Powell Rate Cut Unleashes Volatility Tsunami
It wasn’t supposed to work this way.
In the rate cut playbook envisioned by Trump, Powell’s July 31st rate cut was supposed to send stocks higher while crushing the dollar. However, when the FOMC announce a “mid-cycle”, 25bps cut, the outcome was not only a surge in the dollar but also a surge in volatility not seen so far this year.
The sequence of events is familiar to all by now: at first, Powell’s rate cut spooked the market which had been expected either a 50bps cut, or an explicit promise of an easing cycle. It got neither, and neither did Trump, who the very next day realized that with the Fed now explicitly focusing on global uncertainties, read trade war, as a catalyst for future rate cuts as demonstrated by the following infamous chart…
…. decided to escalate the trade war with China by announcing 10% tariffs on the remaining $300BN in Chinese imports, sending stocks and bond yields plunging, and the market pricing in as much as 100bps of more rate cuts in 12 months, forcing Powell to cut far more than just another 25bps or so as the Fed Chair suggested in the July FOMC meeting.
China immediately retaliated by devaluing the Yuan below 7.00 for the first time since 2008 and halting US ag imports, which in turn prompted the US Treasury to declare China a currency manipulator. Meanwhile, China’s yuan devaluation means the White House is set to unveil even higher tariffs, resulting in an even weaker yuan, and so on, in a toxic feedback loop that may soon escalate the trade and currency war into an all-out shooting war.
And as the market braces for the worst in this new regime of unprecedented policy uncertaint, volatility has exploded, with the S&P chalking up its longest streak of consecutive big daily moves since the start of the year.
When the S&P 500 tumbled as much as 1.2% on Friday, it marked the eighth straight session the index traded in an intraday range of more than 1 percentage point (before closing a more modest 0.7% down), according to calculations by the Financial Times. It was the longest streak of 1%+ moves since a 29-day run that ended on January 10, when the market was convulsed by bouts of sharp selling and subsequent buying.
Additionally, indicating just how fickle traders have become and are willing to buy or sell everything on a single flashing red headline or Trump tweet, the S&P 500 on Wednesday reversed an intraday decline of 2% and finished 0.1 per cent higher; on Friday the S&P went from -1.2% to almost unchanged before closing down 0.7%. July 31 and August 1 marked the first time since May the benchmark swung between positive and negative territory and traded in a more than 1 percentage point daily range for back-to-back sessions.
What happens next is unclear: back in January, the market stabilized on hopes that the Fed would soon turn even more dovish. Now, paradoxically, the volatility has been unleashed precisely because the Fed turned more dovish, raising questions just what will stabilize the market this time.
Yet even with the recent fireworks in the market – the S&P closed down just 0.5% for the week, after suffering its biggest daily drop of 2019 on Monday, following by the year’s biggest 3-day rebound in the subsequent days – volatility has a ways to go before it catches up with the vol explosion that rocked markets at the end of 2018. While the VIX spiked above 24 at the start of the week, its highest closing level since early January, it was trading just below 19 on Friday, right on top of its historical average.
Additionally, at its Monday lows when it tumbled 3.0%, the S&P dropped to the mid-2800s, a level it first traded at the start of 2018 before its suffered the VIXplosive volmageddon event which eradicated inverse VIX ETNs, which sent the VIX just shy of 40. This time, VIX barely crept to 25.
And yet, according to Bank of America analysts, Monday’s selloff was one of the sharpest of all-time on a vol-adjusted basis. The S&P 500 lost almost 3.0%, or about 4.8x its trailing (EWMA) realized vol of 9.9%, the largest sigma loss we’ve seen since 10-Oct-18’s 3.3% selloff on a 6.3% trailing realized vol (-8.3 sigma). In fact, this was the 27th largest 1-day vol-adjusted decline in the history of the S&P 500 (since 1928), a move in the <1st percentile.
And another fascinating observation: while it may not seem like it, especially to traders who were active in 2008/2009 or August 2015, or Feb 2018, the market in the past 3 years has become the most fragile in recent history. As BofA calculates, Monday’s selloff “event” marked the 7th 4+ sigma drawdown in the S&P since 2016, the most in the 4-year window since 1949.
Other recent fragility events include those on 5-Feb-2018 (-5.5 sigma), 17-May-2017 (-5.1 sigma), 9-Sep-2016 (-5.9 sigma), and 24-Jun-2016 (-6.0 sigma). And with the trade and currency war between the US and China only just getting started, traders brace as many more market shocks are set to hit in the coming weeks and months.
One thing is certain: with stocks set to drop, the the dollar rising (for various reasons discussed here) Trump will not be happy, and what’s worse, Trump’s latest calls for 1% in rate cuts (or more), will only make the situation worse as rate cuts of that magnitude would only confirm that a juggernaut of a recession is coming. In any event, the Fed may have no choice but to comply with the president’s and market’s demands, and with Rabobank‘s recession probability index now the highest it has ever been…
… the bank does one better, and lays out how the Fed will cut over the next 16 months as it sends rates back to 0%.
Just as Trump wanted it.