The August tremor on world markets is a stark recession warning

The immediate storm may be passing – but dark clouds have gathered over the US economy

The US Federal Reserve has waited too long to switch from fighting yesterday’s inflation to fighting tomorrow’s unemployment, allowing pre-recessionary conditions to metastasise.
The wild convulsions spreading through the world’s dollarised financial system over recent days have been turbocharged by the August effect of thin liquidity, and should not be over-interpreted.
The immediate storm may already be passing. But there has unquestionably been a massive and sudden repricing of interlinked bonds, equities, and currencies across the world. That is more than a minor tremor.
Parallels with the global financial crisis are completely misplaced. That was a financial meltdown. By the summer of 2008, we had already seen the collapse of Fannie Mae and Freddie Mac, the $5 trillion twin pillars of US mortgage finance. Subprime and Alt-A securities were already imploding.
Nothing of the sort is happening today, although we cannot be entirely sure because the authorities, in their infinite wisdom, have over-regulated banks and pushed extreme leverage into the vast unregulated jungle of global shadow banking.
This episode is driven by fear that the US economic expansion is breaking down and that no other part of the world is strong enough to pick up the slack. The S&P Global index of world manufacturing has fallen back below the boom-bust line of 50. Dr Copper has capitulated and the Bloomberg commodity index has slumped to a three-year low.
The eurozone is in stagnation and is reverting to fiscal austerity rather than doing anything about it. China is sliding further into deflationary semi-slump. Its 10-year bond yields have dropped to an all-time low of 2.1pc. China is exporting its excess capacity and running a record trade surplus as a share of global GDP, sucking net demand out of the world economy.
What happens over the coming weeks depends on how quickly the Fed recognises that it has misread the US labour market and stops tightening monetary policy “passively” by doing nothing.
“Although it might be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk,” said Bill Dudley, former chief of the New York Fed, one of several ex-hawks calling for a screeching handbrake about-turn.
Alan Greenspan had perfect Fingerspitzengefühl at such times: he slashed rates at an emergency meeting in October 1998, preventing contagion from the Asian financial crisis from spinning out of control.
East Asia is again playing a central role in today’s unfolding drama. The Bank of Japan’s long-delayed rate rise finally happened last week, timed to horrible perfection, just as America’s economy wobbles. The two together have caused the yen carry-trade to blow up in spectacular fashion, annihilating traders who borrowed in yen to buy AI shares with leverage in New York. It is a dangerous game trying to pick up late-cycle pennies on the tracks of an incoming Shinkansen bullet train.
Freya Beamish from TS Lombard said the Bank of Japan feared that exactly this would happen as it tried to extricate itself from decades of ultra-easy money, but was forced by events to pick among alternative poisons. “They took the plunge and it turns out their fears were justified,” she said.
A violent realignment of the yen-dollar exchange rate triggered the worst two-day fall in Japanese history, and I would not put much faith on the V-shaped rebound on Tuesday. Yen strength has in turn drawn the Chinese yuan into the maelstrom, making it even harder for China to combat deflation.
Japan is still the world’s largest creditor with some $3.5 trillion of net global assets. When de facto yield differentials between Japan and US narrow suddenly,  and the yen appreciates violently, it leads to massive repatriation flows by Japanese investors.
The giant pension funds and life insurers pull money out of world assets. The scale is enormous and can set off a vicious cycle through derivative contracts until there is a global circuit-breaker. 
The Powell Fed does not want to play that role, and is a less nimble animal than the Greenspan Fed. But it will nevertheless have to tear up the script and embark on a string of jumbo cuts as soon as September. The markets are already pricing in 120 basis points of cuts this year.
Labour economists warned months ago that the US jobs market was breaking down. The “household survey” has been weaker than the headline “non-farm payrolls” watched by markets, which double counts people working two jobs to survive.
They warned that once lay-offs start in earnest, the process sets off a rapid self-feeding dynamic in America’s flexible “hire-and-fire” economy. They were right. The unemployment rate jumped to 4.3pc in July, from a cycle-low of 3.4pc.
“The non-linear softening in the labour market is a tell-tale sign of recession. The Fed will now move urgently to bring policy rates toward neutral,” said Andrew Hollenhorst, Citigroup’s chief US economist. He expects 50 point cuts in both September and November.
Evidence of trouble in the jobs market is by now overwhelming. The hiring rate in restaurants, hotels, and leisure has fallen even more dramatically than in 2008. So has the “employment cost index” for construction workers.
Rising unemployment has triggered the Fed’s internal Sahm rule, which is not a predictor of recession but a red alert telling the Fed Board that the economy is already well into recession. Dario Perkins from TS Lombard says that every time the line has been crossed since the Second World War – bar 1959 – the jobless rate has gone much higher before peaking. You don’t want to cross it.
This episode is different from America’s recession scare in early 2023 when Silicon Valley Bank and three other US banks failed, engulfing Credit Suisse via contagion. The Fed bailed out the banks, halting the crisis immediately. At that time the labour market was still in rude good health. Americans still had excess savings from the pandemic.
Today’s travails have nothing to do with banks – though plenty of regional US lenders are still under water on bad commercial property loans. There is no sign of stress in the credit markets. The average risk spread on US investment-grade BBB bonds is beautifully-behaved at just 130 points. Companies have strong balance sheets, although the full delayed effects of past Fed tightening have yet to feed through.
The chief worry this time is faltering demand in the US and global economy, and behind this is a second deeper worry: America is already running a budget deficit of 6.2pc of GDP at a stage of the cycle when it should be in balance, leaving the US Treasury with little fire-power for countercyclical stimulus.
Today’s AI tech bubble looks like the tech bubble in 2000. If only it were so benign. The US budget was 2.3pc of GDP in surplus at the onset of the dotcom recession. The public debt ratio was less than half current levels.
What happens if the US economy tips into recession with deficit and debt ratios already stretched to extreme levels? You don’t want to find out.
This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday