groundhog day
Fed Funds Rate Expectations, 1/2/23 vs 2/23/23. Source: Federal Reserve Bank of Atlanta. Click for larger image
Inflation quieted the soft landing narrative once again in February, forcing a revision higher in interest rate expectations (chart below) that sparked moderate declines in both stocks and bonds. Relative to previous episodes, equity markets seemed to take February’s setback in stride with the Nasdaq 100 (-0.5% Feb) actually outperforming the S&P 500 (-2.4% Feb) in low-volatility declines that saw both indexes hold above key 50 and 200-day moving averages. Foreign equities struggled with a surging US Dollar, though like their US counterparts, MSCI EAFE (-4.0% Feb) and MSCI Emerging Markets indexes (-6.5% Feb) held above their respective 50 and 200-day moving averages throughout the month.
Extending the 10 month soft-landing stalemate (chart below), another move toward the Fed’s “higher for longer” message has created a VIX inflection point that can lead to- but has so far stopped short of- crisis territory. From our experience, this negative scenario is most likely to result from a financial plumbing issue caused by the delayed effect of a sharp spike in interest rates. Judging by recently resilient markets however, there are roughly even odds of a positive outcome for stocks in which inflation comes under control without any hiccups.
S&P 500 Index, 5/1/22 - 2/28/23. Source: Yahoo Finance
Playing with fire
Of note, both scenarios are likely to be intensified by the explosion of short-term “0 DTE” option strategies that thrive during market consolidations like the past 10 months, but also carry the potential to supercharge volatility when a future catalyst moves markets beyond expectations. Like the mechanical selling created by “portfolio insurance” during the Black Monday crash in 1987, any catalyst that spooks the massive exposure in today’s short-term option markets has the potential to snowball into a feedback loop where selling begets more selling.
“...in an extremely dire scenario, 0DTE options could turn an intraday 5% drop in the S&P 500 into a 25% rout”
Every inflection point in this context carries extra weight and so we will continue to respond in a systematic way, accepting false positives as the cost of protecting against a crisis scenario that could develop with astonishing speed. Of course, navigating difficult markets mostly takes patience- that’s what makes them difficult. For almost 10 months now, markets have gone nowhere and investors are growing anxious, unable to imagine anything changing. In our experience, this tends to produce poor investment decisions that create opportunities for more patient investors, and we intend to capitalize on them as we have in the past.