout contained, market action in August revealed the substantial risk hiding in opaque global market linkages that are highly sensitive to changes in monetary policy. Just as the Bank of Japan turns its focus to fighting inflation with higher rates, the Fed is poised to begin moving in the opposite direction, implying yet more pressure on the Yen carry trade. Even if the currency threat is avoided, rate cuts themselves present a risk to markets depending on whether or not they are associated with a recession (chart).

Ominously, between the recent normalization of the 10 year / 2 year US Treasury yield spread after its longest inversion in history and unemployment rising enough to trigger the Fed’s “Sahm Rule” recession indicator, conditions that have preceded every US recession for the past 40 years are now in place (charts).

*US Unemployment Rate, 10 Yr / 2Yr Treasury spread and US Recessions, Jan 1991 - Aug 2024. Source: St Louis Federal Reserve. Click for larger image*

Though certainly possible that lower rates can turn the tide, it is worth recalling that the highest VIX levels are historically found during recessions that often bring a financial system crisis (chart). With large, slow moving forces at play, this process will take some time to evolve and investors would be wise to have a plan for any outcome.