Remember the equity correction?
If not, don’t worry. You didn’t miss something. There wasn’t one. A correction, I mean. There was, however, a pullback. It lasted for three or so weeks and amounted to a ~5% haircut for the S&P.
The shallow retreat was accompanied by the reemergence of demand for downside against less in way of interest for upside optionality (melt-up tickets, colloquially) and thereby steeper skew.
That marked a regime shift of sorts. Skew had flattened to extremes amid months of de minimis interest in selloff protection set against insatiable demand for calls. For a week or so, the reversal of that dynamic looked like the beginning of something.
Alas for the adrenaline junkies, it wasn’t the beginning of something. Rather, it was nothing.
As the figures above, from Nomura’s Charlie McElligott, make clear, the tension in the vol / equity options space is “dead and gone,” as he put it.
What happened? Two things, McElligott said. To wit (and the bullet points below are direct quotes):
- Jerome Powell snuffed out what had been a growing probability of a potential Fed hike by year-end thanks to a deadpan ‘dovish’ message at the FOMC meeting last week, keeping the Fed path distribution purely asymmetric to easing while also reducing QT by a larger amount per month than expected.
- [The] US economic data [is] now slowing versus expectations, [with] the Bloomberg US Economic Surprise Index at 14-month lows and seeing notable degradation in survey, business cycle [and] industrial data.
Together, those “two major macro catalysts” worked to “cut the left-tail,” Charlie wrote.
I’ve talked at length over the past several days about the “rethink of the repricing,” where that’s a reference to the dovish reversal in rate-cut pricing for 2024 from the pre-May FOMC hawkish extremes.
Recall: Pricing for 2024 cuts was trimmed inside of 30bps ahead of last week’s Fed meeting, which is to say traders had faded almost the entirety of a second hypothetical 2024 cut, leaving just one quarter-point reduction (and some spare change) in the curve.
Over just a few sessions covering the Fed meeting and the NFP /AHE undershoot, market pricing saw most of the second cut priced back in, as illustrated above. Now we’re back to 50bps. Two implied cuts.
As McElligott noted, you can think of that as the market getting some right-tail back.
Traders, he said, are now “honing in on the softer labor data where, after months of negative revisions, lower hours worked [and] lower temp work, the market is now seeing the potential [for] the unemployment rate [to] jump faster than previously expected on weakening overall demand plus immigrant labor supply [which] could then allow the Fed to soften policy more aggressively.”
He drove it home: “As such, index ATM iVol has been crunched, skew and put skew have violently flattened and vol of vol has been destroyed in the clearest expression of disappearing demand for downside tails.”
