In the immediate aftermath of the Fed’s hawkish pivot at 2021’s final policy meeting, I suggested belabored attempts to explain the ensuing bid for US equities by reference to fundamental macro takeaways from the new SEP and Jerome Powell’s press conference were probably superfluous.
To the extent you wanted to divine an underlying bullish (i.e., risk-friendly) message from the otherwise hawkish dots, statement and projections, it was probably just that the Fed is now seen as eager to dispel the notion that policy will remain deliberately behind the curve at the risk of a stagflationary outcome, due to i) inflation that refuses to abate and eventually erodes consumer confidence and thereby demand, ii) ongoing severe inflation overshoots that force the Fed to engineer demand destruction, or iii) some combination of those unpalatable eventualities.
Of course, that’s a fairly complex calculus for “dumb” equities to process in real time, so the more germane consideration may have been the perception that the Fed will be more cautious this time when it comes to presuming to know where “neutral” is.
But the essence of my assessment was that the market had already traded a hawkish Fed and that with the event risk in the rearview, everyone was free to get back to their regularly scheduled programming, abandon hedges, “buy the fact” after selling the rumor, and so on.
Commenting in a Thursday note, Nomura’s Charlie McElligott acknowledged the fundamental points briefly mentioned above, but described the rip in equities as “only marginally to do with a ‘new’ macro datapoint catalyst.” Instead, he wrote, the stock surge was “almost entirely due to the Vol space and flows driven by dealer hedging of their exposures.”
First, and critically, the totality of the Fed’s policy tweaks and messaging may have materially reduced fears of an over-tightening. That, McElligott remarked, “meant that US equities implied volatility got crunched.”
From there, the narrative writes itself. Only not as well as Charlie writes it, which is why he’s such a joy to quote.
“The rather prolific (over)hedging into the Fed event and ensuing nuke job on iVol thereafter, meant it was time for broad equities to ‘get Greeked’ by the Dealer hedging feedback loop,” he wrote Thursday. “All that ‘short Delta’ from Dealers [who] were short puts from large buying of downside protection from clients then got the double-whammy ‘virtuous’ impact of Gamma- and Vanna- sensitivities in their hedges.”
As implied fell, dealers set about covering their short hedges in futures. As stocks rose, helped along by that impulse, “you got the simultaneous Gamma impact kicking in, compounding and escalating the covering,” McElligott added, before (figuratively and literally) closing the loop. “As Vol is getting smoked, this further incentivizes net end-users to unwind their now-cratering downside hedges [while] actual ‘short Vol’ expressions are then too added to the mix, both of which generates (you guessed it) Delta to BUY.”
Importantly, the rally in spot helped push the market back into insulating long gamma territory, which helps inoculate (sorry) equities from large swings going forward.
That matters tremendously, because if spot settles down and daily moves compress, the attendant decline in realized vol will then trigger mechanical exposure adds from a vol control universe that de-allocated massively in the month prior to the Fed meeting.
Commenting on just that, McElligott on Thursday wrote that on Nomura’s estimates, vol control strats “could soon be buying-back rather stunning US Equities notional” over the next two to four weeks.
Of course, that doesn’t necessarily mean stocks have a green light to rally uninterrupted into 2022. All of the above is just the mechanical side of things.
As Charlie went on to say, there are “market risks from central bank tightening tantrums, Omicron, lockdowns [and] ‘no deals'” on Biden’s social spending plan to fret over.
Oh, and more immediately, McElligott noted that “we still have this Op-Ex to clear, and a massive amount of the $Gamma set to expire.”
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