Market Turnaround: A Week in Review

This week in macro and markets is ending very differently than it started. Monday saw the unwinding of trades that had been popular over the past 6-12 months, such as long positions in technology stocks and short positions in volatility and the Japanese yen. The Nasdaq and USD/JPY dropped briefly by 6% and 3.5% respectively, as implied volatility in the US, Europe, and Japan experienced record intra-day spikes. However, by mid-week, global financial markets seemed to have calmed.

Dovish remarks from the Bank of Japan addressing the turmoil, along with positive macroeconomic surprises from the United States, have reassured investors, helping to stabilize equities, yields, and the dollar-yen exchange rate. The VIX has nearly retraced its gains, dropping from 75 to 25. The US Dollar Index is back in positive territory for the week, and short-term bond yields are higher than they were on Friday. Nonetheless, there remains uncertainty about the true extent of the global carry trade.

Historically, the intra-year drawdowns of 9% for USD/JPY and 6% for the G10 Carry Index are not significant over the past 30 years, suggesting that these trades are not overly stretched. The expected convergence of policies between the BoJ and the Fed, along with politically induced volatility around November, are likely to drive further unwinding of short yen positions. Next week, attention will be focused on US inflation data (PPI, CPI) and retail sales. USD/JPY will remain the most closely watched currency pair globally.

Inflation Data in Focus Next Week

GBP/USD has been under pressure due to risk aversion, which has favored the safe haven dollar over the procyclical pound. The downward momentum slowed at the 100-day and 200-day moving averages just below $1.27. Sterling has rebounded from over a one-month low, and short-term rate differentials indicate that further downside risks are limited.

While weak seasonals could limit gains in August—historically averaging around -1% since 2000—the 1-year swap spread between the pound and dollar suggests that the decline in GBP/USD is overdone. Since early July, sterling has dropped about 3% against the dollar, coinciding with global equity declines as investors sought refuge in safe haven currencies. Despite this, 1-year swap spreads remain elevated, indicating potential upside for the pound. Persistent core and services inflation in the UK has markets pricing in fewer than two 25-basis point cuts by the Bank of England by year-end, compared to the Fed's expected four quarter-point cuts.

Next week’s UK and US inflation data will provide more clarity on this pricing. For GBP/USD to make another run at $1.30, UK inflation needs to stay high, US inflation must surprise lower, and technically, the pair needs to break and hold above $1.2810, the 38.2% retracement from the July high to August low.

Euro Steady Above $1.09, Awaiting Clearer Signals

With a quiet day for European macroeconomic releases and bond supply, market focus was on US initial jobless claims data for signs of a potential slowdown in the US labor market. EUR/USD spot rates fell slightly after the report surprised to the downside, easing concerns about the US economy.

In Europe, stock performance was mixed as sentiment stabilized. German bonds, which initially gained, reversed after the US jobless claims data. The 10-year Bund yield held steady at 2.26% after briefly dipping to 2.22%, reflecting a slightly steeper curve as traders adjusted to recent volatility and sought a new yield equilibrium. Despite ongoing concerns about European growth, the market has become more comfortable with less aggressive near-term expectations for the ECB. Year-end rate cut expectations priced into the OIS curve have decreased to about 69 basis points from around 94 at the week's start.

With an empty economic calendar on both sides of the Atlantic, euro volatility is expected to decrease today. The short-term market sentiment in EUR/USD, indicated by 1-week risk reversals, is now neutral. However, this does not mean all risks have subsided. The EUR/USD volatility surface has shifted upwards, with one-month convexity reaching a two-year high, signaling continued caution among market participants.