A Second Look at What's Next for Markets

Markets have retraced portions of early August's extreme moves as they continue to assess and reassess recent data points. As the dust settles, there have been numerous explanations for recent market volatility: The data did it; Carry trade unwinds were the culprit; Tech bubbles are bursting; Markets are fearful of geopolitical risks.

The truth is that when you line up a number of factors that it "could" have been, or simply lazy positions that needed to be adjusted as the facts had changed, it was a confluence of events which generally all pointed in the same direction for markets. But more importantly, we think markets have underestimated the positioning in systematic funds, which by end-July was already signalling significant asymmetries that led us to flag the risks of sizeable volatility in the coming days.

August Saw Sharp Rise in Market Volatility

With our estimates of CTA positioning now signaling selling exhaustion across equity indices and 'max long' positions in rates, the focus now shifts to risk parity portfolios and volatility control funds as the next potential source of forced selling activity, catalyzed by a deleveraging process. We caution that a reversal in fixed income markets could now activate broad-based deleveraging from such funds, amid concurrent declines in every other major asset class in a higher volatility environment. So, this remains a market, given the usual summer illiquidity and now nervous nature, that will likely see traders keen to pare back on risk into weekends, and in which usually more mundane economic surprises could drive outsized market moves.

The next couple of weeks provide some potential catalysts; A U.S. consumer check-up and CPI update followed by our first signals for August payrolls. That will provide the Fed and global central bankers a chance to massage market expectations at Jackson Hole.

None of this is meant to downplay the fact that some fundamentals are drifting. We are still seeing too little stimulus delivered in China, and that continues to raise concerns for us for global manufacturing activity through the end of the year, which means markets like copper and oil could be much better supplied than expected. The U.S. labor market and other data have been phenomenally resilient, but the shine appears to be wearing off and moving us closer to our early outlook for 2024, which expected significant Fed easing to be kicked off in the second half of this year.

On that note, we did change our Fed call following the disappointing U.S. payroll data on August 2, which saw the headline payroll print come in about 60,000 lower than expected, and the rise in the unemployment rate triggered the widely followed Sahm rule that's meant to predict recessions. We now look for an additional 25bps rate cut in November to go along with our prior forecast of easing in September and December. Furthermore, we are also now looking for the Fed to continue easing by 25bps at each meeting next year until it reaches 3% by November 2025. We forecast the upper end of the Fed funds target range to end 2024 at 4.75% and 2025 at 3.00%.

The main risk to our view is that Fed leadership finds itself needing to go back to a neutral stance sooner than we anticipated as both sides of the mandate are largely back to or within the reach of their steady state. We no longer view the bar for 50bps cuts as overly high for coming meetings.

Sahm Rule Suggests Recessions Risks are Increasing