Market underestimates Fed’s risk even after defeat, says Bank of America

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(Bloomberg) — A late summer lull is nowhere to be seen in the stock market, with traders adjusting their expectations after a blunt warning from the head of the Federal Reserve in Jackson Hole. Most likely they still have a long way to go.

So say derivatives strategists at Bank of America Corp. (NYSE:), pointing to a difference in price movements in stocks and other asset classes. The S&P 500’s recovery in the two months to mid-August sent the Cboe Volatility Index, or VIX, into a dormant zone alongside similar indicators in the price or currency markets. The raw awakening that Jerome Powell’s speech has been to US equities means investors must catch up on price policy risk.

“Stocks have been particularly complacent about the changed macro environment and policy design, with the Fed fighting inflation through financial conditions, meaning the rise in risk assets is both forcing them and allowing them to rise more aggressively,” the wrote. Bank of America strategists, including Gonzalo Asis in a note to customers. “As investors return from Labor Day, we believe there is still plenty of room for equity volumes to catch up with stress in other asset classes.”

Mathematically, there is no strict tick-by-tick correlation between volatility meters in stocks and other asset classes, but a conceptual link still exists. Jitters in markets elsewhere create conditions where the cost of hedging against stock movements should increase. It did — up 6.2 volatility points since mid-August. Bank of America’s year-end forecast at 3,600 likely implies a further jump in the fear meter – with the stock benchmark falling nearly 10% from Tuesday’s close.

Read: BofA’s Subramanian Says Reasons To Be Bullish Are ‘Pretty Thin’

Concerns over complacency in the stock market have eased somewhat over the past week, with the VIX moving above 25 after trading below 20 earlier this month.

But that still showed when compared to a broad gauge of implied volatility in Treasuries, the ICE (NYSE:) BofA MOVE Index, which showed little sign of calm during the two-month rally in the S&P 500. The ratio of the MOVE until the VIX eased on a 10-day basis, reaching 5.8 last week, its highest level since 2017.

The relative relationship between the volatility of stocks and bonds has been the subject of intense scrutiny this year, making the real value of the VIX amid wilder swings in the Treasury market front a point of heated debate that is likely to continue.

©2022 Bloomberg LP



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