Turbulence, Parachutes, and Sentiment

Equity markets sometimes have a way of burying the lead.  Today’s release of major bank earnings marked the unofficial start to earnings season.  We also received important reads on the economy with a better-than-expected PPI report and an atrocious set of sentiment readings from the University of Michigan.  More significantly, bond yields are soaring and the dollar is plunging.  Yet as I type this, major US equity indices are essentially unchanged.

Long-time readers know that I wish the banks didn’t lead off the earnings parade.  Their reliance upon interest rates and the yield curve, and in some cases, trading results, makes them too idiosyncratic to be a reliable harbinger of the results to follow.  We heard from JPMorgan (JPM), Wells Fargo (WFC), Bank of New York Mellon (BK), and other key financial stocks like Blackrock (BK) and Morgan Stanley (MS).  The results are mixed, with JPM and BLK rising, and WFC, MS and BK falling.  None are having particularly noteworthy moves.

Yet I have always noted that there is indeed something to be learned from the conference calls that accompany banks’ earnings.  Their managements can offer insights into trends in their customers’ credit quality and loan demand.  The key headlines today came from JPM’s CEO, as they often do.  In his prepared remarks, Jamie Dimon said:

The economy is facing considerable turbulence (including geopolitics), with the potential positives of tax reform and deregulation and the potential negatives of tariffs and ‘trade wars,’ ongoing sticky inflation, high fiscal deficits and still rather high asset prices and volatility.

Seems obvious, no?  Anyone paying attention to markets in the past few weeks would come to a similar conclusion. But business media focused on the word “turbulence”.  And something about that word resonated with me.

I’ve been asked why the Cboe Volatility Index (VIX) is remaining so firm even on a day when stocks are meandering in a relatively narrow range.  Dimon’s verbiage reminded me of how I described VIX in a podcast from August 2023 and again in an article from July 2024:

VIX is the price of parachutes when a plane hits turbulence. 

We explained:

This comes from my experience as a market maker.  Nobody really wants umbrellas when it’s when there’s a drought, nobody really thinks about a parachute if the plane is moving along smoothly at 30,000 feet, but as soon as you hit some turbulence, or as soon as the rain clouds develop, people want them, and they want them in a hurry. And to me, VIX is still the most efficient way for an institutional manager to hedge his or her risks.

There is certainly no shortage of risks to hedge against right now.  Movements in US Treasuries and the dollar are telling us that international investors are concerned.  At one point this morning we saw 10-year yields rise by as much as 16 basis points and the Euro rise by about 2 cents versus the dollar.  Those trends abated at about 11am EDT, implying that European investors were actively selling US fixed income and stopped when it was time to go home for the weekend.  The chart below shows how the selling in the USD abated, but amidst a few days of major losses against major currencies that could serve as alternative safe havens for global investors:

3-Days, EUR/USD (red/green 5-minute candles, right scale), CHF/USD (blue),  USD/JPY (purple, left scale)

Source: Interactive Brokers

Past performance is not indicative of future results

One could certainly assert that the weaker USD should be a boon for US equities.  The leading US companies are multinationals, with revenues in a wide range of currencies.  A weaker dollar means that those foreign revenues are worth more when translated into USD. 

Even though the worst of the week’s volatility in stocks and bonds appears to be behind us, at least for now, some might be wondering why VIX remains around the elevated level of 40.  As noted above, that is partly because investors continue to be concerned about turbulence, but it is also mathematical.  For starters, thanks to the “rule of 16”, we can assert that a 40 VIX roughly implies that the market expects that intraday moves could average 2.5% over the coming 30 days.  That doesn’t seem truly implausible, especially when we consider that recent events play a disproportionate role in traders’ volatility assumptions.

And a second mathematical rationale exists for an elevated VIX – market correlations remain extraordinarily elevated, and index volatility is heavily influenced by whether the index’ components are moving in synch or not.  (More about that here.)  Correlations tend to zoom when markets are extremely nervous, and as measured by the Cboe’s COR1M index they have been zooming recently.  That has a strong influence on the level of VIX:

1-Year COR1M (white), VIX (blue)

Source: Interactive Brokers

Past performance is not indicative of future results

And once again, markets have changed dramatically in the time it took me to type this.  We now see indices up more that 1%, most likely because US traders, ever eager to buy dips and chase rallies, perceived that those dour Europeans are done for the day.  As we reminded yesterday, volatility – and turbulence — moves in both directions.