Derivatives, liquidity gaps, and rate bets—Why the Fed can’t tame volatility

The Federal Reserve is cornered. Markets are sliding, traders are on edge, and the economy isn’t making things easier. The central bank is expected to keep rates unchanged, but that won’t be enough to calm investors.

Everyone is waiting for Jerome Powell to speak. His press conference and the Fed’s new economic projections will shape the next big move. Wall Street is already bracing for the worst. The S&P 500 dropped nearly 10% from its last high. Investors are nervous.

The Fed’s projections aren’t reliable either, with Goldman Sachs warning that they might still include two rate cuts despite economic uncertainty. Tariff policies under Donald Trump remain unclear, making inflation even harder to predict. The central bank will pretend it has control, but the market knows better.

Fed’s next move could break market confidence

Traders have been counting on the Fed put, the idea that the central bank will act to prevent a complete market crash. That belief is getting tested. If the Fed signals a hawkish stance or even hesitates, it could trigger a deeper sell-off. The market has already been struggling, and another hit could send stocks lower.

Venu Krishna, a strategist at Barclays, told investors that panic hasn’t fully set in, but it might. “This may be due to markets’ faith in the Fed put, which crucially could be put to test this week at the FOMC meeting,” Krishna said. If Powell delivers an unexpected stance on inflation or rate cuts, Wall Street could spiral.

Meanwhile, Larry Benedict, founder of The Opportunistic Trader, pointed to the Cboe Volatility Index (VIX), which tracks market fear. It’s lower than last August’s levels, but that doesn’t mean much. “Volatility is a little bit higher, but for what’s going on in the market, it’s not really that high,” Benedict said. If markets are underestimating the risk, things could unravel fast.

The S&P 500 has fallen after five of the last ten Fed meetings, with the biggest drop hitting nearly 3% back in December. If Powell’s press conference brings more uncertainty, that pattern could continue.

Wall Street sentiment crashes as cash piles up

The latest Bank of America Global Fund Manager Survey sent another warning signal. Investor sentiment just saw its biggest drop since March 2020, when the markets crashed during the pandemic.

Michael Hartnett, an investment strategist at Bank of America, called it a “bull crash”, a complete reversal in optimism due to growth fears and Trump’s tariff policies. It was the seventh biggest sentiment drop in 24 years.

Investors are running. Exposure to U.S. equities saw the biggest drop on record. Traders are also hoarding cash at levels last seen during the March 2020 crash. Wall Street is in full defense mode.

Economic growth expectations collapsed, posting the second-largest drop in history. That matters. The survey’s growth outlook has always lined up with S&P 500 performance, and the decline suggests bad news for stocks.

Some traders think the worst is over. Hartnett noted that this kind of sentiment drop could mean the market pullback is nearing its end. But he also warned that the data isn’t bad enough to suggest a true bottom yet. Stocks could still fall further.

The S&P 500 barely held out of correction territory on Tuesday, avoiding a 10% drop from its last high. The market is in a dangerous place.

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