I’m compelled, I suppose, to weigh in quickly on Wednesday’s post-Fed stock “crash” and the accompanying vol shock.
I put “crash” in square quotes. A 3% decline on the S&P’s a meaningful move, but considering the year it’s been — let’s not forget we’re tracking for a second consecutive 20% annual gain — it’s hardly a disaster. The Magnificent 7 dropped 4% as a collective.
The impetus was the Fed, and specifically the prospect of “just” two 2025 rates cuts versus the four tipped in the September dots. Between that, upward revisions to the inflation forecasts and a hawkish dissent in favor of a “Santa pause” (shoot me now if that’s the bar for clever humor in 2025), Wednesday’s cut was indeed of the “hawkish” variety.
Jerome Powell didn’t say anything during the press conference to dissuade the market from that interpretation, and the front-end sold off meaningfully, with twos 10bps higher.
There are two quick points I want to make beyond the pedestrian observation that stocks fell, a thing that can and does happen occasionally, believe it or not.
First is that the selloff looked pretty indiscriminate. As ever, some sectors and names suffered more or less than others, but from where I’m sitting — which, incidentally, is on a bar stool at the kitchen island in the great room of a half-finished house — pretty much everything equities wise was a loser on Wednesday. As the figure below shows, a measure of implied correlation rocketed skyward.
That’s a very large one-day move, and it recalls the fireworks around the early-August growth scare.
The historically acute “haves” and “have-nots” dynamic in play in US equities has contributed to a correlation crush, which in turn facilitated and encouraged the dispersion trade. Simplistically, that trade funds longs in single-name vol with index-vol shorts.
After getting gut-punched in early August and then again after Labor Day, the long dispersion trade was performing well into the bifurcated equity rally. I don’t know, sitting here right now, how a generic (modeled) version of that trade fared in Wednesday’s FOMC rout, but based on the vertical inflection in correlation, my guess would be it ran into problems.
If that’s the case, those problems could’ve spilled over into the vol complex, to the extent the funding legs (i.e., the index vol longs) were squeezed.
“When there’s such a clear dichotomy between winners and losers thematically and correlation drops, long dispersion benefits and index vol bleeds, especially in a world where we have not seen outright risk-off shocks for a long while, and which tend to go hand-in-hand with ‘Corr1 shocks,'” Nomura’s Charlie McElligott wrote, in a December 17 note which sounded prescient just a day later.
Recall that the equities vol complex had a very difficult time in early August (and post-Labor Day), as dealers apparently struggled to recycle risk from the VIX upside they were short to clients. A week ago, I noted, citing Charlie, that end users were buying VIX calls again, which in turn had dealers’ short position looking a bit stretched.
Given that, it’s possible Wednesday’s rather dramatic moves in the vol space were yet another example of the risk-recycling problem. Have a look at the figure below.
Vol of vol was bid Wednesday. (I’m employing a deliberately understated cadence for comedic effect. That’s a 90-degree angle you’re looking at.)
Whether Wednesday’s shock will have any staying power is debatable. As we saw in August and again in September, these sorts of events, to the extent they’re partly a product of a vol complex which, for structural reasons, is prone to outperforming its historical relationship with spot equities, can fade quickly.
Personally, I didn’t hear much from the Fed that should’ve surprised anyone, so I do wonder if the reaction was a bit of a false optic tied to interrelated (and ostensibly esoteric) dynamics that most (too many) investors (still) don’t understand.
Recent past history suggests vol will fall back quickly. But if for some reason it does not, after a week or so we might be treated to some selling from our friends in the fully-loaded up vol-driven models.
Otherwise, it’s back to parsing the nuances in the dot plots.
So, I fail to understand something here (many things, but limiting self to one thing today).
For FOMC to cause a big vol shock, it had to be a big surprise – right? How was it a big surprise that FOMC would deliver “25 then slow/watch and think about 50 more next year”? I don’t think it could have been or was.
Are we in a situation where a little surprise results in a big vol shock? Basically we’re just way too geared up?
is on a bar stool at the kitchen island in the great room of a half-finished house … Sounds just enough uncomfortable to sharpen your mind.
I detect presence of a bond vigilante. if the government does end up having to borrow more or if the economy begins to stall and the government decides to juice it with stimulus, those bond vigilantes could decide to saddle up.
President-elect Elon Musk also blew up the Congressional spending bill. Nothing like threatening a shutdown and ostensibly a US default to chill your risk appetite. Nothing like uncertainty to bid vols.
I love the fact that Trump hasn’t even been sworn in yet and Republicans are already flailing. What’s the over/under on the number of Mooches before Trump gets tired of another social media blowhard with a larger platform and infinitely more money taking away the spotlight and trying to govern for him?
What Powell said was not that shocking. To paraphrase, growth is a bit better than we expected and inflation is a bit higher. Employment is mixed. So we don’t think we need to cut as quickly as previously and possibly not as much.
The reality is too many folks were too bullish and got caught offsides.
This is not a crisis. Problems overseas are bigger, China, South Korea, Brazil, France, Germany, New Zeeland are all having troubles.
We will have ours starting January 20th….
Maybe folks are starting to figure out that the inmates will be running the asylum….
I looked at the daily volumes on a few of the individual stocks that are in my portfolio- about 15% higher than the average trading volumes over the last 3 months. So higher, but not by an alarming amount. Much ado about nothing?
Can’t wait to see pictures of your new home. I still recall the photo, captured the “old fashioned way” -with a camera, that you posted of the view from the kitchen window of your Island home. Such a beautiful view, so I know you have ‘good taste’ in real estate.
jawboning cars and Mars guy didn’t help