How to Trade Amid Growing Recession Concerns? A Focus on US Treasuries, Defensive Sectors, and More

According to the Sahm Rule, when the three-month moving average of the US unemployment rate is at least 0.5 percentage points higher than the low of the past 12 months, it indicates that the economy is in a recession. After the unemployment rate rose to 4.3% in July, the Sahm Rule indicator reached 0.53%, sounding the alarm.

Although historically the accuracy of this indicator in predicting economic recessions has been 100%, economists point out that the current increase in the unemployment rate may be distorted by temporary factors such as the impact of hurricanes and temporary layoffs. Additionally, the continued employment in the construction industry and the relatively high employment rate among prime-age workers seem to suggest that the labor market is not as bad as the data shows. Sahm herself recently stated in a media interview that the market is not at immediate risk of recession, as changes in labor supply after the pandemic and the significant increase in immigration have weakened the effectiveness of the Sahm Rule.

However, this does not mean that the market can breathe easy, as other data besides the Sahm Rule Recession Indicator also indicates a worsening trend of economic weakness in recent months. This includes the largest contraction in the US manufacturing PMI in 8 months in July and a one-year high number of initial jobless claims in the latest weekly data.

● Middle East tensions: The Middle East situation escalated after the top leader of Hamas was assassinated in Iran last Tuesday. According to the latest report from Axios, Blinken told G7 foreign ministers that Iran and Hezbollah could launch attacks on Israel as early as Monday (August 5th). The sharp increase in geopolitical risks has heightened market risk aversion.

● The Unwinding of the Yen Carry Trade: As one of the currencies with the lowest interest rates globally, the yen has been used as an important funding currency, with traders borrowing low-interest yen to invest in higher-yielding assets. However, the unexpected 15 basis point rate hike by the Bank of Japan last week and its consistent intervention stance in support of the yen have pushed the yen into an appreciating trend. For investors borrowing in yen, the significant loss in exchange rates outweighs the returns on non-yen assets, leading to a mass liquidation of carry trades and further selling pressure on the market.

● Increased political uncertainty due to the US election: Historically, the VIX index tends to rise in the months leading up to a US presidential election, possibly due to increased uncertainty. The market needs time to assess the policy stance of the winning candidate in terms of fiscal and monetary policy, as well as their policy leanings in specific areas. The uncertainty surrounding industrial policies also causes companies to adopt a wait-and-see approach to capacity expansion and hiring activities.

Signs of economic weakness have sharply increased, leading Wall Street economists to anticipate that the Federal Reserve will adopt a more aggressive easing stance. Futures traders now expect the Fed to cut interest rates five times before the end of the year, implying an unusually large half-point rate cut at last three meetings this year. Such a significant rate cut has not been seen since the pandemic or the credit crisis.

Economists at Citigroup and JPMorgan also have similar aggressive forecasts, predicting rate cuts of 50 basis points at the September and November meetings, followed by a 25 basis point cut at the December meeting. Furthermore, Goldman Sachs has raised its expectations for Fed rate cuts this year to three times, with the possibility of a 50 basis point cut in September.

Even the prediction of 5 rate cuts is not so unreasonable, as the Taylor Rule model estimates that the Taylor Rule Implied Federal Funds Rate, corresponding to the current inflation level and economic development trend, is only 3.95%. This is 138 basis points lower than the latest Effective Federal Funds Rate, equivalent to about 5.5 cuts of 25 basis points.

As traders bet on the Federal Reserve making a substantial interest rate cut to avoid an economic downturn, yields on multiple maturities of US Treasuries have significantly declined, marking one of the largest rebounds since the banking crisis erupted in March 2023. The 2-year Treasury yield plummeted by over 50 basis points last week, while the 10-year Treasury yield fell by 40 basis points, both hitting their lowest levels in over a year.

In addition to the expectation of a substantial interest rate cut by the Federal Reserve, the prices of US Treasuries have been supported by multiple factors. These include recession fears and the heightened safe-haven appeal of US Treasuries amid escalating tensions in the Middle East. The reduction in the issuance size of US Treasury bonds by the US Department of the Treasury has eased the supply-side pressure on US Treasuries, and funds expected to flow from the stock market exodus into the bond market, among others, have also contributed to the support of Treasury prices.

In a highly volatile market, allocating defensive stocks is also an effective strategy. Specifically, when reviewing the 18 historical recessions in the United States, industries such as utilities, consumer staples, and healthcare have typically shown better performance during mild economic downturns, experiencing smaller declines during stock market pullbacks, and also offering higher dividends.

However, given the rapid increase of the panic index in recent times, it is possible that with the return of market sentiment to calmness, the index may tend to revert to its long-term average. As a result, some investors may be seeking opportunities to bet on a decrease in VIX.