Aftermath of a Big Wake Up Call

Yesterday, we posted a quick reaction piece to Federal Reserve Chair Powell’s Senate testimony.  We noted the sharp initial drops in both stocks and bonds and the modest bounces after the knee-jerk reactions.  Quite frankly, we didn’t foresee the full extent of yesterday’s sell-off, though it was well within the range of likely outcomes.

As we meander around the unchanged line on the S&P 500 Index (SPX), digesting yesterday’s moves in stocks and bonds, here are a few takeaways:

• Even though we gave back all of Friday’s big gains, we never re-tested Thursday’s lows  As a result, the technical factors that have been supporting this year’s advance in stocks – and a good portion of the bulls’ case – remain in place.  The chart below shows how the 50-day moving average remains a magnet for SPX, while the 200-day and major trendlines remain in place. 

SPX 6 Month Daily Bars (red/green), 50-Day (yellow) and 200-Day Moving Averages (blue)

Source: Interactive Brokers

• It would be fascinating, if not concerning, to see what might follow if those supportive levels are clearly broken.  For now, while they hold, there is still a general lack of concern.  We noted the tepid rise in VIX yesterday, and there is no apparent rush for volatility protection today.  The term structure of implied volatility for SPX shows some spikes around Friday’s Payrolls report, CPI/PPI next week, and the FOMC rate announcement two weeks from today but these are not levels that imply major concern.  The 21.6% peak for Friday implies a 1.35% move around the Payrolls data, and all the subsequent peaks imply smaller moves.  To be fair, the current levels are well above those of a week ago – the implied volatility for this Friday was 18 – but one might reasonably expect more concern about volatility surrounding a Fed meeting that is now considered “in-play”. 

SPX Implied Volatility Term Structure

Source: Interactive Brokers

• Speaking of an “in-play” Fed meeting, Fed Funds futures now show a 70% chance for a 50bp hike.  On Monday, that chance was only 25%.  We saw 2-year Treasury notes pierce 5% in response, though we saw a modest dip in yields on 10-year notes and 30-year bonds.  That widened the already concerning yield curve inversion. If the Fed is indeed ratcheting up its fight against inflation, it makes sense that long bonds might incorporate lower inflation expectations over time.  That same logic was a drag on gold prices, though it is allowing the NASDAQ 100 Index (NDX) to outperform SPX today.  If tech stocks are considered the ultimate long-duration assets, then lower long-term rates are a boon to their prices.

The key takeaway was the Chair reaffirmed the notion of a data-dependent Fed.  The magic word “disinflation” has gone by the wayside after a trifecta of higher-than-expected inflation reports.  That is why I have a difficult time wrapping my mind around the relatively low levels of VIX and other implied volatility measures as a series of key data points approaches.  Traders’ risk-on mentality remains in place as long as the technical remain in place.