The Day After Tomorrow: When Markets Get a Summer Shock

Summer volatility is back, and it's packing quite a punch. The VIX, our trusty barometer of market jitters, has spiked to levels not seen since we were all perfecting our sourdough recipes during lockdowns. It's as if the market decided to take a rollercoaster ride without bothering to buckle up first.

The VIX's sudden ascent is enough to make even the most seasoned trader reach for the motion sickness pills. But what sparked this financial fireworks display?

The Bank of Japan's Surprise Party

It all started with the Bank of Japan, which apparently decided that summer was the perfect time to shake things up. On July 31, they announced a surprise rate hike and bid sayonara to their ETF buying program. It seems they forgot to send out "Save the Date" cards for this particular policy shift.

This unexpected move, combined with AI and momentum trades already losing steam in the prior weeks, created a perfect storm. Throw in a dash of U.S. election uncertainty and a sprinkle of weak July data, and voilà! We have a market meltdown that rippled from Tokyo to New York and back.

The Bond Market's Crystal Ball (Needs Polishing)

What kind of party would it be without the bond market throwing in its two cents? The market is now pricing in 5-6 rate cuts by year-end, with some voices even calling for an emergency cut before the next Fed meeting. It's as if they're trying to order a seven-course meal when they've barely finished their appetizer.

Remember, at the start of the year, the bond market was calling for 6 cuts, then pivoted to no cuts mid-year, and now we're back to 6 cuts. If we were grading its predictive abilities, it would be getting an "E" for "Extremely Overconfident". Given the elevated volatility of the bond markets these days (partly due to illiquidity), investors should look at this crystal ball with a squinting eye.

Recession: The Elephant in the Room (Or Is It?)

But let's address the elephant in the room—is the U.S. teetering on the brink of a recession? The Sahm Rule, triggered by last Friday's jobs report, seems to think so. It's like the economy's check engine light just came on, and we're all hoping it's just a loose gas cap.

However, before we all don our recession-proof helmets, let's consider a few factors:

1. July's employment data got a hurricane-sized asterisk thanks to temporary layoffs from Hurricane Beryl.
2. Companies are holding up on spending until the election dust settles.
3. High-frequency consumer and industrial traffic data aren't showing any significant slowdown.

It's too early to conclude a certified death for the US economy, and remember we have the Doctor-in-Residence standing by—the Fed has plenty of room to cut if the emergency room is needed.

The AI Saga: From Boom to "Hmmm"

No discussion of market movements would be complete without mentioning the AI boom—and lately, investors have finally started to ask, "Show me the Money". Q2 results were mostly uninspiring, with Big Tech all announcing big capex plans without a lot of obvious returns to show for it.

Indeed, it appears that the initial stage of euphoria and FOMO is done. The next phase of value creation will be much more uncertain. For example, Meta recently released Llama3.1, a free open-source model, which is meeting or beating cutting-edge frontier models from OpenAI and Anthropic. This puts into question whether LLMs would be commoditized and how all these billions poured into developing LLMs would be realized.

What's Next? The Market's Crystal Ball (Also Needs Polishing)

Historically, when the VIX spikes above its 3-month forward contract, it's like the market's way of saying, "Okay, I might have overreacted a bit there." This inversion of the VIX curve has often signaled a bottom, producing above-average near-term returns.

But given the uncertainty around the upcoming election and the potential for more forced selling by risk-controlled funds and CTAs, expecting a swift recovery might be like hoping for a smooth landing after jumping out of a plane without a parachute.

The Bottom Line

Opportunities often arise in these shoot-first-ask-questions-later environments. Gold and Bitcoin, for instance, took a nosedive with other risky assets, which makes about as much sense as using an umbrella in a sandstorm. If anything, a recession increases the odds of further fiscal spending, which is positive for these alternatives to King Dollar.

As for AI, the fundamental story of being as disruptive as the Internet in the 2000s, or the steam engine in the 19th century, hasn't changed in the past 10 trading days. But like a complex recipe, the details matter. We're still waiting to see who, after NVIDIA, will be capturing the bulk of the returns.

In the end, I remain a hopeful optimist. We live in a world of breakthrough technologies, and history shows that betting against human ingenuity is about as wise as trying to catch a falling knife... while wearing roller skates... on an ice rink.

So buckle up, keep your eyes open for opportunities, and remember: in the market, as in life, it's not about predicting the future—it's about being prepared for whatever tomorrow brings. After all, in the financial world, sometimes the day after tomorrow comes sooner than you think.