Next leg lower for the S&P500?

From renewed inflation pressures to central banks, positioning and option expiries, worrying signs are emerging. Keynes said that markets can remain irrational longer than you can stay solvent. Is that the case now?

The S&P 500 sits near recent range lows and some have suggested that today’s Option Expiry (OpEx) may free the market from this trading zone.

Goldman Sachs show where the option expiries (SPX) are concentrated in this chart:

Their calculations indicate that post expiry, “dealers would lose a significant portion of their left tail ‘long gamma’ positioning”, potentially creating conditions for volatility to rise.

Options terminology can be confusing, but the basic theory is that long gamma positioning can have a dampening effect on volatility, keeping price pinned within tighter ranges as dealers try to hedge their exposure and maintain a directionally neutral book.

Essentially, they buy low and sell high to stay ‘market neutral’. Their flows can be a factor in maintaining a rangebound market environment and preventing a trend from taking hold.

So, why could the expiry be significant?

The expiry of long gamma dealer positions potentially removes this volatility dampener. Obviously much will depend on how market positioning evolves post expiry (i.e. the positioning that dealers need to hedge), but it may be a factor that allows larger market moves and, if dealers end up ‘short gamma’, potentially amplify price movements in either direction.

Moving on from options, Goldman Sachs also point to positioning as one explanatory factor for the YTD rally. In essence, the market was ‘caught short’ last year and forced to cover (buy back) positions. The classic short covering dynamic.

Vincent Lin explains:

US equities on the Prime book have seen 4 straight weeks of short covering (as of COB 2/2). In cumulative notional terms, the short covering from the past month ranks in the 99.4th percentile vs. the past 11 years. Since the start of 2012, it would be the 4th largest short covering episode – only the 4-weeks ending 1/28/21 (meme frenzy), 10/16/14, and 11/17/22 (around the Oct CPI print) saw larger or equivalent amounts of short covering.

If everyone who wanted to sell has already sold, positioning can become one-sided and lead to more extreme price movements. If there are mainly new buyers (new longs) and forced buyers (active shorts being stopped out/covering), the market is imbalanced in favour of higher prices, which may help explain what we’ve seen of late.

If Goldman Sachs is correct, this imbalance has likely been corrected now, possibly leaving markets with a neutral or long positioning bias.

Which opens the door to a question… How will the S&P 500 respond to more hawkish central bank rhetoric and the inflation picture?

If we’re to believe that ‘non-macro’ flows have perhaps pinned price around current levels, then will the macro start to impact markets again, perhaps pushing the stock index down to the 200 day moving average and a retest of the trendline in the 3950 area?

Yesterday, two Federal Reserve officials reintroduced the chatter around 50bps rate hikes. Perhaps crucially, neither of these members are voters this year. Nevertheless, these are warning signs that the Fed may be further from done than previously thought.

Cleveland Fed President Loretta Mester said that she “saw a compelling economic case for a 50-basis-point increase" while St. Louis Fed President James Bullard said he "was an advocate for a 50-basis-point hike and I argued that we should get to the level of rates the committee viewed as sufficiently restrictive as soon as we could."

Since the last meeting, the data has come in hot with employment and retail sales both buoyant. Inflation isn’t falling as fast as hoped, and yesterday’s US PPI data came in above expectations too.

ECB member Isabel Schnabel also leaned hawkish in comments to Bloomberg today:

“There are reasons to believe that transmission may be weaker than in previous episodes”

• We have seen a notable shift from variable towards fixed rates in mortgages.
• We have also seen a shift towards longer maturities in the bond market.
• In addition, our surveys suggest that firms see an urgency to invest in digital and green technologies.
• And then we have the very strong labour market, which means that the usual transmission through a decline in employment may not work in the same way.
• All these factors would suggest that there could be a lower sensitivity of aggregate demand to changes in interest rates.

“We may have to act more forcefully if transmission turns out to be weaker”

Next week, we’ll see how the market responds to US flash PMI’s, the minutes of the previous Fed meeting, and the next inflation print (PCE). If the economy is starting to accelerate and spur a new bout of inflation, stocks may reprice lower as fears of even higher rates and a harder economic landing re-emerge.