Tomorrow brings us the Fed's minutes from their November meeting at 2:00 pm EST. We'll be paying careful attention to what is said about the economy, and in particular inflation, the jobs market, and consumers.
During the November FOMC press conference Chair Powell made it clear he wasn't satisfied with the progress being made, felt that the terminal rate had to go higher than previously thought, and expressed concern about how tight the job market remained. He stated that the consumer remained resilient and that the Fed wanted to see below trend growth (or what we feel is really Fed language for a demand destroying recessionary environment).
While the Fed's press conference rattled the market after a seemingly vaguely dovish policy statement regarding "cumulative tightening", those losses have been more than made up, almost as if they never happened.
But tomorrow will bring a rather jarring reminder of just how hawkish the Fed was during the last meeting, and I think it may give the bear market rally a reason for pause.
Going into tomorrow we see the yield curve falling to -71 bps. The rate at which this inversion is happening, as well as how long it has lasted, likely portends to a rather nasty recession. At least that's what the bond market is telling us.
On average a recession starts within 19 months of the initial inversion, but in this case I think we'll see a worsening recessionary environment as early as the first half of 2023. That all being said, an inversion this deep may start to make some more observant market participants a bit nervous, particularly with earnings season less in focus and the Fed and the economy coming into full view.
Within the last week we've seen an increase of 25 bps for 2023 via CME Fed Funds Futures, but markets have shrugged off this more hawkish projection without a second thought.
Meanwhile, Bullard suggested a terminal rate as high as 7% could be possible if the Fed does not make sufficient progress fighting against inflation. While it's easy to write him off as being extreme, he's actually been relatively on point for over a year.
We may hear more about the Fed's terminal rate in the minutes, and if it is much higher than they thought before as Powell suggested that may not be received well by stocks.
The divergence between MOVE (blue) and VIX (red) is growing again, with the MOVE rising today as VIX fell off a cliff again. Will the Fed minutes be a volatility catalyst again?
As this spread widens between MOVE and VIX, often MOVE will drag VIX higher as volatility in credit markets tends to permeate into equity markets. Such a move higher in equity market volatility often portends to lower prices in stocks.
The spread between realized and implied volatility is growing, with 1-month realized at 26.66 and implied vol 21.29. This implies a market that is underVIXed by about 7.37 points if we include a two point dealer premium.
An underVIXed market can be more vulnerable to fattened left tails, meaning that we may see larger downside with a large event volatility catalyst -- like Fed minutes if they spook traders and investors.
More evidence of the poorly hedged market exists in the lack of skew toward put premium in SPX. Market participants are not using the index's options to offset risk as those put options against it (and VIX calls as well) have not performed well so far in 2022.
But without sufficient hedging in place, left tail risk grows as sell-offs can accelerate quickly. Particularly in an environment like we are experiencing now where liquidity is quite low.
Last week on Wednesday we saw the CBOE equity put/call ratio hit 1.46, the highest level since 1997. An extreme that tells us a lot of market participants are on edge and will pile into puts if there is a strong bearish backdrop that inspires fear.
If we get that sort of flow tomorrow it could extend downside further, particularly in the shares that tend to see these inverse delta squeezes via intense put buying, such as longer duration risk and other speculative parts of the market.
Volume has been dropping, and with that brings a market where it takes less effort to make price really move. Especially given that we're seeing more and more participation expressed through options rather than futures or shares.
The lack of volume and order book depth sets up the market to be more vulnerable to big moves in either direction, amplifying potential price discovery outcomes, particularly if there is a powerful catalyst.
We've all been watching the dollar closely as it's had a strong negative correlation with stocks, but the dollar seems to be following the path of rates and particularly the 10-year note. The recent sell-off in the dollar vs other currency pairs was part of a much needed correction, but I wonder whether the sell-off was too deep.
The firmness of 10-year yields as the dollar fell much farther suggests that perhaps the dollar has some room to catch back up. If that's the case, it could exert some negative pressure on stocks. A Fed that appears hawkish could create that catalyst.
Tomorrow may bring us some fireworks with all of the economic data and in particular the FOMC minutes release. It's already a holiday week, which means there's much less participation, and in an environment where liquidity was constrained already.
I would be cautious of how the market trades during and right after the release as it could get a bit sloppy, but after that we may get a better sense of directionality and whether the move could signal a shift in recent upward momentum or if it is just a small blip as the market looks past it to December's meeting.