Inside Markets — Pain Trade Skewed to Upside

The Fed’s concern is focused on labor market conditions and is nearly one-sided. The debate over a 25bp or 50bp September rate cut could make markets choppy, but we see the pain trade skewed to the upside for the next three weeks. The record compression in realized equity volatility (VIX) from 8/6-8/13 makes Vol Targeting strategies incremental buyers while the corporate buyback window remains wide open through 9/13. Buyback demand was the largest of the year last week according to two sell-side trading desks, while Powell’s comments on Friday could be a green light for systematic funds to add leverage during a period of illiquidity (summer holiday). Note that mid-September usually kicks off a period of seasonal weakness for US equity markets.

Last week’s stronger-than-expected consumer facing earnings reports, services PMI and weekly jobless claims support the resilient growth narrative, while Powell’s presentation at Jackson Hole confirmed that September will begin the easing cycle. The combination caused a mini short squeeze in cyclical baskets and the Russell 2000 (RTY). The RTY catch up trade remains the most compelling alpha generating opportunity in US equity markets with as much as 40 percentage points on the table. In late July, we warned readers that upside in the RTY without confirmation from cyclical cross markets like copper prices was unsustainable. Copper prices and the gold/copper ratio remain key to the outlook for RTY outperformance.

The focus should be on real yields (nominal yields – inflation expectations), which remain at elevated levels that are roughly in-line with levels from last summer. A current 2-year real yield of ~225bp is extreme monetary tightening and the Fed funds rate of 5.30 is at least 200bp above the Taylor Rule implied neutral rate. Note the NY Fed used two other measures to imply a neutral rate (unidentifiable in real time) of ~2.5%. With this in mind, many economists are now beginning to adjust their forecast to include 125bp of rate cuts this year and a cadence of 25bp cuts at each meeting into next summer.

Technical resistance for the SPX sits in the 5650-5745 range. A break below 5455 would signal a change in trend and make us short-term ‘tactically bearish’ for the third time this year. Next level support sits at ~5325 and then ~5130. Longer-term support sits at the ~4800 level that marked the top from late 2021.