Eye on Volatility
October 3, 2023
The $1.9T of additional pandemic-related fiscal spending in the spring of ’21 was unnecessary and reckless given that US manufacturing PMI was at an all-time record high of 59.23 at the time of its proposal in January. In February ’21, we compared the additional spending to the practice of force feeding a goose in the production of foie gras. That seems to be where we find ourselves today as elevated fiscal deficits contribute to the inflation spike and force the Fed to tighten monetary policy further/longer. Bond yields might be lower today had Congress allowed the government shutdown over the weekend, and markets would likely react favorably to a budget that now enforces fiscal discipline.
The S&P 500 (SPX) has moved into oversold territory, increasing the likelihood of a relief rally. At this point, a relief rally requires a meaningful downtick in bond yields with Friday’s Jobs Report and next Thursday’s CPI print as potential catalysts. Keep an eye on volatility. As expected, the CBOE Volatility Index (VIX) has lifted off mid-September lows near 13 and now sits at 19.5. Last week, we explained that levels above 18 tend to be progressive and levels above 22 become a headwind for rally attempts. Once released above 22, volatility often takes months to return to benign readings below 20. Our tactically bearish outlook that still depends on higher levels of realized equity volatility.
Monetary policy is extremely tight with 12-month real yields now at 385bp. Real yields need to be at zero for policy to be considered neutral and negative to be considered accommodative. Every cyclical recovery over the last 40 years was fueled by monetary accommodation and expanding money supply after a period of notable economic weakness. Today’s August JOLTs report shows no sign of a weakening economy, but labor markets are lagging indicators and can weaken abruptly. Markets are leading indicators with the recent price action in cyclically-sensitive equity benchmarks like the Russell 2000 (RTY), equal weight S&P 500 (SPW) and EuroStoxx 50 (SX5E) suggesting a period of economic weakness has already begun. The time to buy these equity benchmarks is just before the Fed is forced to cut rates and expand money supply. In the last 40 years, there have been four tightening cycles >250bp. It’s a small sample size, but each one of those cycles ended 1-2 months after the 5/10 yield curve steepened to a point that broke the downtrend. In current terms, we’ve identified a 5/10 yield spread greater than +19bps as the level that proceeds an ultimate Fed pivot. On Monday, the 5/10 spread narrowed beyond technical resistance at -7bp and is now barely positive.