Mid-week market update: Is the much anticipated market pullback starting? The U.S. equity market recently saw a violent rotation from growth to value, led by downdrafts in market darlings like NVIDIA and Palantir. Notwithstanding the change in leadership, I have been monitoring the evolution of the VVIX, or the volatility of the VIX, which spiked above the 100 level yesterday. Past episodes were signals of market weakness of differing degrees.
Equally important is the 5-day correlation between the S&P 500 and VVIX, which rose to the 0.60 level on Monday and pulled back. Past correlation spikes have also been signals of short-term market weakness.
In all likelihood, VVIX is rising because of the uncertainty arising from Jerome Powell’s Jackson Hole speech on Friday.
Looking Ahead to Jackson Hole
The Fed symposium at Jackson Hole is supposed to be a time for policy makers to take long-term views of policy. This time, the market focus is on the short-term outlook for interest rates in 2025 and 2026.
As this is Powell’s final Jackson Hole appearance as Fed Chair, much anticipation is building over a review of Fed policy. This year’s symposium title of ” Labor Markets in Transition: Demographics, Productivity, and Macroeconomic Policy” tells the story of the stakes involved.
Five years ago, Powell unveiled FAIT, or Flexibility Average Inflation Targeting, as a response to persistently low inflation that was below the Fed’s 2% target. The idea was to allow inflation to run slightly hot as compensation for the past periods of low inflation. Under FAIT, appropriate monetary policy will allow inflation to run “moderately” above 2% for “some time.” In the quantitative policy rule for FAIT in the staff white paper, that “some time” for averaging is 32 quarters. Since then, core PCE has been above 2% for over five years. Core CPI inflation is stubbornly above 2%, and tariff effects appear to have pinned the inflation rate above 3%. Even worse is the revival of service inflation, which is largely unaffected by tariffs.
The Fed is widely expected to abandon FAIT but stick to its 2% target, which could be interpreted as hawkish. However, there will be debate among attendees about the other component of the Fed’s employment mandate. Are the BLS payroll revisions largely attributable to a lack of demand from employers, or the combination of the demographics of Baby Boomers exiting the labour force and the deportations that shrank the pool of available workers? A rate cut will boost employment if there is a lack of demand, but will do nothing because lower rates will not produce more workers.
The market consensus calls for a 85% chance of a quarter-point rate cut at the September meeting and a total of two quarter-point rate cuts in 2025. MarketWatch reported that well-known Fed watcher Tim Duy warned about the risks to the consensus view: “The assumption that the last employment report all but guarantees a September rate cut has driven market pricing… and if that assumption is wrong, pricing may suffer a harsh reversal.” Nevertheless, Duy expects the Fed to cut rates in September and December.
This is the part where expectations plays a significant role in market returns. Even though the consensus calls for a quarter-point cut in September, Edward Bolingbroke at Bloomberg observed that open interest in secured overnight financing rate (SOFR) option positioning is betting on a the tail event of a half-point cut.
All eyes will be on Powell speech, scheduled for Friday 10 ET. As a preview, the release of the FOMC minutes shows a bias against excessive easing as the majority saw inflation risk outweighing employment risk. Many noted the full effects of tariffs could take some time and some worried about the risks of unanchored inflation expectations.
Here are some possible outcomes of what he will say:
- FAIT is dead, the Fed will focus on a 2% inflation target, but give a nod to the Fed’s dual mandate.
- As a compromise, Powell signals a precautionary rate cut in September, but emphasizes that further cuts will be depend on the evolution of the data.
- Powell discusses the limits of monetary policy by highlighting the debate between supply-driven labour market weakness and demand-driven weakness.
The first outcome would be interpreted in a hawkish fashion. The second may not be enough to satisfy the bulls. A discussion of the causes of weak employment would be a signal the Fed may not be ready to fully embrace an easing cycle. The market is setting up for a hawkish surprise on Friday. This explains the spike in the VVIX.
The good news is breadth is holding up as the large-cap growth leadership hit an air pocket. The bad news is that may not matter to short-term market direction, though better breadth participation may cushion the magnitude of a price decline.
