Fed Rate Cut Expectations Drive Equity Volatility and Defensive Rotation

Key Quotes

"Uh, earlier last week, you had four different governors come out and say that they were kind of not in favor of a rate cut. Uh, and the Nasdaq followed suit, sold off, you know, three or four percent. Friday morning, uh, you had another Fed governor come out and say, actually, you know what, we do think that a rate cut is coming. And you saw Nasdaq rally like 1.5%."

Brian Garrett explains that market movements, specifically in the Nasdaq, are heavily influenced by changing signals from Federal Reserve governors regarding interest rate policy. Garrett highlights how initial indications against a rate cut led to a sell-off, while a subsequent statement suggesting a cut caused a rally. This demonstrates the market's sensitivity to perceived shifts in monetary policy.

"When we look at our Prem brokerage data, when we talk to the guys who work on the one delta desk, uh, you know, we continue to see investors be long equities, but there's a rotation between kind of the highest flying, higher vol, information technology sectors into, uh, kind of the more defensive sectors. Healthcare, financials, industrials."

Brian Garrett observes that while investors remain generally bullish on equities, there is a discernible shift in their strategy. Garrett notes a rotation away from high-volatility technology stocks towards more defensive sectors like healthcare, financials, and industrials, indicating a move towards perceived stability.

"So as you see VIX and implied vol rally, um, you know, the top of book liquidity in E-mini futures is actually at one of the lowest points of the year. So it's kind of like vol begets vol. One thing that a lot of clients are focused on is the systematic community. SPX broke its short-term momentum threshold last week, which in our data, Goldman Sachs data, you know, suggests that you could see up to $50 billion of global equities for sale over the next week, $60 billion over the next month."

Brian Garrett points out a correlation between increasing market volatility (VIX and implied volatility) and decreasing liquidity in equity futures. Garrett explains that this phenomenon, where rising volatility leads to reduced trading depth, is further exacerbated by systematic trading strategies. He cites Goldman Sachs data suggesting that a broken momentum threshold could trigger significant sell-offs in global equities.

"You take VIX, you divide it by 16, and that tells you roughly what the daily implied move for the market is, for the SPX. So VIX at 16, you'd expect the market to move 1%. 16 divided by 16. Uh, the VIX at 24, you're talking about a percent and a half. When we look at what the market has done intraday over the last two weeks, it's been about a two and a half to three percent daily trading range. In that sense, VIX at 24 is not high."

Brian Garrett provides a simple heuristic for understanding market volatility by relating the VIX index to expected daily price movements in the S&P 500 (SPX). Garrett illustrates that a VIX of 16 implies a 1% daily move, while a VIX of 24 suggests a 1.5% move. He then contrasts this with recent market behavior, noting that the actual intraday trading ranges have been larger, implying that a VIX of 24 is not exceptionally high in the current context.

"Very simple way to do that, which we've seen is rotating from S&P market cap weighted into S&P equal weighted. Uh, so, you know, the equal weight S&P index is 15% financials, 15% healthcare, 15% industrials. You still have 12% tech, so it's not like you're not invested in tech. You're just not benchmarked to the mag 10. You know, you've got an exposure to 500 of the best companies on planet Earth."

Brian Garrett suggests a strategy for investors seeking to diversify away from concentrated technology holdings. Garrett explains that shifting from a market-cap-weighted S&P index to an equal-weighted S&P index rebalances sector exposure. He highlights that this approach increases allocations to financials, healthcare, and industrials while still maintaining some technology exposure, offering a broader investment in 500 companies.

"As we mentioned before, the rate decision in December is going to be extremely important for the market. Uh, we went from 30% odds of a cut last week to now 70% odds of a cut as of this morning. You know, and equity markets have rallied on the back of that. I think if you get a cut, no wammies and and we can kind of rally and grind higher into the end of the year. I think if you don't get a cut, um, you know, there could be significant downside in in markets."

Brian Garrett reiterates the critical importance of the upcoming December interest rate decision for market performance. Garrett notes the significant shift in market expectations, with the probability of a rate cut increasing from 30% to 70%. Garrett concludes that a rate cut would likely lead to continued market gains, while a failure to cut rates could result in substantial declines.