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Written by: David Lebovitz
Risk assets were better behaved in the aftermath of the Federal Reserve (Fed) meeting in July, and also coming out of Labor Day weekend. However, both of these rallies proved to be false dawns. In July, investors were under the impression that the Fed would pivot and cut rates in 2023, while more recently, investors had latched on to the idea that inflation was cooling faster than expected. In each instance expectations were divorced from reality, with tougher Fed rhetoric and an August CPI report that showed less cooling than expected forcing a repricing across capital markets.
Higher volatility represents a wider distribution of outcomes; given the plethora of questions around the outlook for inflation and rates, it should not be surprising that volatility has moved higher. As shown in the chart below, equity market volatility is sitting just above its long-run average while interest rate and foreign exchange (FX) volatility have remained nearly two standard deviations above their respective long-run averages. Looking ahead, it seems unlikely that equity volatility will be able to sustainably decline until interest rate volatility has returned to more normal levels; it is nearly impossible to price a financial asset if you cannot decide what the discount rate is supposed to be.
We still believe headline inflation has peaked on a year-over-year basis, but more clarity on the trajectory of inflation will be key in order for interest rate volatility – and therefore capital market volatility broadly – to decline. The Fed looks set to continue raising interest rates in a fairly aggressive way through the end of 2022, and potentially into 2023 if inflation proves stickier than expected. Housing inflation in particular looks set to remain stubborn, and a key question will be whether the Fed is able to differentiate between the stickiness in core inflation that is coming from housing versus consumer prices more broadly. The bottom line is that volatility looks set to persist into year-end, and we could well retest the lows seen in June; that said, it is important to remember that volatility creates opportunity for long-term investors.
Equity volatility has diverged from FX and rates
Z-score, 4-week moving average
Source: CBOE, ICE BofA, J.P. Morgan Index Research, FactSet, J.P. Morgan Asset Management. Equity volatility is represented by the VIX Index, interest rate volatility is represented by the MOVE Index and foreign exchange volatility is represented by the J.P. Morgan Global FX Volatility Index Data is based on availability as of September 14, 2022.
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