The markets continued to stabilize following last week’s massive spike in the VIX. That’s been a good thing for equity prices, but it’s likely coming at the expense of central bank credibility. The Fed’s insistence on using a backward-looking “data dependent” view instead of a forward-looking rate of change perspective has likely put it about one to two quarters behind schedule from when the easing cycle should have begun. The focus on an elevated core inflation rate was justifiable at the time, but ignored the cooling labor market, slowing growth and rising credit risk trends that were beginning to develop. Barring an emergency inter-meeting rate cut, which in my opinion seems very unlikely, the Fed will now be forced to wait five more weeks for its next meeting. During that time, we will get another round of inflation and labor market data that could further confirm the current negative trends before they can do anything about it (and let’s not forget about the 12-month lagged effects). Conditions are setting up for another potential bout of high volatility as investors are getting sucked back into risk assets right now.
For now, the VIX is back below 20, credit spreads have contracted and the yen has stabilized versus the dollar. That confluence of factors probably minimizes downside risk in the immediate-term, but does not mark a return to pre-VIX spike conditions. As it stands right now, I think two things are true. Small-caps hold the key and gold is sending a warning.
With regard to the former, we’ve seen small-caps within a month go from rotation beneficiary to risk-off asset. The event that triggered the huge rotation was a below expectation reading on U.S. inflation. Because U.S. growth was still viewed as largely positive at the time, equities were able to rally, but the sectors that did the rallying were changing. Value stocks, small-caps, cyclicals and defensives were the big winners, while previous leaders, including tech, were the big laggards. When the weak July jobs report was released, recession risk became the primary narrative and brought with it a strong risk-off pulse. That led to small-caps trailing large-caps again, which is what you’d typically expect in a regime of bearish sentiment. If small-caps keep trailing here, which is what’s consistently been happening since late July, it’s a stronger risk-off signal and a sign that the current rebound in equities may be a fakeout.
Gold may be sending a stronger signal.
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