There are numerous indicators flashing warning signs for a recession or major economic downturn.
Blood Indicator: A Recession Warning
This chart features the blood indicator, which is the ratio of US 3-month Treasury Bills to High Yield Spread. Historically, the blood indicator crosses below the 100 week moving average before a major financial crisis and recession. The blood indicator is currently trending for a cross below the 100 week moving average over the next few weeks or months.
Recession Indicator: TLT/XLE Ratio
The “Recession Ratio” (TLT vs. XLE) conveys the shifts between U.S. bonds and the energy sector. In 2008, a sharp rise in this ratio signals an escape from riskier energy stocks and a flight to safety by investing into safer U.S. bonds during a recession. Currently, the ratio is breaking out of a downtrend and may rise sharply in Sept/Oct 2024. There is an eerie similarity between the current price action and the price action that occurred in 2008 before the financial crisis. There is a breakout forming, and if the ratio continues to rise then it could foreshadow a potential recession.
Manipulated Unemployment Data
The unemployment data has been manipulated to show strong labor market growth during the year of the presidential election. The jobs data has been overestimated by 810,000 jobs, and these figures are being revised down at a later date.
Despite the manipulated and overrepresented data, the current unemployment rate is still signaling a recession with the unemployment rate rising above the 2 year average, which commonly occurs before a recession. The lower half of this chart also features the percentage of the yield curve inversion. Historically, a yield curve inversion above 80% indicates high recession risk. Currently the yield curve inversion has crossed the 80% threshold and is around 80.77%.
3 Month Treasury Bills
Historically, when 3 month Treasury bills cross below their 52 week moving average the U.S. stock market has experienced major downturns. The last three times occurred during the burst of the dot com bubble (early 2000s), subprime mortgage crisis (2008), and the COVID-19 pandemic (2020). Currently the 3 month TBILLS are crossing below the 52 week moving average, which is signaling a major market downturn on the horizon. However, there needs to be a major catalyst that is causing the market’s downturn.
Multitrillion Dollar Yen Carry Trade
I believe that the key catalyst is the Japanese carry trade, which has already shown some concerning signs in August. During early August there was a flash crash across the financial markets, including U.S. stocks, crypto and commodities. The media narrative is that the flash crash was caused by worse than expected unemployment data. However, the real reason is likely caused by the Bank of Japan hiking rates by 25 basis points on July 31. This is Japan’s first rate hike in 17 years because the economy is too weak to stand on its own. Japan has a high debt ratio that is 263% of GDP, and the extremely low rates are used to encourage investment in Japan to drive economic growth.
The Bank of Japan maintained negative interest rates for 8 years, which incentivized foreign investors to borrow inexpensive Japanese yen. This became known as the yen carry trade, which involves borrowing in a low-interest currency (the Japanese yen) and investing in higher-yielding assets (i.e. crypto, U.S. stocks). The Japanese yen experienced negative interest rates for a very long time, and is viewed as free money with low interest. Over time this yen carry trade has emerged as one of the largest trades in history with an estimate between $4 and $40 trillion (exact figures are not known).
Large VIX Spike Signals Institutional Panic
The Bank of Japan increased rates on July 31, and the financial markets quickly panicked within a few days. The VIX experienced a 200% rise in a two day span between August 2nd and August 3rd. The rise in the VIX signals panic and fear in the markets. The magnitude of the VIX spike is so large that it suggests institutions were panicking. The speculation is that institutions likely received a margin call due to the yen carry trade starting to reverse course. Investors that borrowed cheap yen were panicking to sell their financial assets (i.e. U.S. stocks and crypto) to buy back into yen and pay off their debt.
Every financial crisis begins with significant outflows from the financial system. So there needs to be a catalyst before the financial crisis can occur. I believe the yen carry trade is a multi trillion dollar trade that could be the key catalyst for a financial crisis. We’ve already seen some warning signs in August, and there should be concerns for further warning signs in the months ahead.
Japanese Yen in Serious Trouble
The Japanese yen has been declining for three consecutive months in a row, and is at risk of losing a key support level around $142.67. If this support level is lost there could be a serious financial crisis where the yen carry trade will start to unwind with trillions of dollars exiting out of the financial markets (i.e. crypto and U.S. stocks) and to pay off the yen that was borrowed from Japan. This crisis is taking place because of the Bank of Japan’s decision to hike rates for the first time in 17 years. The speculation is that the rate hike disrupts the yen carry trade because there are thin profit margins. Even the 25 bps hike from the BOJ was enough to cause institutions to panic. The key concern is that institutions will rush out of financial assets like U.S. stocks and crypto to pay off their borrowed debt in Japan.
Since Japan has such a high debt ratio the BOJ doesn’t have the option to print more money. The BOJ is forced to hike rates again in the future to curtail inflation, which is going to result in more margin calls and panic from institutional investors.
JPMorgan and Goldman Sachs Likely Received a Margin Call
On September 11, JP Morgan stock suffered a steep decline when Jamie Dimon said that JPM stock is overvalued and the financial forecast over the next few quarters are too optimistic. The speculation is that Jamie Dimon is setting the stage for reporting lower revenue over the next few quarters due to losses sustained from the reversal of the yen carry trade.
The speculation is that JPMorgan and Goldman Sachs are two key players that are invested in assets across the globe, and these two banks likely suffered a margin call from the yen carry trade starting to reverse course in early August. This would explain why bank stocks suffered such a large decline yesterday.
How will each asset class perform during a recession?
There are numerous signs indicating an economic downturn and recession after the Fed pivot. The key question is how is each asset likely to behave during a recession. These are my key observations based on historical data:
- US treasuries & bonds tend to experience upside after the Fed pivot. They are perceived as “risk off assets” and a safe way to invest without taking risks in financial markets (i.e. stocks, crypto)
- Crypto doesn’t have enough data, BTC crashed after the Fed pivot in 2019 so there should be concerns for a crash.
- U.S. stocks are likely to experience downside. In recent Fed pivots the S&P has crashed after the pivot.
- Oil tends to experience downside after the Fed pivot.
- Gold tends to experience upside or sideways price action after the Fed pivot.
- Silver tends to experience downside after the Fed pivot.
- U.S. dollar index likely to remain neutral after a Fed pivot and is likely to form either a peak or a bottom.
Ways to Prepare (not financial advice)
We already experienced a recent flash crash in early August, so it is a good idea to prepare in case if a larger and more severe crash occurs. These crashes can start anytime, and they often occur when you’re not paying attention. For example, the recent August flash crash occurred on a Sunday when most investors weren’t even thinking about the markets. These are some top ways to prepare for a potential crash:
- Stop loss for any buy positions (3% below current price levels or below major support levels)
- Stay away from margin and leverage to avoid getting liquidated or margin called.
- US bonds tend to rise and are perceived as a safe investment during recessions.
- Gold is already pretty expensive, but is also viewed as a safe investment that is likely to rise during a recession.
- Some investors prefer to be on the sidelines by holding cash and not taking any risks.
- Some investors prefer to hold their assets even if there will be a steep market decline (often times these investors don’t want to trigger a taxable event).
Good luck, I will keep you all updated over the next few weeks. For now I’m thinking we can see some downside in Sept and early Oct.
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