Sticky Inflation and Opportunities Offered by Volatility in the Equity Market

June 15, 2023

Source: Bloomberg Source: Bloomberg

During the pandemic, the prompt suggesting a tip of 15%, 20% or 25% started to pop up in coffee shops, bakeries and take-out eateries. This was originally a way of saying “thank you” for essential workers, but then it stayed after the pandemic. The trend of technology nudging people to pay more tips essentially increased the costs of buying coffee, bakery items and take-out food. Sometimes, I do feel it is unfair to the people in professions where harder work is typically required to earn tips.

Amid this “everyone gets a tip” phenomenon, The Wall Street Journal also recently published an article titled “Customer Ratings Have Become Meaningless. ‘People Hand Out 5 stars Like It’s Candy.’”1 Personally, I have taken Uber rides where the driver was texting frequently or driving well above the speed limit. Still, I gave 5 stars to all of them because I didn’t want to hurt their livelihoods.

The economic outcome of these social changes is hard to quantify, but the direction is inflationary. Earlier this year, almost everyone (including me) expected that continuing interest rate hikes by the Federal Reserve (Fed) would push the economy into recession by the second half of the year. We completely underestimated the underlying momentum in the economy. At this moment, the economic data is still robust and the risk of recession in 2023 is low.

Was the hard landing avoided or just delayed? Inflation’s future path will be the key. Sticky inflation could force the Fed to hike interest rates again, or just not cut them when growth slows, which would increase the risk of a hard landing. A smooth return to 2% inflation would give the Fed more flexibility to manage the growth, and increase the odds of a soft landing. I am still in the camp believing that recession has been delayed, but will not be avoided.

The volatility market is currently pricing in a fairly benign outcome. Today’s Chart of the Week demonstrates that the Chicago Board Options Exchange’s CBOE Volatility Index, commonly known as the VIX, has recently been trading at its lowest level post-pandemic (14.65). However, the market does expect the VIX to increase quite rapidly in the coming months. For example, June VIX futures are trading at 15.4, while July VIX futures are trading at 17.1 and October VIX futures are at 20, per Bloomberg as of June 13. This scenario indicates that there is at least some anxiety in the market.

For those with doubts about the current market rally, it may make sense to buy June or July VIX calls. The low VIX and “volatility of volatility” make these calls fairly cheap to purchase, and a great hedge for equity downside. For those who are more confident about a soft landing, selling September and October VIX calls or buying September and October VIX puts may make sense, as they might benefit from the rolling down of the forward-volatility curve and collect attractive carry.

Key Takeaway      

The pandemic changed consumer behaviors, and technology continues to do so as well. The path of inflation will dictate how risk markets perform for the rest of the year. Currently, volatility in the equity market is fairly calm and short-term volatility is attractive. For those who worry about sticky inflation, buying short-term VIX calls may be a cheap way to hedge the risk. For those who are more confident about a soft landing, selling longer-term VIX calls or buying longer-term VIX puts may be good ways to monetize the steep forward-volatility curve.


1The Wall Street Journal — Customer Ratings Have Become Meaningless. ‘People Hand Out 5 Stars Like It’s Candy;’ 6/5/2023

Tags: Volatility | Inflation | Risk Markets | VIX | Federal Reserve

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