Last week was a roller-coaster ride for anyone who watches markets closely. There was a brief period of near-panic on Monday when it even seemed like the wheels were falling off the lead car: The so-called VIX Index – a measure of volatility that’s sometimes described as the market’s ‘fear gauge’ shot as high as 65.7 early in the session. The last time VIX was anywhere close to that was back in early 2020 when the U.S. economy was fighting its first bout with COVID. While things settled down significantly into Monday’s close, the VIX still finished the day higher than any point since 2020 (and that includes 2022, the most difficult calendar year for both stocks and bonds in a very long time).

Monday’s plunge from the peak was a gut-wrencher, but by Friday, calm had mostly returned, and equity markets ended up pretty much where they left off the week before.

The immediate cause of Monday’s plunge was probably a follow-through from a slightly weaker-than-expected payrolls report on the Friday before. As we discussed last week, the July employment situation summary wasn’t a disaster. But it was weaker than expected and featured an unemployment rate that was about two-tenths of a percentage point higher than economists were expecting.¹ That was just enough to trigger the increasingly famous recession signal imbedded in the “Sahm rule” while reminding everyone that the long hoped-for soft-landing wasn’t a foregone conclusion. More simply, it was a reminder that months and months of restrictive financial conditions following a very aggressive tightening campaign by the Federal Reserve is very unlikely not to produce at least a few bumps along the way.

To be sure, there were other contributing factors as well. Market valuations remain high and corporate earnings are showing signs of stress – something that current valuations leave little room for. Indeed, last week’s labor report probably wouldn’t have generated the reaction it did if it hadn’t been accompanied by several disappointing high-profile earnings reports.

Other, more subtle explanations for Monday’s shaky session revolved around the so-called “yen carry trade” – a relatively complex strategy that involves borrowing cheap money in Japan and investing it elsewhere, perhaps propping up global markets with speculative demand in the process. The strategy relies on low interest rates in Japan and a weak – or at least stable – USD/JPY exchange rate. Both of those assumptions were tested recently when the Bank of Japan (BoJ) raised rates by a quarter-point and suggested it might tighten further.²

 However, if you needed any evidence that last week’s spike in volatility was at least partially related to recession fears and a weaker U.S. labor market, you got it on Thursday when stocks rallied after a somewhat benign weekly initial claims report that seemed to ease fears that the previous Friday’s payrolls report was in fact screaming “recession”.

Other data continued to lack much oomph. Last week’s purchasing manager index reports continued to suggest mild- to moderate growth for the services sector, although with a notable side-eye glance in the form of not-quite-dead-yet inflationary pressures that suggest the Fed was probably wise to hold off on interest rate cuts at its July meeting.^3,4 Meanwhile, probably the easiest-to-overlook report from last week – the Federal Reserve’s quarterly Senior Loan Officer Opinion Survey (or SLOOS) – showed that credit conditions and loan demand haven’t improved all that much since first clamping toward recessionary tights a few quarters ago.

So where does all this leave us? To recap, we have a U.S. labor market that may or may not be weakening its way toward recession, corporate earnings are showing a few signs of stress (particularly in cyclical and discretionary categories like travel), steady (but potentially re-inflationary) trends in the services sector, and still-tight lending conditions

What to watch this week

This week’s most important economic releases will be inflation-related: The Producer Price Index (PPI) on Tuesday and the Consumer Price Index (CPI) on Wednesday. Economists are expecting both to show continued progress towards the Fed’s 2% inflation target, a result that would solidify expectations for a cut in rates at the September 18th FOMC meeting that has now become the overwhelming consensus. Stating the obvious, markets would be less than forgiving of a miss on the high side as it would suggest further delays in the easing timetable that traders have pinned their hopes on.

Earnings season is starting to wind down, but there are still a few reports worth paying attention to, including Home Depot on Tuesday and Wal-Mart on Thursday. Home Depot is in the unique position of offering read-through into consumer trends broadly but also into the long-moribund housing market. For those reasons, post-earnings commentary will likely draw the market’s attention as analysts try to divine the health of the economy from any anecdotes the company can provide. Meanwhile, Wal-Mart was early to recognize consumer stress when it reported that shoppers with annual incomes in excess of $100,000 were making up a growing share of sales several quarters. That message has since been repeated by Wal-Mart and its peers and seems likely to factor in the company’s results again this quarter.

Thursday’s retail sales release report contains an excellent breakdown of sales by establishment type that allows you to infer a lot about consumer trends. Watch trends in highly discretionary and cyclically sensitive categories like food away from home and home furnishings for clues about whether or not consumers are feeling stressed.

Housing markets are becoming increasingly important to the economic narrative. Last week, mortgage applications rose notably in response to a drop in mortgage rates, but so far, the impact has been limited primarily to higher refinancing activity. That reflects still-challenging affordability as prices remain out-of-reach for some segments of the homebuying public. Thursday’s builder sentiment report from the National Association of Homebuilders should help clarify whether that, plus a recent tendency among homebuilders to focus on more affordable products, is making a dent. It will be difficult for the economy to reaccelerate unless and until housing improves significantly. Declining mortgage rates are a necessary but insufficient condition for that to occur.

Finally, the manufacturing sector will be in the spotlight again this week as we get the first two regional Fed manufacturing reports, Empire State and Philly Fed, both due out on Thursday. These and similar reads of manufacturing activity have been weak, which places greater pressure on the services sector to continue to underwrite economic performance. Thursday’s report seems unlikely to change that dynamic but watch those releases for evidence to the contrary.