Volatility Expected to Persist as US Economy Remains on Course for Soft Landing: UBS

The equity market has experienced notable volatility in the past 24 hours, with major indexes, including the tech-heavy sector, closing 1% higher on Tuesday. This comes after a significant 3% drop in the S&P 500 on Monday.

Concurrently, the VIX implied volatility index decreased to around 28, having spiked above 60 during intraday trading on Monday.

In response to these changes, market expectations regarding the Federal Reserve’s pace of rate cuts have shifted considerably in recent weeks. Fed funds futures markets are currently indicating an anticipated 136 basis points of cuts in 2024 and an additional 97 basis points in 2025.

Analysts at UBS expressed that with interest rates at 5.25-5.5%, the Fed has the ability to support the economy and markets. They believe that recent data should enhance the Fed’s confidence in achieving its 2% inflation target sustainably.

Expectations are now that the Fed will implement a 50-basis-point cut at its September meeting, followed by an additional 50 basis points of easing throughout 2024, with more reductions likely in 2025.

Market fluctuations in equities, bonds, and currencies have been partly attributed to the unwinding of popular investment positions, including long positions in large-cap U.S. tech stocks and short positions on the Japanese yen.

While assessing the full impact of these adjustments on market volatility is complex, UBS notes a growing cautious sentiment among investors towards riskier assets. Evidence of this shifting mindset can be seen in the options market.

The put-call skew has increased since last week, indicating that investors are now more inclined to pay for downside protection rather than seeking upside potential. Additionally, the implied volatility term structure for the S&P 500 has inverted, with three-month volatility surpassing one-year volatility for the first time since the banking crisis in March 2023.

Strategists believe this reflects concerns that the Fed may risk a policy error by failing to respond quickly to slowing growth.

Despite the weaker payroll data reported last Friday, analysts maintain that recession risks are low. Their base case scenario suggests a “soft landing” for the U.S. economy, predicting growth to bottom slightly below the 2% trend while inflation continues to moderate.

Analysts also highlight that corporate profit margins remain robust, suggesting that companies are unlikely to initiate job cuts. Data on June retail sales and personal consumption expenditures indicate that consumer spending is stabilizing from elevated levels rather than declining. Overall, households are in a solid financial position, and sentiment in the services sector remains positive.