Fed-Induced Equity Volatility

With little economic or political news this week, markets kept doing what they’ve done since late December. The Nasdaq-100 is essentially at record highs. In a day or two the S&P 500 will cover the 20 more points to the upside to get to its record highs. Meanwhile the VIX volatility index broke lower to its lowest level since October 2018 — just before U.S. equities began to roll over. All we can conclude at this stage is that the “good entry point” into equities (when the volatility index was spiking) is well past. We only need to harken back to 2017 to remember that volatility can stay at these low levels for months…and equities produce more upside gains for investors who take the risk of staying in.

Our bet is that there is one more upside surge in equities, which will come with the official announcement of a U.S.-China trade deal. Look for at least marginal record highs on the indexes (as the trading algos suck in the last money from the sidelines) before institutional program traders flip onto sell programs.


VIX index sp500 volatility


The macroeconomic news this week was highlighted by the Consumer Price Index, which shows inflationary pressures are mounting. The consumer price index jumped +0.4% in March to mark the biggest increase in 14 months. Over the past year, the cost of living has increased +1.9%, up from +1.5% in February.


consumer prices


Optimists will point out that three-fifths of the increase in March stemmed from higher energy prices, mainly gasoline and electricity. If the volatile food and energy categories are stripped out, so-called core consumer prices rose a scant +0.1% (a 12-month pace of +2% from +2.1%…the lowest level in a year). We believe that Energy counts, and that higher oil prices may very well stick. The Fed is too complacent on inflation, as we discuss below.

Elsewhere among U.S. macro data this week:

  • Factory orders in the U.S. fell in February for the fourth time in five months, reflecting a slowdown in the economy that began late in 2018 and carried on through the early part of the new year. Orders dropped -0.5% in the month.
  • The wholesale cost of U.S. goods and services surged in March, but almost all of the increase reflected the higher cost of gas. The producer price index climbed +0.6% last month. The rate of wholesale inflation in the past 12 months rose to +2.2% in March from +1.9%. PPI is still much lower compared to last summer, when it touched a seven-year high of +3.4%.


Producer prices


  • The price of imported goods rose sharply in March for the second month in a row, but once again almost all the increase was tied to higher oil prices. The import price index climbed +0.6% last month after a revised +1% gain in February. The increase in overall import prices in the last 12 months was flat.


import price index


The Fed Is Amplifying Market Swings

Each 6-weeks we get insights into the Federal Reserve Open Market Committee (FOMC) member thinking. According to the FOMC minutes published this week, the Federal Reserve’s decision in March to cease raising interest rates this year was driven by unease over the U.S. and global economies and surprisingly subdued inflation (at the time). As displayed above, the year-to-year changes in the CPI, PPI and import prices slowed sharply into year-end 2018 before accelerating again thus far in 2019.

Readers should recall that Fed rate decisions are officially based on the (1) inflation rate (Personal Consumption Expenditures), (2) the degree of “full employment” in the U.S., and (3) unofficially on the level of the S&P 500.

Starting with inflation, yes, the macro data was showing slowing price pressures since Q2 2018. In this week’s minutes, the Fed wasn’t worried about was rising inflation.

“It was noteworthy that [inflation] had not shown greater signs of firming in response to strong labor marketconditions and rising nominal wage growth, as well as to the short-term upward pressure on prices arising  from tariff increases”

Its hard to explain the Fed’s 180 degree turn-around based on inflation data. The Fed was “hawkish” on inflation as it was slowing int late 2018, yet the Fed has become “dovish” now that inflation is rising with higher energy prices.

Next, the full employment criteria. U.S. unemployment is at 3.8%. Federal Reserve policy should in no way be simulative based on employment.


civilian unemployment rate


So that leaves us with the unofficial FOMC objective of the S&P 500. Readers will already understand that the S&P 500 Q4 correction and rebound corresponded with the inflection in FOMC interest rate policy.

Given the huge V-shaped movement on the S&P 500 (2940 in October 2018, down to 2350 in December and back up to 2910 in April) surrounding the Fed’s interest rate forecasts, it’s hard not to conclude that the Fed has been the primary culprit for this wild equity market. Many are saying, including Mohamed El-Erian, that the Fed has switched from a stance that was “too hawkish” at the end of last year to “too dovish” presently. We agree that the Fed has done too much….way too much.

After the December FOMC decision Chair Jerome Powell held a press conference. In an “oh my God, he can’t be saying this” moment, Powell, with the S&P 500 already in a precarious position on December 19 (having ALREADY broken below the February 2018 lows), the chair struck a hawkish tone, reporting that two more rate hikes were in store for 2019. The “hostile Fed” triggered the sell-off capitulation into the December 24 lows.

Did the Fed chair forget about the FOMC policy objective concerning the S&P 500? Was inflation a worry in December? Gaming the Fed has been the secret to success since the Financial Crisis. However the Fed is not coherent, making gaming the Fed even harder. With the S&P 500 back to record highs, why this extremely dovish message from the FOMC. Do they know something we don’t know? Its hard to imagine PhDs on the committee can completely lack market savvy, but that is our best explanation. Blowing financial market bubbles is not beneficial in the long-run, obviously. Banking on the wealth effect to keep the economy rocking is short-termism, at best.


We are reminded of a quote from Peter Lynch. Saying that the stock market has gone up so much already, and it can’t possibly go up by much more, is one of the silliest and most dangerous things to say about the stock market. We can extend this to say that guessing at what moment that the Fed decides when equities are “high enough” or “too low” is also a silly and dangerous endeavor. We can conclude that, through missteps, the Fed is contributing to greater volatility in financial markets globally. Be cautious, and don’t fight the Fed blunders!


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