"The dominant fact in all price movements is the psychological state of the participants." - Charles Kindleberger
There was a lot of very rare occurrences in markets over the last few trading sessions. Firstly, we had a Fed meeting where Powell appeared sanguine about the economy, and while he hinted at cuts he didn't guarantee them. Next, a soft labor report came in that caused a growth scare in markets. Fear reached a fever pitch and people were talking about depressions and emergency Fed cuts, which has now subsided.
The unemployment rate unexpectedly ticked up and the headlines jobs number missed by about 65k. At the same time, the Yen carry trade and other short volatility trades came unwound and a massive volatility blowout occurred.
You can see the violence of the VIX spike by date following the Fed meeting. Initially, there was a wave of optimism after Powell's comments, but the VIX spike that occurred on Monday was the third largest in the history of the fear index. And this fact alone might scare the hell out of you, but when you pair it with what has happened yesterday and today, you get a much different side of the picture.
There's an old saying that markets take the escalator up and the elevator down. It is very rare that markets, and the VIX, take the elevator both ways. But that's exactly what happened this time. While the size of the VIX rise on Monday was the third largest in history and the highest level since the pandemic, the collapse of volatility on Tuesday was the largest ever.
You can see how rapidly the curve has normalized. Above was the collapse from August 5th to August 6th. You can see today's curve is much more normal with lower levels of backwardation. For example, the election is now elevated above the front two months, and even though there is a slight inversion it is nothing compared to the curve from Monday.
If you're interested in shorting volatility and having insurance for another upside spike, I recommended a trade yesterday that you can see here. The backwardation has already significantly decreased since I recommended the trade.
One of the other areas the rapid and rare adjustments were seen was in the expectations for Fed cuts themselves. Many instantly accused the Fed of being offsides for not cutting at their July meeting, and the probability for larger magnitude cuts in September have now become the majority probability. These were a far outside probability on July 31st, but things can change very quickly for markets during the dog days of summer.
While the Fed has been accused of all the sins in the book, I actually think some of the recent events work in their favor. Firstly, if the Doves were still facing any internal resistance to cuts, I think that should all but have evaporated by now. The progress on inflation has been near complete, and by some core measures, we have already reached the Fed's target. The probability has actually risen for larger cuts that will get monetary policy to a less restrictive stance quicker.
Secondly, the Fed put is back. Fed officials have said explicitly that they would "fix it" if the economy showed significant deterioration. The current level of rates gives the Federal Reserve a lot of flexibility to act should conditions worsen. Thirdly, as you can see above, the consumer hanging in there and credit conditions remain strong across consumer and corporate debt. The wealthiest US consumers control a lot of wealth and are pretty much insensitive to wealth. This has helped the economy achieve a soft landing, which I still believe is occurring despite the last jobs report.
The jobs report was anomalous and potentially affected by weather as well. Furthermore, the strength of US consumers and stock market earnings both suggest a recession is not imminent. Default rates suggest strong consumer balance sheets, and the labor market is still creating jobs, not shedding them.
Another thing is this, now that volatility has blown off, the Fed is in a much safer position to make cuts into a scared market instead of into a frothy market. I think this helps the internal politics of the dove/hawk divide and now the FOMC is likely pretty much on the same page. Furthermore, if the next jobs report and CPI both cooperate and suggest that the last one was an anomaly, those calling for Powell's head will likely be silenced.
The level of volatility spike, and the speed with which markets have regained their footing suggest to me that we are in a much better position than hot blooded market participants would suggest.
What It Means for Markets
We get a slate of data next week that I think will be largely positive, or at least won't contain the nasty surprises coinciding with the unwinding of the carry trade. The Bank of Japan has also capitulated and played down possibilities of an imminent rate hike. The Yen slumped in response to this news. The psychology of markets that Mr. Kindleberger's opening quote stresses the importance of has decidedly stabilized for the time being.
This reality removes the immediate fear of mass forced liquidation that seemed to be permeating markets on Monday.
Overall, the Fed is in a pretty good position and if economic data cooperates, the next few hundred points on the index will likely be up.
Even if recession occurs, the adversity will likely be mitigated by the important consumer wallet inputs of mortgage payments and gas declining, as well as corrective Fed action.
Volatility should continue to stabilize toward a mean in the high teens or low twenties as market participants realize that while the chance of recession might have increased, it is still a pretty low probability.
One major risk to pay attention to is increasing Middle East tensions. An uncontrolled escalation could reignite volatility to high levels, and given recent ranges an associated spike could be pretty spicy.
