Hawks at the Fed, Omicron, Buyer Fatigue: A New Set of Negatives Are Driving Volatility


After smooth sailing for most of the year, a series of negatives are hammering stocks as December begins.

The S&P 500 is down 3.8 percent since Wednesday, November 24. While that might not sound like much, it’s the biggest five-day drop since late October 2020. The decline started just three sessions after the index hit a new all-time high and reversed lower — a failed breakout.

While the omicron variant of coronavirus has triggered the latest selloff, negative forces were already developing. Investors may want to consider these to judge whether a longer period of weakness is beginning. That could be especially useful after 1-1/2 years of steady gains.

The main item could be the Federal Reserve, which is unwinding the most aggressive monetary stimulus in U.S. history. The combination of super-low interest rates and asset purchases helped the economy survive the pandemic’s mass-shutdowns and layoffs. But now that businesses have reopened and inflation is rising, the central bank is cutting back.

On November 3, the Fed indicated it will finish all stimulus by July. But on Tuesday, Fed Chairman Jerome Powell told the Senate that it may happen “a few months sooner.” That would suggest interest-rate increases would also come earlier.

S&P 500, daily chart, with 5-day change and failed breakout on November 24.

There are a few more things to know about the Fed’s message. First, the hawkishness is relatively new because tapering only started last month. Policymakers have also been getting more aggressive in their stance by raising their inflation forecasts at the last meeting.

Good-Bye ‘Transitory’

Second, Powell ditched the idea that inflation is “transitory.” This has been the Fed’s go-to concept since prices started rising in May and June. Powell repeated it throughout the summer to fend off critics worried about an inflationary spiral. His abandonment of “transitory” suggests that he views inflation as a real threat. And that means he’s more likely to fight it.

Third, the strong economy could make it a convenient time for the Fed to battle inflation. Non-farm payrolls are back within within 3 percent of their pre-pandemic levels and the unemployment rate has dipped to 4.6 percent. At the worst of the crisis, total employment was down 15 percent and the jobless rate had spiked to 15 percent of the workforce. Retail sales have also beaten estimates for three straight months. Industrial readings from the Institute for Supply Management have surprised to the upside, as well.

Fourth, the Fed seems united in its course. Powell was just appointed for a six-year term over Lael Brainard, who’s considered slightly more dovish. Other officials including Atlanta Fed president Raphael Bostic have made hawkish comments lately. Minutes from the last meeting (released November 24) also indicated tapering could go faster than “currently anticipated.”

This likely increases the importance of the next meeting on December 15.

2-year vs 10-year yield curve, courtesy of St. Louis Federal Reserve.

Flat Yield Curve

One impact of tighter monetary policy is a flatter yield curve, which is when short-term rates increase more quickly than long-term rates. That can hurt banks and financials that borrow in the short-term and lend at longer-term rates.

Why does the curve flatten? First, reducing inflation makes longer-term bonds (10- and 30-year Treasuries) more attractive. Investors buy them, pushing down their yields.

Second, the short-term rates (two-year Treasury notes) rise when the Fed talks about hiking its overnight lending rate.

Traders can see this in a security like the SPDR Regional Bank ETF (KRE). At one point yesterday, it was up 3.7 percent. But then it closed down 1.3 percent at its lowest level since the end of September.

Slower Economy?

Tighter monetary policy can also slow the economy. This can potentially hurt other cyclical sectors like industrials, energy and materials.

Let’s consider two other charts. First, the Russell 2000 small cap index (IWM) often had a failed breakout last month. That’s a potential sign of risk aversion as investors shun smaller and less-established companies.

Second, junk-bond yields are rising. Data from the St. Louis Fed and BofA shows the average spread on high-yield debt widened to 3.67 percentage points this week. That’s up from 3.03 on November 8, and the highest reading since the first quarter. (Higher spreads are a sign of increased fear.)

SPDR Regional Bank ETF (KRE), daily chart, showing failed rally on December 1.

Investor Fatigue?

Investor fatigue could be another risk. As covered earlier, breadth has deteriorated sharply in the last two weeks. Fewer companies are hitting new 52-week highs and more are hitting new lows. Short-term momentum has continued to weaken since Monday, with just 45 members of the S&P 500 above their 20-day moving averages. That’s the fewest since September 23, 2020. (See this for yourself on the TradeStation platform with the custom index “$20DMAASP”.)

Another potential consideration could be the National Association of Active Investment Managers (NAAIM) Exposure Index. This survey shows the the relative amount of stock professional money managers own. How long or “overweight” equities are the big-money players?

The answer recently was “very.” NAAIM’s index hit 108 a month ago, the highest reading since mid-February. It’s been dipping since, but the latest reading on November 24 was still near the top of its range. Used as a contrary indicator (like AAII’s sentiment survey), this may suggest portfolio managers have maxed out on stocks for now and have begun selling.

Volatility Spikes

Volatility could be another thing that’s different about the current market versus other moments earlier in the year. Cboe’s “fear” index (VIX) jumped 60 percent last week. That was its biggest spike since the pandemic hammered markets February 2020. The VIX continued to climb this week, and closed yesterday at an 11-month high.

In conclusion, the S&P 500 has tumbled as the Fed prepares to taper and the omicron variant of coronavirus spreads to the U.S. While much of the risk may now be priced into the market, investors start to view conditions more negatively and see less opportunity in stocks.

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