Last week’s severe market whipsaw caused the VIX to briefly hit the highest level since the pandemic’s eruption in March 2020. — Bloomberg
NEW YORK: The stock and bond markets are sending different signals about the likelihood of a US recession, leading some major investors to say there is too much complacency in credit.
Last week’s severe market whipsaw caused the VIX, also known as the stock market’s “fear gauge,” to briefly hit the highest level since the pandemic’s eruption in March 2020.
Meanwhile, the average blue-chip credit spread shifted to the widest level since November, but remained well below historical averages – and nowhere near periods of serious economic stress.
Although many said the VIX’s movement was exaggerated by technical factors, others including Boaz Weinstein, founder and chief investment officer of US$5bil hedge fund Saba Capital Management, said bond investors were not fully pricing in economic risks.
“VIX and credit spreads tend to be correlated,” Weinstein said in a phone interview.
“A VIX that high with credit spreads very moderate is pretty unprecedented,” referring to the market volatility last week.
Brian Gelfand, co-head of global credit at TCW Group, had a similar point of view.
“We think the VIX is more appropriately calibrating risk,” he said, also by phone.
“Credit spreads are still pricing in complacency. We expect spreads to continue to widen and reflect more of what we are seeing in the VIX.”
Of course, risk barometers have come in sharply since last week. As of Monday’s close, the VIX was down almost 70% from its intraday peak on Aug 5.
The average investment-grade credit spread had tightened by seven basis points, or 0.07 percentage points, from the same time a week earlier.
However, the underlying debate about which metric to trust has not gone away. It centres on whether softness in recent US economic data is the beginning of something worse, and whether the Federal Reserve (Fed) has been too slow to react.
Optimists cite technical factors that sent the VIX to seemingly catastrophic levels. The metric is calculated from an algorithm that can overstate the severity of conditions when markets are turbulent and liquidity is thin.
Because stocks have recovered some gains and the VIX has fallen quite a bit, they argue the United States economy is hitting bumps instead of potholes.
Those bumps started with weaker-than-expected inflation data in July, followed by similarly unimpressive reports on manufacturing, housing and certain corporate earnings.
A limp jobs report last week especially troubled Wall Street, leading economists at Goldman Sachs Group Inc and JPMorgan Chase & Co to raise their recession-probability forecasts.
To the optimists, who appear to represent the consensus, these are things to worry about, but not too much.
Although the Fed did not lower interest rates in July due to inflation concerns, they believe the central bank will be able to bring down inflation to its 2% goal while avoiding recession.
A Bloomberg survey last week showed most Wall Street economists predict the Fed will manage a soft landing.
According to that view, the bond market has been adequately reflecting risk that the economy might fall off a cliff, while the VIX has been overstating it.
“Markets were largely priced to perfection, particularly in the lowest-quality markets,” said Lawrence Gillum, chief fixed income strategist for LPL Financial.
“So, the current growth scare is causing spreads to move higher but only back to levels seen late last year and not to levels that would be consistent with panic selling.”
Similarly, Richard Cheng, portfolio manager at Nuveen, expects spreads to drift a little wider, but does not see major moves on the horizon.
“Market participants are now concerned about whether there is a Fed policy error,” Cheng said.
However, “we don’t see panic selling or a risk that spreads will widen dramatically.”
Even Peter Tchir, head of macro strategy at Academy Securities, who calls himself “bearish on the economy” does not expect spreads to widen very much.
“I’m getting a little bit more nervous about the economy,” he said.
“That could push spreads wider, but I’m not panicked about it.”
That said, the VIX is usually much more correlated with bond spreads than it has been lately.
One or both of the metrics must be wrong, Weinstein said in an X post last week. — Bloomberg
