As has been the case for the last few days, 2 data points to review with you today:
#1: We promise to come off Fed Watch once markets hear what Chair Powell says Friday morning, but for now we remain chained to this particular oar.Fed Fund Futures remain an important leading indicator of investor sentiment, as they have throughout 2019.
Here are the current odds of further cuts over the rest of the year:
- September contracts show 94% odds of a rate cut.
- Odds for a cut in October sit today at 58%, down from 68% yesterday.
- The odds that Fed Funds end the year with the central bank having cut rates three times (i.e. once at every meeting) are down to 33% today from 43% yesterday.
What this tells us: even if Futures markets are backing away modestly from their view that the Fed will systematically cut rates through December, that belief still lingers. Equity markets have learned to follow this lead since Futures have had the right call so far. Now it will be up to Chair Powell and the Fed to either support this perspective (good for stocks) or keep markets guessing (not so good…).
#2: Since August has been as volatile as we expected (and discussed with you repeatedly last month), let’s look at the sources of that churn and see what it says about the near future. To do this analysis we look at the Implied Volatility (IV) of both the S&P 500 as well as industry sectors by measuring the IV used to price listed options for SPY and sector ETFs like XLK (Tech sector), XLE (Energy) and XLY (Consumer Discretionary).
First, here is what the S&P 500 data has to say:
- Over the past 30 days the CBOE VIX Index is up 22%. Those of you who follow this measure know it only captures 30-day expected volatility. Looking across all expirations, S&P 500 IVs are actually up 36%.
- Options pricing as of today shows that traders expect volatility to decline in coming weeks. The numbers: actual 30-day volatility is 18.3%, but the IV in options prices is just 15.0%. Since volatility and market returns are typically inversely correlated, that’s a bullish sign.
- Unfortunately, the options market’s track record of calling future volatility has been mixed over the past year. It missed the December selloff, although it did catch the move higher for stocks in June/July.
The takeaway: expected future market volatility is low because options traders see a quieter cash market for stocks, due in large part to a belief the Federal Reserve will be cutting rates. As discussed in Point #1, that is far from a certainty.
And here are the sectors that most contributed to recent volatility:
- The IV of the S&P Tech sector is up 58% over the last month, the most of any industry. Given its 22% weighting in the S&P – the highest of any sector – Technology’s volatility is the prime driver of market-wide price moves.
- Industrials are the only other group with an outsized increase in future Implied Volatility, up 36%. Every other sector, from Communication Services (+4% in the last month) to Consumer Staples (+32%) actually shows smaller increases in IV than the S&P as a whole.
The takeaway: uncertainty over ongoing US-China trade negotiations and, to a lesser extent, the value of the dollar are the issues pushing expected volatility higher. The Tech sector, in addition to being heavily exposed to trade talks, also has the highest percentage of non-US revenues (58%) of any S&P group. Industrials, with their high fixed cost base, bear the brunt of market uncertainty regarding global growth.
Summing up our thoughts on market volatility: as much as we’d love to call an “all-clear” for US stocks after August’s 2% decline-to-date, we think it is too early for that. The data we have presented here shows that markets have stabilized because they think they know future Fed policy, but trade uncertainty remains and can move stocks lower whenever it rears its head. So far, one has offset the other. But remove the support of the former and stocks will face a rougher road coming into September.