August 10, 2024 Market Update

Global equity markets began last week with a sharp decline, driven by recession fears, the unwinding of failed hedge fund trades, and escalating geopolitical tensions in the Middle East.  Stocks staged a comeback in the latter half of the week, as better-than-expected labor market data renewed investor confidence.  By the close of trading on Friday, the Dow, S&P 500, and the Nasdaq had recovered nearly all their earlier losses.

The bond market also experienced significant volatility, partly due to weaker-than-expected demand at the Treasury Department's auctions of 10-year and 30-year bonds.  The Vanguard Total Bond Market ETF (BND), which serves as a proxy for investment-grade corporate and government fixed-income securities, dropped 0.75% over the course of the week.

As noted above, one of the catalysts for this week’s stock market turmoil was the collapse of speculative hedge fund trades that unraveled unexpectedly.  A prominent example is the so-called yen carry trade, where traders borrow Japanese yen at low interest rates and then use the borrowed funds to invest higher-yielding assets denominated in other currencies such as U.S Treasury bonds.  When the value of the yen unexpectedly surged in July, many hedge funds were forced to sell stocks to cover the increased cost of repaying their yen-denominated loans.  

The good news is that stock market declines associated with high leverage and complex financial instruments generally tend to be short-lived.  For instance, on October 19, 1987, (commonly known as “Black Monday”), the Dow Jones Industrial Average (DJIA) plummeted by 22.6% after the failure of Long-Term Capital Management hedge fund.

LTCM’s collapse was brought on by a result of the inability of its sophisticated mathematical models to accurately account for a spike in market volatility caused by the 1997 Asian financial crisis and the 1998 Russian financial crisis.  But it only took the Dow Jones Industrial Average two days to recover 57% of its losses.

As for the current market situation, the failed yen carry trades have mostly been unwound and so no longer appear to be a significant threat to the markets.  Whether a slowing economy, global tensions, potential policy errors and other more persistent threats to the markets will materialize remains to be seen.

If you would like to read more on sudden market drawdowns and how to prepare for them, check this article posted last week on The Milwaukee Company’s TMC Research website.