Time For a Refresher Course

By: Steve Sosnick, Chief Strategist at Interactive Brokers

Those of us who work in a registered capacity in the securities business are not fans of the periodic emails from compliance reminding us that we need to refresh our credentials for the Series 7 and other registrations. We understand the logic – it is important for any professional to remain current – but it seems burdensome nonetheless. In that spirit, we offer a refresher about the concepts that have been driving markets over the past few sessions.

Lesson 1: Expect Volatility, the Socially Acceptable Variety Too

Our main theme for the year was for investors should prepare themselves for more volatility. What we said at the end of last year applies today:

The primary theme is for investors to expect more volatility than we’ve seen over the past year-and-a-half. The changing monetary environment should be the cause. At the risk of introducing an inconvenient analogy, investors have become addicted to ever-present monetary stimulus. Even under the care of a skillful clinician – or central banker – patients who are withdrawing from an addictive substance can suffer setbacks en route to a cure.

It is also crucially important to remember that upward moves count as volatility too. The difference is that people generally like when markets rise. That led us to term those moves “socially acceptable volatility.”But it is clear that we are moving up and down much more dramatically than we have since the Covid-induced stimuli took hold. Get used to it.

Lesson 2: The Fed Hasn’t Actually Done Much Yet

Federal Reserve Governor Lael Brainard spooked markets yesterday when she mentioned that the Fed could raise rates more aggressively than 25 basis points per meeting and that balance sheet reduction could begin as soon as May. Neither of these actions should have come as a major surprise to investors – both have been rumored as possibilities for some time – but they proved to be an inconvenient reminder at an inopportune time. Bond markets were already fragile, and her comments led to sharp rises in long-term rates. Stock traders eventually took notice of the plunging bond prices, leading to significant two-day selloffs in major US indices. 

It is important to keep in mind why markets may have reacted so negatively. The Fed hasn’t really done anything yet! Sure, they’ve raised Fed Funds rates by 25 basis points, but ¼% is just a drop in the bucket. They’ve ceased their bond purchases, but the holdings of securities on the Fed’s balance sheet have continued to grow anyway, just at a slower pace:

(Click on image to enlarge)

Source: Federal Reserve H.4.1 Releases, Interactive Brokers

If stock and bond, markets have generally reacted poorly to the idea of Fed tightening even before it has started apace, what happens when the Fed actually kicks their activities into gear?

Lesson 3: VIX Is Not the Market’s “Fear Gauge”, but It Plays One On TV

The movement in the CBOE Volatility Index (VIX) over the past month has been nothing short of spectacular. While we have consistently reminded readers that VIX is not actually constructed as a “fear gauge”, it harbors important messages regardless. Consider the following graph:

VIX Futures Curves, Current (yellow, top), 1 Week Ago (red, top), 1 month ago (purple, top), with Changes (bottom)

(Click on image to enlarge)

Source: Interactive Brokers

When we compare the purple and red lines in the top graph, we see not only that the “spot” VIX level (the leftmost dot) plunged, but that the curve flipped from inverted to normal in that time. In short, we went from quite nervous to quite sanguine in just three weeks. Over the past, we see VIX reflect a bit more concern in the short term, but not full-fledged anxiety like we saw a month ago. 

It is common for traders to consider that the market is due for a bounce when VIX futures are steeply inverted and at a high level, and too complacent when the curve is normally sloped with spot VIX in the teens. While both of those signals held over the past month, the current picture is a bit murkier. Perhaps we need to re-read item 1.