Poised for a Volatilty Spike

Preface: Explaining our market timing models

 

 

 

 

Volatility Suppression and Expansion

The accompanying chart shows the hourly swings of the S&P 500 as an illustration of realized market volatility. The grey bars represent instances of large swings of 2.5% or more, which are consistent with market panics and likely bottoms. Realized volatility calmed since the “Liberation Day” sell-off, but began to expand slightly recently.

This is a case of price stability can create instability. Excessive positioning in response to a lower volatility sets up periods of volatility bursts. This is one of those times.
 

 

Needless to say, higher implied volatility generally translates into air pockets for stock prices. Here’s why.
 

 

Volatility Suppression at Work

There are two factors that suppress realized volatility. The first is the Trump collar and the second is a surge in call option overwriting in response to the lower realized volatility environment.

Let’s begin with how the Trump collar works. When trade war anxiety is high and implied stock and bond volatility spikes, the TACO (Trump Always Chickens Out) trade is activated, which suppresses downside volatility. On the other hand, when trade anxiety is low and implied volatility is low, it encourages Trump to assert his Tariff Man persona, which suppresses upside volatility. In the wake of headline trade deal victories with Japan, the EU and other major trading partners, the market entered the Tariff Man zone and volatility is poised to spike.

The pattern has become sufficiently predictable that Nomura cross-asset derivatives analyst Charlie McElligott dubbed Trump the “human VVIX”, as he is one of the few people who can singlehandedly move the VVIX, or the volatility of the VIX, in an instant.

Short-term risk is rising. A negative divergence is forming as trade war anxiety has risen from the low to neutral zone, but equity and bond volatility is tame and falling. The divergence is a setup for a volatility spike in the near future, though the cause is unknown.
 

 

The derivatives team at JPMorgan argues that the current environment is setting up for a volatility spike from option overwriting. Here is how the process works.

In response to the relatively low realized volatility environment, large institutional players stampeded into buy-write positions, where the investors buy the underlying and sell a slightly out-of-the-money call option against the position, to enhance income. As implied volatility fell in response to realized volatility, these players have resorted to overwriting, or selling more calls than the size of their underlying long positions.

Here is what happens. As the market rises, the positions run into call inventory held by dealers and realized volatility declines. As the positions expire, and they are reset at higher levels, the market moves more freely, less constrained by the stabilizing influence of dealer gamma hedging.

 

These conditions is a set-up for a disorderly unwind where sudden downward price spikes, which can be caused by anything such as a sudden risk-off market surprise or even overly exuberant profit taking, could generate a selling stampede by leveraged dealers to hedge their downside risk of their option positions.
 

This is another “this will not end well” set-up with no obvious bearish trigger. Here are some possible bearish tripwires to watch.
 

 

Fed Policy Uncertainty

In the wake of the much weaker-than-expected July Jobs Report, the market consensus is now overwhelmingly discounting a quarter-point rate cut in September, and a total of three quarter-pint cuts in 2025.

Everyone please calm down! While the Jobs Report was extraordinarily weak, it was only a single data point. What if the consensus is wrong and market participants are caught offside in their positioning?
 

 

Fed policy makers will see one more jobs report and two inflation reports before the September FOMC meeting, starting with a CPI report next week.

In addition, debates are appearing about the meaning of the weak July report. Former Fed economist Claudia Sahm (of the Sahm Rule fame) rhetorically asked the reason behind the weak July report.
She first analyzed the source of the negative revisions that caused the uproar. She found that the June revision was mainly attributable to the collection of late data and the May revision was attributable to seasonal adjustments from the birth-death model.

 

Sahm went on to analyze the reason behind the weak jobs growth and the implications for monetary policy. Was it mainly driven by weak demand or weak supply?

She concluded that weak jobs growth is mainly attributable to weak supply, which cannot be boosted by rate cuts.

Currently, the data suggest that reduced labor supply is likely the key driver though reduced demand is playing a role and the risk of cyclical weakening in the labor market have risen.

In her post, Sahm went on to analyze the indicators she cited, immigration, the unemployment rate and wage growth, and found that they are consistent with the picture of weak labour supply.

I concur with her interpretation. The effects of Trump’s immigration crackdown and deportations are showing up in the economy. As an indirect indication, remittances to Mexico have collapsed in 2025.
 

 

The recent decline in initial jobless claims (red dots and line, inverted scale) is consistent with an economy that’s slow to fire and slow to hire. Given the rough inverse correlation between initial claims and nonfarm payroll, it’s therefore entirely possible to see nonfarm payroll strengthen in the coming months.

Watch for Fed officials to raise these issues at the annual August Jackson Hole symposium.
 

 

 

A Question of Credibility

While I am on the topic of Fed policy, Trump’s actions in the coming weeks and months will be a signal to the markets of the credibility of the Federal Reserve and U.S. government institutions.

Two positions will be open on the Fed’s Board of Governors in the coming months. Trump stated in an interview that he has narrowed the short list to replace Fed Chair Powell. While Treasury Secretary Scott Bessent is expected to stay in his job, Trump said that he likes the “two Kevins”, Kevin Hassett and Kevin Warsh.

As well, Fed Governor Adriana Kugler’s resignation leaves an opening for Trump to pick a governor who conforms with his preferences. However, the nomination of a candidate that the market judges to be overly sycophant to Trump’s expectations could damage Fed credibility.

The nomination of Stephen Miran to fill Kugler’s position on a temporary basis until the expiry of her term on January 31, 2026 has the elements of both good news and bad news for market stability. The bad news is Miran is a strong proponent of tariffs and made a dogmatic case that the levies have no inflationary impact, which would support Trump’s case for rate cuts. In his paper, A User’s Guide to Restructuring the Global Financial System, Miran is also an advocate of an unconventional policy of global financial repression by pressuring trading partners to buy U.S. century bonds to finance U.S. debt through a combination of tariff threats and the offer for the protection of the American security umbrella. The good news is the appointment is only temporary until a permanent replacement can be found. The choice of Miran is a preliminary signal of how a Trump ally that could cause disquiet in the bond market.

There was also general surprise and pushback against the firing of BLS Commissioner Erika McEntarfer, a career and nonpartisan civil servant, for the poor jobs report. While it was perfectly understandable to call her on the carpet to explain the nature of the revisions, the consensus was her termination for “cooking the numbers” went too far and risks the politicization of an important government agency like the BLS.

The market’s perception of her replacement will be another important sign of U.S. credibility. Benn Steil of the Council on Foreign Relations “found that firms in high‐manipulation [Chinese] provinces [that manipulate GDP growth] suffer higher cost of equity — in the range of 3–6 percent higher”.
 

 

A Bloomberg market commentary went further and characterized it as “Trump’s $2 trillion gamble”. In particular, “That link is perhaps most acute in Treasury inflation-protected securities, where the face value of a bond is adjusted based on the consumer price index, which is calculated by the BLS. Interest payments are based on that floating principal.”

The CPI report next week, which is produced by BLS, highlights the importance of an unbiased and nonpartisan government statistical agency. It’s possible that the weak 10-year and 30-year Treasury auctions last week were shots across the bow of the Trump Administration. Since the announcement of McEntarfer’s termination, foreign sovereign bonds have outperformed Treasuries, the USD has weakened and non-U.S. stocks have beaten the S&P 500.
 

 

 

Ripe for a Technical Reversal

In the short run, the technical internals of the stock market are primed for a corrective reversal. Banking system liquidity is falling, which will create headwinds for stock prices.
 

 

Nautilus Research pointed out that the relative ratio of defensive to cyclical sectors is testing a multi-year support level. A reversal and evidence of defensive leadership, even if it’s brief, would be the sign of a risk-off event that’s bearish for equity prices.
 

 

Even more disconcerting, the defensive to cyclical ratio looks worse than it appears. An analysis of the relative performance of the technology sector compared to the cyclical sectors shows that cyclical relative performance isn’t that exciting. Of the three major cyclical sectors, industrial stocks performed the best, but they violated a relative uptrend and the sector is consolidating sideways. The relative performance of the other two cyclical sectors are flat to down. U.S. leadership is narrowly concentrated in technology stocks.
 

 

These conditions raise the risks of narrow leadership and weak breadth. Even as the NASDAQ 100 has ground steadily upward on a relative basis, leadership has failed to broaden out in other market cap bands, which is a negative divergence warning.
 

 

I am closely monitoring the market action of consumer staples, an important defensive sector, as a bearish tripwire. The sector ETF is testing resistance at its all-time high. Relative performance is turning up and relative breadth indicators (bottom two panels) have been slowly improving. An upside breakout would be a signal that the bears are taking control of the tape.
 

 

 

A Correction in an Uptrend

Despite my caution, I remain long-term bullish on equities. The buy signal on my long-term timing model flashed a buy signal in June when its monthly MACD recycled from negative to positive. That buy signal is still in force.
 

 

In addition, the percentage of countries in a bull market, defined as up 20% or more from its 52-week low, just reached 65%. This is an indication of global breadth support for an advance in the equity asset class.
 

 

In conclusion, I remain long-term bullish on equities. In the short run, realized volatility declined since the “Liberation Day” panic, but conditions are setting up for a near-term volatility spike. Uncertainty over Fed policy and government credibility are possible catalysts for a disorderly increase in volatility and market correction. As well, the signs of narrow leadership, weak breadth and stretched risk sentiment elevates the risks of a pullback.