On Wednesday, the stock market had its worst down day since September 2016. Many headlines claimed the stock market fell because of political controversies involving the firing of FBI director James Comey, but I’m skeptical of that conclusion because the market has ignored this story for days. In Monday’s article, I predicted that the VIX would end its streak of closing under 11 this week and that the streak of days where the S&P 500 had a less than 0.5% move would also end this week. This isn’t because I had special knowledge of the political investigation. It’s because the market had been too quiet given the weakness in economic data as measured by the Citi Surprise Index. It’s like water building up pressure against a wall; eventually, the wall will come down and the floodgates will burst open.
The chart below shows that the iPath S&P 500 VIX Short-Term Futures exchange-traded note had record volume on Wednesday. The S&P 500 fell about 1.8% and the VIX finally soared. My point isn’t that the Trump investigations don’t matter at all. It’s that the market was bound to fall at some point given the weak data. The biggest question the market has regarding this story is whether it slows down Trump’s agenda of getting tax reform and healthcare reform passed. I don’t think it will slow it down because healthcare reform depends on how negotiations among Republican Senators go. The White House’s budget plan will be announced next week. While I don’t this latest controversy will slow down the legislative agenda, that’s not saying that it will pass easily. The reason the process has been so slow is because GOP members have ideological differences. How those differences are resolved will determine what gets done.
As you can see from the chart below, the chance of a rate hike in June fell on Wednesday. The odds rebounded on Thursday back to 73.8%. The fact that the chances of a rate hike fell so much supports my claim that economic weakness caused this selloff. If the decline was caused by only political risk, the chance of a rate hike wouldn’t move. As much as the media focuses on political issues, economic activity isn’t affected by it. For example, in Q1 optimism ran high after the election, yet GDP growth was 0.7%. In Q2 we may have a reversal where pessimism runs high, yet GDP growth is above 2%. While I don’t claim that the Citi Surprise Index is the ultimate arbiter of economic activity because it was strong in Q1 even though GDP was weak, I do understand that if economic surveys disappoint, the stock market usually falls. The fall to a -37.50 reading along with hard data weakness was behind the selloff on Wednesday.
