There was an increase in market volatility last week that was heavily impacted by the recent acceleration in the U.S. dollar exchange rate. While this is a concern, most of the market signals we monitor continue to suggest deflation and recession risks remain low.

Last week, we noted that market signals were going to be a helpful guide for determining investors’ expectations for the future state of economic growth and inflation. 

Volatility increased last week, especially in commodities and currencies.  However, most market signals still suggest that the economy is not headed toward a recession or deflation.

In the equity market, we noted that if deflation or recession were a likely outcome, equity indexes would decline sharply, and volatility would increase (VIX and other measures above 30).  The S&P 500 closed the week 1% below the all-time closing high it reached on Monday and the NASDAQ 100 closed less than 0.50% below the all-time closing high reached on Monday. 

Source: Koyfin.

The VIX index increased last week but intraday did not get above 25, never closed above 21, and ended the week at 18.5.  Those are not levels associated with deflation or recessions.

Source: Koyfin.

In the fixed income market, high yield spreads continued to move higher.  This is common in periods when the rate of change in economic growth is slowing, and inflation remains elevated.  The current absolute level of spreads remains low and is not in-line with prior periods of deflation or recessions. 

Source: Koyfin.

The yield on the 10-year Treasury only decreased 2bps last week despite the movements in other assets.  If investors are becoming more concerned about deflation or recessions, yields should likely start to decline back to where levels were at the end of 2020, before economic activity had started to accelerate. 

Source: Koyfin.

The yield on the 2-year Treasury increased 2bps last week.  If the primary view of investors was deflation or recession, two-year yields should move back towards 0% in anticipation of more easing from the Federal Reserve.

Source: Koyfin.

The commodities market has been experiencing some volatility in the month of August.  Oil prices (WTI) have declined by 17% since their recent high in mid-July.  Copper prices dropped 12% from their July high before recently bouncing back. Corn prices are down 25% since July 1st, Wheat prices declined over 6% last week, and Soybeans are down 10% from their August high. 

Source: Koyfin.

Even with all of those moves, the CRB commodity index is only down 6.5% from the high at the end of July, which was the highest level since late 2014.  This puts the index back at the same level it was on July 19th.  If deflation or recession risks were rising, the commodities index would be down significantly, and volatility would be spiking.  Last week, oil volatility did not get above 42 and closed at 40.  This is below prior periods of deflation and recessions. 

Source: Koyfin.

The area that has become more of a concern is the currency market.  The U.S. Dollar Index (DXY) has been rising since June and the pace has accelerated in August.  The DXY closed above the prior local highs made in July and at the end of March.  The U.S. dollar ($US) also has strong performance momentum against all of the developed market pairs.

Source: Koyfin.

The DXY is still well below the levels reached in 2020 but a continued increase would raise the likelihood that investors are pricing in a risk of deflation or recession.  The $US has had a strong negative correlation with oil over the last 30 days and a continued increased in the $US would likely cause oil to decline.  More weakness in oil would likely cause the commodity index to continue to decline, as oil is the largest component of the index.  

We will continue to monitor the market signals to determine where investors are expecting the economy to head, with the most important signal in the near term being the direction of the $US.     

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.