We have noted in the last few days the divergences between US equity and volatility markets and chatter of a major fund needing to liquidate positions. After today's price action (and more color from trading desks) we are starting to see the 'fingerprints' of what appears to be a multi-billion dollar forced short cover that has almost perfectly correlated with the linear surge in US stocks.
Here's RBC's Charlie McElligott to explain the details behind this move...
1. A purported / murky melt-down over the past week in a large trade by a multi-billion Dollar (open-ended) futures fund which sells vol on S&P. Without going into specifics, there is market speculation that the entity is effectively short upwards of ~$17B of SPX (deltas to buy) through selling February expiry upside 1x5 (or 1x4) call spreads.
The convexity seemingly ‘kicked-in’ ~2300, and as witnessed by market participants, the short-gamma ‘take’ since has been nothing short of astonishing.
The ‘fingerprints’ in trading SPX 3rd weeks was notable yesterday, where big 2280 calls traded (amongst others) which created $5.5B of deltas to buy in-and-of itself.
As visualized in the chart of e-minis below, the ‘short gamma’ grab is evident since we took-out the 2300 level.
2. US nominal yields still can’t meaningfully “punch through” 2.50 / 2.52 level, while real rates and USD actually trade LOWER despite an outstanding run of data (especially inflation) and hawkish Janet Yellen. I think there is a two-fold rationale here: 1) As highlighted earlier in the week by Mark Orsley and me, the turn in Chinese data and concurrent squeeze in short Yuan trades actually has alleviated some of the PBoC’s UST-selling pressure. That and 2) the market is still ridiculously short duration, with some leveraged funds likely covering out of frustration. Either way, it seems reasonable that a sharp-reversal in broad risk-asset sentiment could REALLY squeeze this short-base, and with no China-supply this time around. A FTQ-bid would drive rates lower and could see recently-accelerated “value” and “cyclical” equities-plays get wacked, while duration-sensitives (defensive yield-plays) would be sent scrambling-higher.
3. The catalyst to make things get weird? The potential for President Trump’s speech to a joint-session of Congress on February 28th to disappoint very-high market expectations with regard to tax-policy clarity. We’ve spoken for months now on how the ‘corporate tax cut input’ is the largest anecdotal driver of the S&P / single-stock estimate upgrades since the election, with the generic assumption being applied of a 20% corp tax rate. The issue is this: it is abundantly-clear at this point that in order to fund a cut to a 20% rate, you HAVE TO incorporate a B.A.T. as the funding mechanism…otherwise the best-case cut is significantly weaker. But as this Senate / CEO “anti-B.A.T. food-fight” drags on, it’s incredibly doubtful that Trump will be capable of making any specific claims to the larger policy construct in just such a short period of time, as it would require TREMENDOUS progress from the current bickering. And if today’s public-portion of Trump’s meeting with retailer CEOs counts as anything, there was no mention on camera between parties of the B.A.T. whatsoever. Again, this reiterates to me the high-potential for disappointment.
However, more ominously, McElligott concludes with his biggest concerns...
This equities upside short-gamma grab has taken out a ton of ‘bid on the downside’ in equities index, in the case that we were to see any sell-off post a Trump speech disappointment.
This lack of cover-demand on a vacuum-move could see sloppiness develop, as it seems that the data and Fed itself are no longer dictating the market story at this stage - whether stocks, fixed-income or vol. “Policy” is now firmly “in the driver’s seat,” and that is where I see the least degree of confidence in the market.
I’m worried that this stock ‘melt-up’ move is extraordinarily mechanical right now - almost entirely the aforementioned forced-covering, not high conviction induced-buying - and may be sending a “false signal” which is potentially dragging-in new buying on the breakout to new highs. This could lead to a scenario where a market can “collapse under their own weight.”
I also am concerned about the ‘knock-on’ effect w.r.t. the scale of the ‘short duration’ trade out there IF this “Trump speech failure to meet tax policy expectations” scenario were to play-out. As mentioned, this wouldn’t just impact fixed-income, but also likely equities thematic trades as well.
There is certainly a long way down...
This should surprise no one of course - anyone who has experienced the moves of the last week or so is exasperated, as our veteran trader noted earlier - "something snapped" - and the ammo for this mechanical move is out on Friday when the options expire.