The Market: Volmageddon is Here
Israel-Hamas was the spark on the gasoline-soaked kindling the Fed and soft landing economic and market bulls have been piling up for over a year. Buckle up.
Discussion
On September 24 I said that Volmageddon’s hand was on the door, and on September 28 I said that Volmageddon had opened the door while asking the question of whether it would step through. SPX went on to make a minor new low at 4216 on October 3 versus 4239 on September 27, but VIX never broke 20 on the upside and SPX quickly snapped back to almost 4400 by mid-October. Hardly a 2018-like Volmageddon event that takes the VIX well above 30 in a matter of days.
But now it’s here.
All the ingredients for a Volmageddon event have been in place for weeks now following a year of the Fed aggressively fighting soft landing economic and market bulls. As I’ve said from the very beginning of the Fed’s tightening campaign, the longer and harder the market fights the Fed, the worse the ultimate downturn because the Fed will need to take rates that much higher to force economic activity and markets down to a level that brings inflation durably back to its 2% target. And that is EXACTLY what has happened.
Now we’re in the process of reaping the hideous consequences. You don’t take UST 30s from a post-GFC average of 304 bps to 515 in less than two years, in a highly levered system, and keep fully valued equities pinned just below ATHs. That’s not how economic and financial gravity works.
Gasoline-Soaked Kindling
(1) First and foremost, underlying market breadth has been melting. This is classic late-cycle topping behavior and there is no debate. This is what happens ahead of “surprising” market events to the downside. And now breadth is breaking down sharply through key levels.
(2) The CDX market, through all of the soft landing mania, has refused to fully confirm soft landing economic and market bulls’ hopes and dreams. And now the important Investment Grade CDX index is breaking out to new local highs, leaving behind a nasty set of bearish divergences with SPX.
(3) Long-term interest rates have broken out decisively to the upside as the Fed has gone on pause with growth and inflation reaccelerating to the upside. And the upside pressure remains firmly in place as the US government refuses to take action on runaway fiscal deficits.
(4) Lastly, the gasoline. The Fed has soaked all of the above with highly aggressive rhetoric endorsing the move in rates as a way to tighten financial conditions sufficiently enough to contract economic activity in a manner that brings inflation durably back to 2%. Chair Powell’s Q&A last Thursday was the hawkish capstone to Operation Tighten FCI. Now with the Fed in blackout ahead of its November 1 FOMC meeting, Volmageddon’s path to strike is clear for the next 5 trading days.
The Spark: Israel-Hamas
As I said in The WOTE Report on October 15, outside of nuclear war or a global pandemic, Israel-Hamas might be the worst shock imaginable for this current macro/market environment. At minimum, war in the Middle East will keep a floor under the already-uncomfortably-high price of oil (if not drive it higher) against the backdrop of above-2% sticky inflation; additional spending in the US to fund support of Israel will keep upward pressure on long-term interest rates; and just broadly, acute geopolitical tensions will depress risk appetite at a time when risk premiums are already inappropriately narrow due to misguided belief in the Fed’s ability to engineer a no-recession soft landing.
Israel-Hamas is the classic “spark” that will be looked back on as the key catalyst for Volmageddon, but in reality, as discussed above, the gasoline-soaked kindling was already in place.
I have covered Israel-Hamas at length here and here, and I believe it will be critical to continue to monitor on an on-going basis given the market- and society-wide complacency about the likely and potential consequences of the war. My strong hunch is that the world is likely to finally “wake up” to the war’s importance once an event outside of Israel-Hamas takes place. Given the widespread #FreePalestine protests around the globe, a follow-on terrorist attack of uncomfortably large size is highly likely in the coming weeks.
The Window
On Friday, Cem Karsan detailed the bearish outlook for equities in a “window of weakness” that’s open ahead of the November 1 FOMC meeting. But most interestingly, he talked about a potential shift in the regulatory landscape going on behind the scenes in an attempt to rein in VOL market speculation.
Adding up all of the above: Don’t bet against the VIX moving substantially north of 30 by the end of this week.