Worried About Inflation?

It’s been a wild few days for stock traders.  Last Wednesday, ahead of the FOMC meeting, we warned that volatility often increased in the 3 day period after a Fed announcement. Last week proved no exception with a 1.89% fall, as evidenced below:

Three Day Chart, S&P 500 Index (SPX, white), June 16^th-18^th, 2021, Intraday Ticks

(Click on image to enlarge)

Source: Bloomberg

I believe that much of the move was exacerbated by Friday’s quarterly expiration of futures, index options, and stock options. Today, despite significant falls in the Asia/Pacific region overnight, stock traders are in a much more forgiving mood. Friday’s drop has been essentially erased this morning:

Four Day Chart, S&P 500 Index (SPX, white), June 16^th – 21^st, 2021, Intraday Ticks

(Click on image to enlarge)

Source: Bloomberg

Many technical analysts believe that gaps need to be closed. If that is the case, consider it mission accomplished for Friday’s opening gap.

It is customary for traders to think that volatility ebbs when markets move up sharply. That is a gross misconception. Right now we are looking at 2 consecutive days with over 1% daily moves. Just because today’s move was higher does not mean that the volatility doesn’t count (my friend Steve Sears refers to days like today as “socially acceptable volatility”). Volatility measures down AND up moves, though traders are understandably less eager to hedge when stocks move higher. Indeed, we see a substantial drop in the CBOE Volatility Index (VIX), but remember that VIX attempts to measure the market’s best guess for a constant 30-day expected volatility. The current reading of 18.35 is still consistent with roughly 1% daily moves, though. [1] 

Inflation fears and potential Fed tightening are widely believed to be behind the market’s action since last Wednesday. One would think that all the talk of reflation or tapering would lead to sky-high implied volatilities in common inflation hedges. So far that is nowhere near the case. Consider the following two graphs:

One Year Daily Chart of iShares 20+ Year Treasury Bond ETF (TLT, yellow), with 20 Day Historical and Current Implied Volatilities (orange, blue)

(Click on image to enlarge)

Source: Bloomberg

One Year Daily Chart of SPDR Gold Shares (GLD, yellow), with 20 Day Historical and Current Implied Volatilities (orange, blue)

(Click on image to enlarge)

Source: Bloomberg

Bonds and gold are both considered to be highly sensitive to inflationary fears. In the case of long-duration Treasuries, the sensitivity is direct. Government bond prices reflect inflationary expectations over the life of the bond and are also influenced by the Federal Reserve’s open market bond purchasing. Gold prices are not directly influenced by inflation, but as a “real” asset, it should benefit if inflation rises. It would be reasonable to expect either bond or gold markets to see higher implied volatilities if traders are fearful about the inflation picture or changes in Fed policy. We see that implied volatilities for both have risen from recent lows, but are nowhere close to levels that we have seen at various points throughout the past year. 

That points to an interesting conundrum. Implied volatilities were generally higher when Fed policy was more certain. Until recently there was no reason to expect an imminent change from the FOMC. Now, we have Fed governors who are actively discussing tapering bond purchases and inflation measures that are nearing or exceeding Fed targets. Yet bond and gold options are not pricing in levels of movement (or fear) that we saw when the Federal Reserve was undisputedly a tailwind to markets. In that light, is it all that surprising that equity markets are relatively sanguine as well? VIX and other volatility measures are also generally lower than they were for most of the past year. For now, stock traders are unwilling to be more fearful than their bond and gold brethren. They imply a relatively calm summer on the horizon. Let’s see if that forecast is correct.

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[1] See here: https://www.tradersinsight.news/traders-insight/securities/options/understand-the-rule-of-16/

and here: https://www.tradersinsight.news/traders-insight/securities/macro/vix-is-not-now-nor-has-it-ever-been-the-fear-index/ for more explanation.