Fed officials put market participants on notice this week: There was no “dovish pivot” from Jerome Powell at July’s press conference. That narrative was a canard.
Mary Daly, Charles Evans and Loretta Mester all underscored the Fed’s commitment to the inflation fight and a bevy of additional Fed speakers were poised to do the same for the balance of the week.
To the extent the recovery in equities (helped along by a concurrent rally in bonds) was a function of the idea that recession risk would compel a dovish turn, that recovery is now on shaky footing.
BofA, whose 3,600 year-end S&P target is among the lowest on the Street, cautioned market participants last month that the S&P’s duration is still some 30 years (figure below). The world’s risk asset benchmark par excellence is very sensitive to rates. “Every 10bps change in the discount rate represents 2% of S&P 500 fair value,” the bank’s Savita Subramanian noted.
This week, Subramanian reminded investors that bear market rallies are quite common. As discussed here on Monday, if you’re searching for big monthly gains, a good place to start looking is bear markets.
The S&P’s 13% gain from the June 16 lows was the second double-digit rally since the selloff began from the highs on January 3 (figure below).
“We view this as a bear market rally, which is common, occurring 1.5 times on average per bear market since 1929,” Subramanian said, adding that July’s 9.2% total return for the S&P 500 ranked as the best July since 1939 and was 98th%ile since 1936. It was driven, she wrote, “almost entirely by falling rates.”
Of course, the rally in bonds was amplified by short covering, and the more pronounced the rally there, the more impetus for stock gains. It’s possible rates will now reassess the situation in light of aggressively hawkish banter from Fed officials. As Bloomberg’s Ven Ram put it, US rates may “rediscover a Fed message that was lost in translation.” In the event Friday’s jobs report is robust, it’s conceivable that yields could rise sharply, capping an already big weekly increase. That’s not a prediction, it’s just one possible outcome in the constellation of risks.
If you’re curious as to the total contribution of CTA covering in legacy global equities shorts over the course of the summer rally, the impulse was roughly $60 billion on Nomura’s model (figure below). It was nearly $40 billion in bonds.
There’s still “plenty of firepower to gross-up further” in equities if signals flip outright “long,” Nomura’s Charlie McElligott said, noting that net exposure is still just 18.6%ile since 2011. He described the scope of option-related flows from closed puts and new calls as “biblical” — the implied +$Delta add across US majors over the past month came to almost $617 billion.
Going forward, vol control could take the baton. If equities manage to stay well behaved (which in this case means daily changes of around 1% or less) Nomura’s model suggests $22 billion of buying in US stocks over the next month.
The “well behaved” bit will be challenging, though. August can be especially perilous on the liquidity/market depth front. Relatedly, the seasonality isn’t your friend. August-September have “historically been the seasonally weakest months,” BofA’s Subramanian remarked.
As for the VIX, well, “you are here,” as McElligott put it, in an all-caps annotation (figure below).
“We are seeing vol try to firm again in recent days, which I’d imagine is a function of funds adding back small hedges as they take bets back up,” Charlie said earlier this week.
Fast forward to Wednesday, and McElligott suggested the nascent bid for downside may be more than a lark. “Hedgers are seeing some value return in outright puts,” he wrote, flagging “signs of life” in tails evidenced by the two-day move in VVIX.
“The speed of the rally off the lows is feeling increasingly unstable,” he cautioned. “Particularly as more people get comfortable with the idea that the Fed is going to struggle with this recent impulse-easing in financial conditions.”
Billy Ray: “Louis…”
Louis: “Not yet … almost…”