Weekly Economic Trends and Indicators

Two Fridays ago, the main story was the disappointing job growth in July. The financial market reaction was decidedly negative, and many started talking about the possibility of a recession. Was this wave of pessimism warranted? This week, we take a closer look at recent events to better understand why uncertainty has increased and what it means for the outlook.

While employment grew less than expected in July, the trouble was just beginning. When Japanese markets opened on Monday, August 5th (Sunday night in the U.S.), the Nikkei index fell by 12.4%. This sudden drop in Japanese stocks was largely a response to the increase in the policy interest rate by the Bank of Japan. Because Japanese interest rates have been near zero for several years, traders have been borrowing relatively cheap yen to invest in high yielding dollar assets. As the Japanese interest rates rise, and with U.S. rates set to come down, this “carry trade,” as it is known, becomes less profitable. When U.S. markets opened Monday morning, the sell-off continued as traders unwound their positions.

The unfortunate coincidence of the yen carry trade unwinding on the next business day after the negative job market news intensified talk of recession. Some commentators even suggested that the Fed should move on interest rates immediately. However, the markets ended the week close to where they ended last week. Furthermore, according to the CME FedWatch Tool, the probability of a 50 basis point cut in September actually decreased compared to August 2nd.

For as much attention as it garnered, the stock market volatility was only indirectly related to the underlying recession risk that we have been discussing for some time. As I mentioned last week, the recent upsurge in recession talk has been because of something called the “Sahm rule.” Economist Claudia Sahm observed that when the three-month moving average of the unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages over the last 12 months, it is a strong indicator of a recession. July’s unemployment rate pushed the three-month moving average over that threshold, and this was widely reported last Friday. However, Sahm, herself, said in an interview that this does not necessarily mean that the economy is in a recession now, but that the risk has increased. She also said that she does not believe the Fed needs to make an emergency rate cut, but that there is a “good case” for a 50 basis point cut in September.

The events of the last week (and, indeed, the last two years) actually serve to underscore the strength and resilience of the U.S. economy. This is not to say that a recession cannot or will not happen. To be sure, the risk of recession is elevated compared to a year ago. However, the economy has withstood an aggressive campaign of rate increases, a regional bank crisis last spring, and now a sudden realignment in global financial markets with inflation now under 3% and unemployment under 5%.

Next week, we will examine how all of this affects the Quad Cities region and why the unwinding of the Japanese carry trade could actually benefit the region going into next year.

Next week: The local outlook in light of recent events