The swap market has fully digested the Federal Reserve's interest rate hike expectations for September and implies the possibility of another rate hike later this year.

Written by: Bu Shuqing, Wall Street Journal

Stock investors can no longer indulge in summer leisure. This week, multiple risk events including the Federal Reserve's interest rate decision, the concentrated earnings reports of tech giants, and oil prices breaching $100 have all combined to usher in a rough market period.

Microsoft and Meta will be the first to announce their earnings on Wednesday, followed by Apple and Amazon on Thursday. Meanwhile, the Federal Reserve and the Bank of England will successively announce their interest rate decisions, and European inflation data as well as China's PMI will also be released intensively. Goldman Sachs partner Richard Privorotsky pointed out that all of the above occurs against the backdrop of Brent crude oil briefly surpassing $100 per barrel, global bond yields remaining high, and the stock market declining for two consecutive weeks.

In terms of market pricing, the swap market has fully digested the Federal Reserve's rate hike expectations for September and implies the likelihood of another increase this year. JPMorgan's market intelligence department warns that if the 10-year U.S. Treasury yield breaks above 4.8% again, interest rate-sensitive stocks will face greater pressure.

Volatility Relaxes, Systematic Investors' Positions Are Fragile

Geopolitical tensions have caused volatility to heat up early, while this week’s earnings reports and economic data have the potential to trigger more significant market fluctuations.

Historically, Goldman Sachs data shows that in U.S. midterm election years, volatility at the index level typically begins to rise in August and continues to increase until October. Richard Privorotsky believes that VIX call options are currently a good tool for tail risk hedging and states that the market is more likely to maintain a fluctuating pattern—implied correlations remain near the lowest levels of the past few decades, and diversification is suppressing overall market volatility.

Technically, there is also a need for attention. The MSCI World Index has encountered significant resistance around the 4885 point. Deutsche Bank strategist Parag Thatte and others noted that systematic investors' positions are at the 70th percentile, which is considered high. Once volatility rises or the stock market breaks downward out of its range, this position will face considerable fragility.

Additionally, last week, active investors showed a significant trend of deleveraging, with their risk exposure falling back to the 17th percentile, near early April lows, far below the rational level implied by earnings and macroeconomic growth.

Valuations of the "Seven Giants" Have Fallen to Historical Lows, Discrepancies Have Increased

The earnings reports of tech giants are the focal point of the market this week. The "Seven Giants of Tech" have long been the source of funds for AI beneficiary stocks and semiconductor trades, but in the recent wave of profit-taking in related sectors, the seven giants themselves have not benefited. According to Deutsche Bank strategists, the position adjustment in large-cap tech stocks is about three-quarters complete, after clearly rolling back from high positions.

However, there are noteworthy signals at the valuation level. The forward price-earnings ratio of the seven giants has fallen to near the bottom of the range over the past seven years, both in absolute and relative terms. Deutsche Bank believes that the current valuation compression was primarily driven by stock price declines rather than earnings expectation downgrades, which may provide opportunities for buying on dips.

Concerns over AI capital expenditures continue to fester, and Alphabet's announcement last week further reinforced this worry, suppressing the willingness of investors to re-enter. However, Morgan Stanley analysts Stephen Byrd and Michelle Weaver hold a different view. They remain optimistic about the "intelligent superhighway" theme, suggesting investments in fuel cell and energy storage companies, companies within the computing manufacturing ecosystem, as well as large-scale cloud computing firms that possess economies of scale and return capacity on AI capital expenditures, specifically naming Meta, Alphabet, Microsoft, and Amazon.

"Given that the recent market pullback has impacted a range of AI infrastructure stocks, we believe this point in time represents a rare attractive buying opportunity," the Morgan Stanley team wrote, "We fundamentally look forward to the speed of enhancing AI capabilities, the benefits brought by AI applications, and the related capital expenditures."

Fed Statements Become Key Variables, Bond Yields Affect Stock Market Nerves

This week, the biggest threat to market calm, aside from tech earnings, is the direction of central bank movements. The swap market has fully priced in the Federal Reserve's September rate hike, with an implied possibility of a second increase this year. Any statement from Federal Reserve Chairman Kevin Warsh will be highly scrutinized by the market.

Warsh has a cautious stance on forward guidance, which means rate hike expectations will rely more on data. Should the situation in the Middle East further ease and oil prices follow suit, it will help central banks achieve their policy objectives.

JPMorgan's market intelligence department emphasizes that for the stock market, the speed of interest rate changes is more critical than absolute levels. The institution noted that last week the 10-year Treasury yield surpassed the May high of 4.67%, with the next key observation point being the January 2025 high of 4.79%. "If subsequent data or the Fed's wording supports a further breaking above 4.8%, interest rate-sensitive stocks will begin to face greater pressure."