Stocks' Post-Fed Rally Threatens to Accelerate the Selloff

The stock market surged following the Federal Reserve’s much-anticipated interest rate cut last week, but the rally comes with an underlying sense of caution. This rate cut, larger than what many expected just a week prior to the Fed’s meeting, has shifted market sentiment in a notable way. According to Charlie McElligott, a cross-asset strategist at Nomura Securities, this shift reflects what he describes as the "'fear of left-tail’” scenario transforming into a self-fulfilling “right-tail outcome.” In simple terms, the market is being pushed away from recession-related concerns and is now betting on the possibility of a soft landing, which is a less severe economic slowdown.

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This evolving market perception is triggering a wave of re-risking and an increased grab for exposure, McElligott explains. Some of this behavior is mechanical in nature, particularly involving leveraged exchange-traded funds (ETFs) that are buying up various products. Meanwhile, funds that specialize in market overwriting strategies are now scrambling to cover short call positions that they had previously sold. Investors who had lowered their risk exposure during the heightened volatility of August are now being forced to jump back into the market at record highs. This is not a comfortable situation, given the many uncertainties looming on the horizon. The presidential election is approaching, and the macroeconomic outlook remains murky. Moreover, corporate earnings are just around the corner, adding another layer of unpredictability.

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Volatility and skew indicators reveal further signs of hedging activity, which suggests that investors are not entirely comfortable with the rally to record highs in U.S. equity indices. Investors are still willing to pay a premium for protection, which can be seen in the behavior of the Cboe VVIX Index, a measure of volatility in VIX options. VIX options are commonly used by traders to guard against a significant selloff in the market, and the VVIX Index remains about 20% higher than it was at the start of June. Similarly, the Nations SkewDex, an index that measures the relative cost of bearish put options, is also elevated, indicating that investors are paying more for downside protection.

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More evidence of tail-risk hedging is visible through increased purchases of Cboe Volatility Index (VIX) calls and call spreads, particularly at strike prices of 85 and 90, as well as the growing use of S&P 500 Index put spreads. Prior to the Fed meeting, the net-short positions in VIX futures held by non-commercial traders had dropped to their smallest level since 2019, reflecting a shift in sentiment.

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This uptick in hedging activities can provide protection for individual investors, but it also introduces complications for options dealers. When options dealers find themselves short gamma, it means that they must adjust their positions as the market moves. If the market drops suddenly, dealers may be forced to sell more aggressively in order to stay balanced, which could further exacerbate a sharp decline.

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The Federal Reserve’s decision to cut interest rates by half a percentage point raises an important question: was the central bank’s move simply a reaction to market fears of a hard landing? The selloff in August was a clear expression of these concerns, and it’s possible that policymakers felt compelled to act decisively in order to restore confidence in a softer economic outcome. Yet, even as the markets respond to the Fed’s actions, the debate over how low interest rates can go—and how effective rate cuts will be in stimulating the economy—has only just begun.

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Holger Schmieding, an economist at Berenberg, expressed skepticism about how much more room central banks will have to cut rates in the coming years. In a recent note, Schmieding wrote, “We continue to believe that central banks will have less leeway to ease in 2025 than they and many investors believe.” He pointed to several factors that could limit the central banks' ability to provide additional stimulus. Among them are the continued use of loose fiscal policies, persistent inflationary pressures, and structural labor shortages. These conditions, Schmieding argued, will make it difficult for central banks to justify cutting rates too deeply without risking further economic complications.

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As the market digests the implications of the Federal Reserve’s recent rate cut, investors are faced with a complex and uncertain environment. While the rally in equities may suggest optimism about a soft landing, the elevated demand for hedging instruments and lingering concerns about future rate cuts highlight the challenges that lie ahead. The upcoming months will be critical as investors navigate an unpredictable macroeconomic landscape, a contentious political climate, and an ongoing debate about the role of monetary policy in sustaining growth.

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