What Could Prompt Higher Volatility?

Equities were buoyed last week in the wake of US President Biden’s infrastructure deal and renewed reflation trade optimism amid mixed post Federal Reserve FOMC messages from Fed officials. This resulted in US stocks recording their biggest weekly gain since February.  The prospects of passing the infrastructure deal has improved in the wake of Biden’s decision not to tie it to a much larger spending package that is being pushed through by Democrats but is not supported by Republicans. 

Given heightened sensitivity over inflation, the slightly weaker than expected US Personal Consumption Expenditures (PCE) data on Friday, which increased 0.5% m/m in May, slightly below the 0.6% consensus, added further support to the reflation trade, helping the US Treasury curve to steepen.  Moreover, the University of Michigan 5-10y inflation expectations series came in lower in June compared to the previous month. Fed officials likely put much more emphasis on this long-term series and will view the 2.8% reading as consistent with their “largely transitory” take on the pickup in inflation.

Cross-asset volatility has continued to decline, which bodes well for carry trades and risk assets.  For example, the VIX “fear gauge” index has dropped to pre-COVID level, something that has been echoed in other market volatility measures.  However, it’s hard to ignore the shift in tone from many central banks globally to a more hawkish one while risk asset momentum will likely wane as the strength of recovery slows, suggesting that low volatility may not persist.  It is notable that changes in global excess liquidity and China’s credit impulse have both weakened, implying a downdraft for risk assets and commodity prices and higher volatility. 

If there is anything that could prompt any increase in volatility this week, its the US June jobs report on Friday.  June likely saw another strong (consensus 700k) increase in nonfarm payrolls while the unemployment rate likely dropped to 5.7% from 5.8% previously.  Despite the likely strong gain in hiring, payrolls would still be close to 7 million lower compared to pre-COVID levels, suggesting a long way to go before the US jobs market normalises. The June US Institute for Supply Management (ISM) manufacturing index will also come under scrutiny though little change is expected from the May reading, with a 61.0 outcome likely from 61.2 in May. 

Other data and events of importance this week include the 100th year anniversary of China’s Communist Party (Thu), the release of purchasing managers indices (PMI) data globally including China’s official NBS PMI (Wed) for which a slight moderation is expected.  Eurozone June CPI inflation (Wed) which is likely to edge lower, Sweden’s Riksbank policy decision (Thu) where an unchanged outcome is likely and Bank of England (BoE) Governor Bailey’s Mansion House Speech (Thu), will be among the other key events in focus this week. 

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