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“Do you believe in miracles? Yes!”
—Al Michaels (play-by-play sportscaster)
In the rankings of the greatest sports moments in history, the U.S. men’s hockey team’s upset of the Soviets at the 1980 Winter Olympics in Lake Placid usually finds itself at the top. The Soviet team was widely regarded as the best hockey team in the world. The U.S. team, on the other hand, was made up of a bunch of college kids. Expectations going into the game were that the Soviets would win easily. U.S. coach Herb Brooks even told his team before the game that if they played 10 times, the Soviets would win 9. But the expectations were wrong, and Herb was right—and the one time his team would win was that night.
In America, the game is still considered one of the greatest sporting events ever. But to the Soviets and their fans, it was a huge disappointment and the most shocking defeat of all time. This is all to say that expectations matter.
We have often written on the blog about how expectations drive markets—until they don’t because the news or data calls the consensus into question. When everyone expects one thing to happen and it doesn’t? It creates miracles in sporting events and volatility in capital markets.
Measuring Market Volatility
Investor expectations have been for the Fed to engineer a soft landing for the U.S. economy. After the June Consumer Price Index (CPI) data was reported on July 11, confidence grew that inflation would move toward the Fed’s 2 percent target and interest rates would decline.
The VIX measures market expectations on how volatile the S&P 500 will be over the next 30 days, and it is often called the “fear index.” Recently, relative to history, the VIX has been quite low:
Source: The Daily Shot
Until it wasn’t. On Monday, August 5, the VIX spiked above 60 intraday. Expectations of a soft landing were called into question on the back of a weaker U.S. jobs report, leading to concerns about a recession. A Japanese interest rate increase caused the yen to strengthen, also resulting in market concerns. Finally, geopolitical risk in the Middle East weighed on investors’ minds.
Over the past couple of weeks, volatility has returned to the level seen at the end of July, as financial conditions have calmed down in Japan and inflation data in the U.S. has continued to trend positively. The VIX is now at 16.27 (as of the close on August 14).
Reading the Market Tea Leaves
The VIX indicates that overall macro concerns seem to have moved into the background from the investor perspective. But are the markets telling us anything else?
After the announcement of the June CPI, which led to a drop in yields and a belief the Fed would cut rates at its September meeting, the market broadened:
| % Change, July 10–July 31 | % Change, July 31–August 14 | |
| S&P 500 | –1.98% | –1.21% |
| Nasdaq | –5.62% | –2.31% |
| Russell 2000 | 9.88% | –7.50% |
| 10-year U.S. Treasury yield | 5.94% | 5.33% |
The decline in rates led to a strong rotation in the market. Those parts of the market that have led the rally over the past several years—mostly the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla)—came under pressure. Areas of the market that hadn’t participated in the rally and appeared relatively cheap performed the best. The market was led by small-cap stocks, as measured by the Russell 2000, which rose almost 10 percent. This result was similar to the 22 percent rally in the small-cap index seen in November and December of last year when 10-year Treasury yields dropped from 5 percent to 3.85 percent.
But since the end of July, as weekly jobless claims and the July employment data raised questions about the health of the job market, the Russell 2000 has declined 8 percent. While the S&P 500 and the Nasdaq have also declined, those moves has been more muted.
Through it all, Treasury bonds have rallied—a good sign for diversified portfolios. Bonds have resumed their role as providing ballast during periods of equity turmoil. This was missing in 2022 when equities and bonds declined together.
Ask Why (Not When) the Fed Will Cut
The action of the VIX and the markets over the past month helps illustrate that the key question is not when the Fed will cut rates (as investors have tried to discern for more than a year) but why it will cut rates. If the Fed cuts rates because inflation continues to moderate while the economy continues to grow on the strength of a healthy jobs market, that decision will have one set of implications for investors. If the Fed ends up reducing rates because economic growth slows and eventually tips into a recession, this will have a different set of implications for investors.
While our crystal ball is not clear enough to know the answer to that question yet, the next several weeks will continue to provide data points that will help investors assess where we are. On August 23, Chairman Powell will speak at the Fed’s Jackson Hole Economic Symposium. This will be his chance to set expectations for the Fed’s September meeting. But anything he says will be caveated by the fact that the August employment report will be released on September 6. Finally, the Fed will deliberate and announce its next rate decision on September 18.
Stay the Course
Market action over the past several weeks illustrates that it is hard, if not impossible, to time markets. The best approach to navigating the uncertainty in the path forward is to continue to maintain a balanced outlook and diversification across market capitalizations, styles, and geographies.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.
