Volatility’s Quiet Confidence

The bond market has been on high alert since Federal Reserve chair Kevin Warsh’s speech at Jackson Hole, with odds of an interest-rate hike jumping to nearly 60 percent by September. Meanwhile, the Cboe Volatility Index (VIX) touched its year-to-date low.

The VIX, a measure of investor anxiety, is not just calm before the storm – it’s a sign that markets are growing more confident in the Fed’s ability to manage monetary policy. For months, investors have been bracing themselves for higher interest rates due to a hot economy and rising inflation. However, Warsh’s speech demonstrated a more nuanced approach from the central bank.

Rather than slamming on the brakes or hiking rates aggressively, the Fed is employing a surgical touch by keeping interest rates relatively low and focusing on getting inflation under control without choking off growth. This reassuring message has been sent to markets: the central bank has this under control.

The market’s reaction has been telling. Stocks slipped midday as Nvidia unwound some of its earnings gains, but the S&P 500 was down only three-tenths of a percent – half the implied range for the day. Bitcoin and gold, often seen as safe-haven assets, dropped at least 2.5 percent.

Investors are starting to believe that the Fed’s narrative about vigilant inflation-fighting without aggressive rate hikes is positive for the economy. As Ben Emons, managing director at Highline Asset Management, noted: “The VIX is low because a Fed that is vigilant on inflation…is seen as positive for the economy.” But there’s more to this story than just investor psychology.

A closer look at S&P 500 volatility suggests that higher interest rates may not have an immediate impact – and could even be months away. According to Cboe derivatives market intelligence head Mandy Xu, uncertainty around inflation and rate paths will only affect longer-term equity volatility.

The spread between six-month options and 1-month options on the S&P 500 is currently in the 96th percentile of the past year. This steepening of the curve suggests that investors are pricing in higher interest rates – but not just yet.

VIX futures show a notably steeper curve than last month, when front-month contracts were near 20. And yet, the entire curve has shifted lower as volatility subsides. It’s almost as if markets have collectively decided to trust in the Fed’s ability to navigate these uncertain waters.

Even James Perry, founder and chief investment officer of Perry International Capital Partners, thinks the Fed is still in “ease mode.” With oil prices down and inflation expectations falling further, Perry believes that the central bank will maintain its cautious approach – at least for now.

This raises an interesting question: what does it say about markets when they’re more concerned with the timing of rate hikes than their inevitability? Are investors really so confident in the Fed’s ability to manage monetary policy that they’ve started to price in higher rates without panicking?

Whatever the answer, one thing is clear: volatility may be low now, but it won’t stay that way forever. As markets continue to grapple with the implications of Warsh’s speech and the Fed’s newfound approach to inflation-fighting, investors would do well to keep their eyes on the horizon – and their fingers crossed that this fragile calm will hold.

The bond market may be bracing itself for higher interest rates, but it seems the stock market is taking a more sanguine view. As we move forward into the uncertain waters of September, one thing’s certain: only time will tell if markets’ newfound confidence in the Fed is misplaced – or if it’s just a case of volatility’s quiet confidence.