Blink Once For Crash Up

You should be able to tell this story yourself. It’s a familiar tale.

Friday’s raucous rally on Wall Street didn’t defy explanation. It just defied the capacity of the journalists tasked with penning daily market wraps to quickly assess recurring dynamics and contextualize them via a burgeoning policy narrative centered on the notion that central banks are in the process of “blinking,” and reducing the pace of rate hikes.

The figure (below) is simple, but it has a lot of explanatory power. Notwithstanding an uptick to close the week, five-year US reals have collapsed off recent highs (right-most annotation). They came into Friday down 37bps in just six sessions. High-to-low, it was more than 50bps.

When five-year reals fall sharply, it can be tantamount to a blast of easier financial conditions. In other words: Bullish for risk assets. 10-year US reals are more than 20bps lower since October 20.

Although the dollar was bolstered Thursday by a dovish ECB (and an attendant swoon in the euro), the greenback nevertheless notched a second consecutive large weekly decline. And if you’re willing to look past an odd session for Treasurys on Friday which, among other things, found the front-end cheapening markedly (spurred on late by a block sale in two-year note futures), the more important story is implied terminal rate expectations, which were ~15bps lower over six sessions.

“The bigger picture, however, is a continued sympathy rally with a perceived pivot by the Bank of Canada and the ECB this week,” Bloomberg’s Alyce Andres said. The “however” was an allusion to Friday’s weakness in Treasurys which, as noted above, was difficult to dissect. “Market participants in the futures market continue to commit to the long side,” she added.

“The rates / Treasurys market has continued to trade the Fed ‘step-down,’ with consistently lumpy demand seen in upside calls / call spreads / call flies around Dec22 into Q123 in recent weeks… with OI showing the majority to be new risk added, not just short covering [and] unwinds,” Nomura’s Charlie McElligott remarked.

With all of that in mind, consider how under-positioned everyone is. Cash levels are the highest in decades, a de facto short. Hedge funds simply don’t have it on, so to speak, when it comes to equities exposure. So, when stocks start to run away higher, “a bearishly under-positioned and under-allocated investor base” is forced “into ‘chase’ / stop-out / ‘buy-to-cover’ behavior in shorts and dynamic hedges,” as McElligott wrote Friday.

October has been extremely notable for the preponderance of crash up sessions (figures above).

Crucially, Friday’s stock rally was almost surely turbocharged by short-dated options trading and associated hedging — so, weaponized gamma and the (partially deliberate) facilitation of a self-fulfilling prophecy.

Apparently, almost two-thirds of trading in SPX options on Friday (and nearly that much in SPY and QQQ), was in 0- and 1-days-til-expiration options midway through the session. Of those SPX options, 13% were the 3900 call, a level more than 2% above the cash open. The close was 3901.