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How Carry Trades and Market Fragility Impact Investors

As we transition into the post-Labor Day season, it’s the perfect moment to reflect on the year so far and fine-tune our financial strategies for the remainder of 2024. While August brought the sharpest market dips we’ve seen in two years, we’ve witnessed a remarkable rebound, with the S&P 500 now hovering just shy of its all-time high. The Federal Reserve is anticipated to announce its first rate cut at the upcoming September 18 meeting, a move that has already brought stability to interest rates. Inflation continues to trend downward, and the broader economy remains resilient. As we step into September with some market uncertainty, it's crucial to keep a big-picture perspective.

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We know that volatility is part of the investing journey, particularly with potential market-moving events on the horizon. The Fed’s full rate cut strategy, the upcoming presidential election, and ongoing geopolitical developments are key areas to watch. What can we learn from recent months to better navigate these events and remain focused on our long-term financial goals?

Markets Have Rebounded Over the Past Month

Despite recent market swings, the S&P 500, Nasdaq, and Dow have posted impressive gains of 19.5%, 18.6%, and 11.7% with dividends this year, respectively. The S&P 500 has experienced only two periods of sustained pullbacks this year, with the largest decline measuring just 8%, well below the historical average. While bonds struggled earlier this year due to high rates, the anticipation of Fed rate cuts has recently boosted returns. This highlights the importance of not overreacting to short-term events.

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The stabilization in the stock market has shifted investor focus back to fundamental factors, particularly corporate earnings. The stock market typically mirrors the trajectory of corporate profits over time, which rises alongside the economy. Current earnings projections are positive, with an expected growth rate of 10% in 2024 and nearly 14% over the next twelve months.

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Similarly, bonds have performed better, with the Bloomberg U.S. Aggregate Index gaining 3.1% year-to-date and 6.7% since its low in April when the 10-year Treasury yield peaked around 4.7%. The high-yield bond index has risen 6.3%, the corporate bond index 3.5%, and Treasurys 2.6%, driven by improving inflation and steady economic growth. Bonds have also played a crucial role in balancing stock market swings, emphasizing the importance of maintaining portfolio diversification, especially during uncertain times.

The Fed is Expected to Cut Rates in September

The Fed is expected to begin cutting rates later this month after a rapid rate hike cycle from early 2022 to mid-2023, primarily due to continued improvements in inflation. The Fed’s preferred inflation measure, the Personal Consumption Expenditures Price Index, has decelerated to 2.5% overall and 2.6% excluding food and energy. Similarly, the headline Consumer Price Index has fallen to just 2.9% year-over-year, with the core index declining to 3.2%. While prices remain elevated compared to pre-pandemic levels, these improvements give the Fed room to shift its monetary policy.

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Much of the market volatility experienced this year is due to changing expectations around the Fed. The year began with investors forecasting several rate cuts due to concerns of a “hard landing.” When inflation ran hotter than anticipated in the first quarter, expectations shifted to no rate cuts this year. Now, the Fed is expected to cut rates by about one percentage point by year’s end. These shifts remind us that markets can get ahead of themselves and highlight the importance of focusing on underlying trends.

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Additionally, recent jobs data show that the labor market remains strong but is softening. The latest employment report, for instance, revealed that 114,000 new jobs were added in July, well short of the 175,000 projected. Unemployment rose from 4.1% to 4.3%, overshooting expectations and reaching a level not seen since the pandemic (though still not historically high). In a recent speech, Fed Chair Powell discussed the downside risks to the job market, saying, “we do not seek or welcome further cooling in labor market conditions.” While the Fed had been focused primarily on bringing down high inflation, it is now shifting its focus to the job market.

Interest Rates are Adjusting to a Shift in Fed Policy

Finally, with Fed rate cuts approaching, market-based interest rates have adjusted as well. As the accompanying chart shows, not only have yields moved lower, especially on the short end of the curve, but the yield curve is no longer inverted. The spread between the 10-year and 2-year Treasury yields has flattened in recent days due to the expected trajectory of rates.

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If these moves continue, they could have several potential implications for the economy and markets. One reason some investors expected a recession in 2024 was because the yield curve experienced its sharpest inversion since the 1980s. Historically, yield curve inversions precede recessions since they typically occur later in the business cycle when the Fed has overtightened. While a recession is always possible, this time could be different since higher short-term yields were the result of inflation shocks.

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While nothing is certain, lower rates could be positive for economic growth, especially in rate-sensitive areas such as real estate, technology, small caps, and more. As discussed earlier, bonds have benefited from improving rates as well, partially restoring their traditional role as portfolio diversifiers.

The Bottom Line?

How we react to stock market swings is perhaps more important than the market moves themselves. The uncertainty experienced by investors during the summer is a reminder to always stay focused on the long run as they work toward their financial goals.