JPMorgan: "Significant Risk" Is Coming Next Week... And Nobody Is Prepared

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With arguably the most important two weeks of the year looming, on Friday Bank of America's Chief Investment Officer, Michael Harnett, laid out a 2-by-2 matrix summarizing the four possible scenarios that could result from the Fed's announcement next week, and the G-20 meeting on June 28-29, where there is a chance (if minuscule) that Trump and Xi will announce the trade war ceasefire, although far more likely, will simple lead to further trade war escalation.

Of these 4 scenarios, two are most remarkable: the best/best and the worst/worst cases. The first one sees a Dovish Fed statement, coupled with a G-20 deal, which according to BofA will send the S&P > 3000, and the 10Y yield to 2.00%, while the worst possible outcome would be if there is a 1) a hawkish Fed surprise and 2) no Deal at the G-20, which would send the S&P below 2,650, or potentially resulting in a 12% drop in the market, while slamming 10Y yields to 1.50% and helping gold rise above its 5 year breakout zone as the VIX surges.

And yet while the market's reaction to a favorable outcome from the G-20 meeting will undoubtedly be bullish, and vice versa, we disagree that a dovish Fed would necessarily push stocks higher (recall that the Fed cut rates on average 3 months before the last three recessions, effectively telegraphing a start to the economic contraction), because as JPMorgan noted last week, the trajectory for the equity market during Fed rate cut cycles has differed historically depending on whether the Fed was seen as preemptive and cutting rates to provide insurance or seen as simply reacting to weak growth.

So, in picking up where Hartnett left off, JPMorgan's Nikolas Panigirtzoglou writes in his latest Flows and Liquidity report, that next week's FOMC meeting provides an opportunity where the Fed can act pre-emptively in the current cycle. Considering how little probability of a cut is priced in next week (as opposed to July), a cut by the Fed would surprise markets while signaling an openness to a July cut, closer to JPM's house view which expects rate cuts in 2019, and could essentially 'validate' market pricing. So a rate cut next week which is not priced in, JPM argues, "would show that the Fed is moving ahead rather than staying behind the curve."

But what if Powell doesn't cut?

By remaining on hold and failing to convey an overall dovish message, JPM echoes what Hartnett said, warning that "there is a risk of a shift in equity market thinking away from a preemptive towards a reactive Fed."

The resilience of the equity market is in our opinion showing that equity investors have been leaning towards the thesis of a preemptive Fed, i.e. a Fed that is keen to provide insurance against downside growth risks in the current cycle similar to the 1995 and 1998 rate cut cycles.

As a result, a more "cautious and patient" Fed next week could cast doubt on the above thesis, creating what JPM simply calls "the risk of an equity market correction"... and which BofA quantified as a potential drop of as much as 12% from current levels.

Further complicating the picture is the feedback loop between deteriorating trade and monetary policy (with Trump chiming in periodically on his twitter account). Which is why a negative outcome in US-China trade talks into the G20 meeting on June 28th-29th could further raise the hurdle for the Fed in the future by intensifying rate cut expectations for the July meeting and beyond, according to JPM. In turn, if the Fed does nothing next week, it would add to the perception of a policy error, as a collapse in G-20 talks "could make it even more difficult to surprise markets and move ahead of the curve in future FOMC meetings."

But wait there's more, because if the next US payroll report at the beginning of July is as weak as the one released in early June could intensify fears in markets of a US downturn or recession, which in turn could require an even larger cut for the Fed not to be seen by equity investors as reacting belatedly to weak economic data. 

Yet the biggest paradox remains that fear of a US recession seems to be far from priced in equity markets. Indeed, as JPM calculates, its framework of assessing the probability of a US recession embedded across asset classes "is still showing a large disconnect between equity and rate markets with equity markets still pricing in very little probability of a US recession."

This complacency is also consistent with consensus earnings expectations. The S&P500 earnings per share expectations at $167 for this year are pricing a modest 3% increase from last year, i.e. far from a severe contraction likely to be seen in a recession.

The above discussion, according to the JPM strategist, exposes what he calls "the significant event risk" markets are facing over the coming weeks, which will likely result in a spike in volatility, especially if rate vol finally spills over into equities.

This leaves us with one last question: are markets (especially option and vol) anticipating this potential rise in volatility, something we touched on yesterday when we showed that equity vol remains stubbornly low even as equity and oil vol has been rising sharply.

To JPMorgan, one way of answering this question is by assessing the volatility premium embedded in option markets via calculating the implied to realized volatility ratio across asset classes. This is shown in the next chart which depicts a cross asset implied to realized vol metric based on a weighted average of 12 implied vols across 5 asset classes with 20% weight on each of the five asset classes. The 12 implied vols used are: V2X Index, VIX Index, VNKY Index, JPMVXYG7 Index, Cl1 Comdty, HG1 Comdty, GC1 Comdty, C 1 Comdty, iTraxx, CDX.IG, Euro 10y swap rate and US 10y swap rate. The implied to realised volatility ratio uses 3-month implied volatilities and 1-month (around 21 trading days) realized volatilities for each asset. Figure 3 shows that the cross-asset implied to realized ratio stands significantly below its historical average of 1.2x pointing to little volatility risk premium embedded in option markets.  

Of course, that's not all, and other vol-related indicators are also pointing to complacency; for example a simple   inspection of the spec positions on VIX futures suggest that there still a large short base not different from the levels  seen in September 2018 or January 2018 which at the time were followed by a sharp rise in vol (Figure 5).

Finally, the Put to Call Open Interest ratio for S&P500 options points to low rather than high hedge ratios (Figure 6).

Putting it all together, JPM finds that "option markets do not appear to embed enough cushion against the significant event risk markets are facing over the coming weeks." In other words, if Powell for some reason unveils a hawkish surprise next week, it's going to get very, very messy.