The Federal Reserve could cause a massive shock to the stock market this week

Drew Angerer/Getty Images News

The week of July 25 will be big for the markets, with the Federal Open Market Committee meeting on Wednesday afternoon. I pointed out at the end of last week that the markets might be due to a big drop, and I still think likely to happen. Unfortunately for me, it seems as if my time has been off for a few days because VIX has been down all week.

This makes one think that the market is either playing a game or feeling too complacent, heading into a pivotal week. VIX (VIX) is trading around 23 at its lowest leading up to this year’s FOMC meeting. The day before the four previous FOMC meetings in 2022, the VIX closed above 29 each time. So not only is VIX down before the FOMC meeting, but if it stays at that level or drops, it will be exceptionally low. So either this is a trap the market is preparing for the bulls, or this market is completely underestimating the importance of this week’s FOMC meeting.

S&P 500 volatility index during FOMC meetings

Trading View

In addition, the VIX is now very oversold and is even trading below the lower Bollinger band, which indicates that the indicator may be close to a low point due to a significant rally on the upper side of the Bollinger band.

Selling VIX oversold

Trading View

More satisfaction measurement

One can turn to the implied volatility term structure of S&P 500 options to better understand market satisfaction. Looking at this term structure and comparing the current structure to the Friday before the June FOMC meeting, one can see that the current term structure is much lower.

The money option on the expiration date of June 15 had an implied volatility of about 28.5% on June 10. As of July 22, the at-the-money option has an expiration date of July 27 that has an implied volatility level of close to 8%. Less by 20.4%. It seems that the market is not taking this week’s event as seriously as it was in the past. As the May FOMC meeting approaches, the in-the-money option for the May 4 expiration date is at 31.9%, making the implied volatility difference between the May-June FOMC meeting just 3.4%.

Given the low levels of implied volatility, it appears that the market is taking this meeting as almost no event.

SPX lowers implied volatility levels

Bloomberg

Market Underestimates Fed

This complacency may occur because the market has convinced itself that the Fed is about to pivot and give up and go back to its old ways of supporting asset prices. This week’s meeting may change the market’s opinion of how serious the Fed is about its fight against inflation and that it does not view the economy as weak or heading for recession.

Chris Waller, FOMC board member, gave an interview recently and was openly asked about the possibility of a second quarter of negative GDP growth. In that interview, Waller revealed that GDP and GDP were diverging and that while GDP was trending lower, GDI was not. He noted that these two measures of the economy are supposed to head in the same direction and believes that at some point GDP is likely to be adjusted upward, and perhaps GDI is likely to be revised slightly lower. But the strength of the labor market and the GDI numbers indicate that the economy is neither in a recession nor heading into a recession. He also noted that negative GDP prints may be due to export category metrics undermining the performance of the domestic side of the economy.

Looking at this closely, while real GDP was negative in the first quarter, real gross national income rose 1.8%. This indicates that the economy may not have been as weak as the GDP report. If the Fed takes into account these other factors, such as the biodiversity index when looking at the growth and strength of the economy, this could be a problem for the market that is now anticipating a pivot from the Federal Reserve.

Real GDP and real GDP

Unique

Ironically, this topic came from GDP and GDI appeared in the latest FOMC minutes, where participants noted conflicting signals between GDP and GDI regarding the pace of economic growth and that the labor market was very tight.

Worrying signs of the Federal Reserve axis

Digging deeper into this, the latest data from the Kansas City Labor Market Conditions Index, as of June 30, shows that the index is still at its highest level since the late 1990s.

Worrying signs of the Fed's pivot

Bloomberg

In addition, the Atlanta Fed wage growth tracker hit a new high at the end of June. This was the highest level recorded since 1997. At this point, the tracker was rising vertically and not showing signs of peaking yet.

Federal wage growth in Atlanta

Bloomberg

Even the Cleveland Fed’s CPI expects its annual CPI rate to change at 8.9% in July, which would be just a tenth of a percent lower than its June CPI rate of 9.1%.

Cleveland Fed Consumer Price Index

Bloomberg

Meanwhile, the Atlanta Fed’s 12-month inflation forecast is currently at 5.6% and, like many of the mentioned indicators, is rising sharply and vertically. The last time this indicator saw a reading of this spike in viscous inflation was in April 1991, when the three-month Treasury rate was around 5.7%. The spread between the constant inflation gauge and the 3-month Treasury note was the last of that range in July 1980.

Atlanta Fed Inflation Expectations Constant 12-Month

Bloomberg

What all this gets is that, up to this point, the Fed has had virtually no effect on its mandate to bring inflation back to its 2% target, and the Fed could find plenty of metrics to use to offload growth slowdown concerns if they so choose to reach to the inflation target.

The other point is if inflation becomes flat and entrenched as some of these forecasts suggest. Rates may need to rise higher than the Fed is currently protecting, and two quarters of negative inflation-adjusted real GDP will not slow them down.

If this is the message the Fed is sending this week, then the stock market is not only very satisfied, it will be in for a big shock.

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