Markets are currently in risk-off mode, primarily due to the unwinding of the JPY carry trade following the BOJ’s 25bp rate hike and the market coming to terms with the fact that the economy is slowing more than expected on the back of rising US unemployment. The QQQ has now retraced 15% since its peak, entering correction territory, with the RSI currently at 28, at the 200MA and the bottom of the rising channel. We lock in profits on our QQQ Sep24 440 Puts and VIX Jan25 35 Calls but remain cautious as market uncertainty is still high.
As mentioned in last week’s note An important week ahead, the market lacked a last capitulation leg down given the elevated positioning and a seasonally weak month of August, when a combination of low liquidity and low market gamma could be the perfect recipe for a spike in volatility across the board. Volatility has indeed spiked across asset classes, with the VIX reaching 65, and the outsized rise in short-term maturities pointing to panic mode in the market. Downside protection, as measured by SDEX, has also spiked to the highest level of the last 3 years, but credit spreads are still tight, not reflecting the risk of a potential credit event from a sudden unwinding in broader market leverage.
As the market recalibrates the recession probabilities, a more aggressive easing cycle of five FED rate cuts are priced in for 2024 with expectations of an emergency rate cut to support the market ahead of an election period, driving a sharp drop in yields and a disinversion of the yield curve. However, we assign a low probability to this materialising absent any credit event, as we believe only a c.15% sell-off in equity markets is not enough to warrant an emergency rate cut. In addition, if the sell-off is driven by the unwinding of the carry trade, rate cuts by the FED would exacerbate the problem even further.
Looking at earnings, roughly 75% of the S&P500 and 60% of the Stoxx 600 have reported and we have seen a mixed bag of results from the biggest technology companies and companies have been penalised on a lack of guidance upgrades, reflecting a potentially excessive optimistic outlook. According to FactSet, analysts are expecting S&P500 companies overall to post a 11.5% YoY increase in 2Q earnings vs. c.9% growth expectation heading into earnings season, and with the recent deterioration of the previously expected “strong” job market, the downside risks increase related to earning cuts ahead.
Due to elevated volatility and uncertainty on market direction in the short term we do not propose any further positions and wait for more market clarity, but we continue to see more risks to the downside.