One of these "Normalizations" is Not Like the Other
Among the many ways to describe the Federal Reserve's behavior is that they are "normalizing" interest rates. I.e., boosting basement-level rates from the QE days towards a more historical average, which for the Fed funds rate is around 5% (currently at 1.7%).
Now of course there's a big debate over how to define normal, and one can see from the chart the trend lower the past 30 years yadda yadda yadda. A fun discussion for the policy and econ wonks out there.
I'm more interested in what this means for equities. The common narrative is that the Fed is raising interest rates to combat imminent inflation; inflation creates challenges for companies exposed to higher input prices, wages etc, and the rates themselves create challenges for indebted companies and those looking to raise cheap money. The bears will tell you it means the end of the bull market. The bulls will tell you higher rates happen when things are good and so stocks rise with them (for a bit).
Somewhere in the middle will probably be true. It's just a more nuanced environment. Aka, the "stock-picker's market" you hear too much. Sigh. Let's call it market dispersion, the inverse of high correlation. And that's what we got a glimpse of in Q1 earnings -- lots of CEO mentions of rising input prices, with some companies able to handle them better than others. Industrials and transports are hanging in there, and consumer staples companies don't have the pricing power, i.e., margins, to handle it. Dispersion.
You could argue this too, is a sort of "normalization." What's interesting the past week though, is that traders are not really pricing in equity normalization. The VIX dropped below 15 at the start of this month and is currently 13.5 going into Fed minutes. Sure, stocks have made a nice move higher since April so the VIX is down.
If you believe the Fed is "normalizing," and this should all usher in a different trading environment than 2017, the VIX action should be somewhat surprising. Check out the long-term chart of volatility. The average is about 16.5 post-S&P 500 conversion.
You may be tempted to say Feb-April was unique, given the biggest single-day VIX jump in history, XIV blowup, tariff noise etc, but actually, the VIX average between Feb. 1 and April was 19.3. High, but not extraordinary above average.
Now we're at 13.5. Sure, the worst fears of a trade war seem unlikely to materialize, corporate earnings were numerically impressive, and rates are not shooting up. Fine. But if you think the Fed is serious and higher rates/inflation will continue to create winners and losers, the fact VIX is going back to 2017 levels is a very, very different type of "normalization" than one would expect given the market's certainty about the Fed.
Or maybe it truly is just about the rate of yield change, which I get into here.