06/06/2023
It feels the dog days of summer have arrived. After last
Friday’s monster jobs report the Vix fell to its lowest level since February 2020 – the calm
before the Covid storm – as the S&P 500 finally made a concerted break above 4,200 to
hit its highest in nine months. Bank of America’s MOVE index, a measure of Treasury market
volatility, is at its lowest since March and FX volatility has also notably declined
recently, hovering around a roughly 1yr low.
Is the market complacent about what’s coming around the bend?
Maybe investors are content that the Fed is near the top and will either skip or pause in
June – maybe one more hike this month, maybe delay it until July. Whether the Fed goes for a
couple more hikes or not there is a definite sense that it is near the end of its hiking
cycle – whether this is true or not remains to be seen. Certainly, the debt ceiling deal
removes one worry – the tail risk of a default. And the banking crisis in the US appears to
have calmed down – for now.
But volatility has been squeezed lower since March; and the
main reason is probably technical. We have a seen a volatility crush that has mechanically
driven stocks higher – funds buying when vol is low. This gamma trap is neatly described as
a market dominated by options sellers, which encourages mean reversion, spurring mechanical
buying by low vol strategy funds. Dealers are long gamma and the path of least resistance is
to drift up on the lower vol squeeze.
As per a JPM note of late April: “We believe the reasons for
low volatility are technical in nature with the market dominated by option sellers. Selling
of options forces intraday reversion, leaving the market price virtually unchanged many
days. This in turn drives buying of stocks by funds that mechanically increase exposure when
volatility declines.”
Long gamma means that option market-makers buy S&P500 on
dips and sell on rallies – low vol. Short gamma means they sell when it falls and buy when
it spikes. So, the market is more volatile when gamma goes negative. Right now it’s long and
is allowing SPX to drift up. But why so low and can it last?
Against the decline in implied volatility measured by the Vix
etc we have seen the SKEW index shoot higher – which may be down to dealers protecting short
volatility positions with longer out of the money options. This happened in 2021 when the
Fed was doing QE and this latest appears to be correlated to the Fed’s banking crisis pump
since March.
Note that SKEW is not always a great indicator of a major
dislocation – but it helps to describe the volatility crush we are witnessing.
And it could signal a rerun of the 2018 melt up in stocks which
preceded a 10% drawdown. We have a similar setup in terms of Vix lows and SPX at the upper
end of the weekly Bollingers, though RSI is not as high.
Part of the reason for the long gamma vol crush is that
there has been a lot of liquidity provided by the Fed over the last 2-3 months. And the
market may be about to see a sudden spike in volatility as the Treasury issues a huge volume
of T-bills. In the wake of the debt ceiling deal something like half a trillion dollars’
worth of these bonds may be needed in June alone, with a little more over the course of the
year – about $1.3tn in total for the rest of 2023 according to DB. Issuance may lead to a
major drain on liquidity, which has been buoyed up by the Fed’s bank lending since the
banking crisis blew up in March. The impact of the liquidity drain will depend on how much
money market funds can absorb as they shift out of the Fed’s overnight reverse repo facility
(RRP). Meanwhile the S&P 500 looks over-extended on its current run. Bespoke says that
after Friday’s rally, the S&P 500 closed 2.47 standard deviations above its 50-DMA,
which was the most ‘extreme’ overbought reading for the index since July 2021. Driving the
market higher has been the anticipated Fed pivot on disinflationary trends, liquidity
injections, megacaps picking up bid and delivering fresh leadership on a flight to safety
and, of course, AI bubble tailwinds…loss of liquidity and exhaustion of the megacap bull
run looks like conspiring with a failure to find fresh leadership from cyclicals and lower
‘quality’ shares amid persistent recessionary indicators from most of the surveys we are
getting from the US. The lack of breadth in the rally has been stunning – it’s like an
upside pyramid. GS’s Brian Garrett has some interesting reading on gamma positioning for
SPX. He’s highlighted a rare occurrence in in the S&P options market, noting that if the
market keeps drifting higher “things get very interesting for dealer community.” If the
S&P goes up another 4% to 4,390, dealer gamma flips from positive to negative – the sort
of flip that almost never happens in a rally…presumably that sort of flip could see
dealers chasing the market higher… Net-net, I sense that stocks overbought + gamma flip
into negative + liquidity drain = higher yields and equity volatility spike incoming + this
rally can’t last. Plus, this is still a bear market rally, albeit a heck of a long one. Pain
trade remains equities up, vol down and continued crush but this will not last forever.
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