It’s certainly tempting to cite the “peak inflation” narrative and attendant expectations for an incrementally less hawkish Fed as the proximate cause for a “sticky” rally in US equities.
Halfway through August, there was scant evidence to suggest stocks were inclined to roll over after a weekslong surge found the Nasdaq arguing for a new bull market designation, while the S&P eyed its 200-day moving average.
In our haste to ascribe causality, it’s worth taking a step back to remind ourselves that the spark for a conflagration shouldn’t be confused with the kindling or with the blaze itself.
There’s little question that Jerome Powell inadvertently gave the rally a boost during last month’s post-FOMC press conference (figure on the left, below). And to the extent that eased financial conditions, it was counterproductive.
Similarly, July’s inflation report emboldened those inclined to push the issue, and an accompanying sharp drop in the dollar only added to the FCI easing impulse from rising stocks (figure on the right, above).
But, as Nomura’s Charlie McElligott reiterated on Tuesday, “the reality of the equities price action” isn’t about “past-peak inflation” or the (mis)perception of a dovish pivot from Powell last month, or even about expectations for easing starting early next year.
“Instead,” Charlie wrote, the equities story “continues to be about “mechanical flows in the market.”
Last week, I noted that dealer positioning was back in positive gamma territory. I called that “a key piece of the stock stability” puzzle. A few days later, I flagged the “weight” (if you will) of proximate options strikes as a likely source of local stability. On Tuesday, McElligott called the gravity around 4,300 “stifling.” Spot is effectively pinned between 4,250 and 4,350, which likewise carry a lot of weight. In a separate note, he described the implied net $Delta add over the past month as “impossibly enormous.” The figure on the right (below) gives you some context.
“Crash-y’ downside puts have been melted out of existence,” McElligott wrote. The heightened sense of desperation among woefully under-positioned funds is evident in call skew, which he described as “foaming at the mouth” — it’s basically 100%ile (figure on the left, above).
Of course, that means OpEx is meaningful. As Charlie put it, decisions need to be made, “not only on whether or not funds are going to just let some delta roll off / monetize some part of those upside calls which have been put on with abandon into this booming rally since mid-June, but also, whether funds are going to capitulate or roll any remaining (and absolutely torched) legacy downside hedges, which are decaying in brutal fashion.”
Meanwhile, the ongoing vol control reallocation bid (catalyzed by collapsing one- and, now, three-month, trailing realized), sums to almost $28 billion on Nomura’s estimates.
As realized vol continues to recede (figure above), the implied latent bid will proceed, with help from additional vol-expansion days (i.e., fireworks sessions) dropping out of the sample.
Assuming 1% daily changes on the S&P, the model-implied buying would exceed $32 billion over the next month. If the daily distribution was confined to 0.5% changes, the total could exceed $40 billion.
The figure (above) gives you a sense of the dynamic: The more compressed the distribution, the more scope for re-leveraging, and vice versa.
Finally, on the CTA front, the S&P is close to triggering the next wave of buying, according to Nomura’s models. 4,329 was the level to watch on S&P futures. The Nasdaq 100 was a bit further away, but the overarching point is just that meaningful additional upside from current levels on the benchmarks has the potential to dictate “significant” demand.
All of this into an illiquid market made even thinner by the summer doldrums.
Coming full circle, it’s always worth asking whether or, in many cases, how much, mechanical flows have contributed to a given move, be it a sizable run higher or a harrowing dive. In the case of 2022’s bear market rally, the answer is “quite a bit.”