This article was originally published on Saturday March 19 for members of Reading The Markets, an SA Marketplace Service
The week ending March 18 was unforgiving, especially for those like me who were expecting a drop after the Fed. But most of the evidence I found supports the idea that this week’s rally was about options expiring rather than a less hawkish Fed.
While I know many would be quick to jump on the idea that it’s wrong to call markets lower, and it very well could be, the mix of the quadruple witch and index rebalancing makes a good too early for this assessment. Although very lively, the rally was about the same distance covered at the end of January; the only difference was that there was no weekend to break it.
The bond market reacted to the Fed exactly as we expected it to react, which is a much better indicator at this point than the stock market. The yield curve steepened this week with the biggest gains in two- and three-year rates, up about 18 and 21 basis points, respectively.
Meanwhile, the 10-year minus 5-year is now at 0% predicting a US recession.
The Overnight Index Swap curve also saw a giant jump in rates and is now reversed from the 3-year rate up to the 15-year rate.
There was also a significant rise in December 2022 Fed futures, which now peg rates around 1.92%.
Thus, the idea that the market had already priced in the more hawkish Fed is not valid. You wouldn’t have seen rates on the short end of the curve increase by 20 basis points. In addition, the fed funds futures were not priced correctly either; they too were trading nearly 20 basis points lower. The Fed therefore appears to have been more hawkish with a rate hike in 2022.
Additionally, fed funds futures for 2023 were trading around 2.4% prior to the Fed meeting and are now trading at 2.6% and likely heading towards 2.8%, which was in Fed projections over the next few weeks.
So why the rally in stocks? From what I can tell, this was a countertrend rally due to the loosening of volatility and the expiration of options. My mistake was to underestimate the magnitude of the potential unwinding of volatility and OPEX. I thought the more hawkish Fed would trump options expiration, and it’s not.
The cycle below, which I found over the weekend, shows that 6-8 days before options expiration, there is a countertrend forming and continuing through expiration, with a reversal of this trend in the days following expiry.
For example, stocks fell sharply from Jan. 12 at options expiration, followed by a rally from lows on Jan. 24 through Feb. 2 of more than 10% in the NASDAQ QQQ ETF. The ETF then fell sharply back into the options expiration and continued for two more days, hitting a low on Feb. 24. This led to a nearly 10% rally from the February 24 lows to the March 3 highs. This is the rally that most resembles this one.
But for some reason the March cycle has shifted and appears to have moved forward with the QQQ peaking on March 3rd as part of the Post OPEX countertrend rally and then declining through March 14th. This led to a very strong 10% rally we would typically see after Opex.
The move continued further after the Fed statement was released at 2pm causing the VIX to spike, then at 2:30pm when the press conference started the VIX started to melt, which sparked a massive move to start as implied. volatility levels have started to drop, causing put options to lose value.
If the valuation is correct, we should see the index continue higher on Monday in an attempt to close the gap to 4,475, which is from February 16th. If this gap is closed and the index continues to push past the gap, then the next level the index is expected to climb would be around 4,660. After that, there would be no more gaps.
However, I think it is more likely that once the gap closes at 4,475, we will see a retracement of this recent rally over the next few days as OPEX moves sideways and the Fed effects on the bond market are reflected in stock prices. Additionally, investors will likely look to re-establish short positions, especially amid the uncertainty of Fed minutes, which will likely contain more details on the balance sheet run-off.
Moreover, liquidity in the market remains very thin and spreads remain very wide. This makes market volatility even more pronounced.
The Fed’s intention to listen to Powell indicates that the Fed wants financial conditions to tighten further. Tighter financial conditions have hurt stocks over time. This time will probably be no different. While it’s impossible to say when markets will bottom, what seems clear is that in the coming weeks as details of the Fed’s plan for the balance sheet run-off and rate hikes will increase, the financial situation will tighten further .
The most similar period today is in 2015 and 2016, when the Fed wanted to raise rates. The competition from QE led to a long period of tighter financial conditions, which led to enormous stock market volatility.
Early indications are that financial conditions have eased somewhat this week, at least based on the IEF/LQD ratio. If financial conditions continue to ease in the short term, this could contribute to a further rise in the share price. However, based on what Powell said at the press conference, any easing is unlikely to persist as the Fed wants tighter financial conditions in an effort to slow the economy.
This will produce a lot of volatility in the market in the coming weeks and will likely lead to a lot of instability as seen in 2015 and 2016. The only difference between today and 2015 and 2016 is that the balance sheet run-off is starting a lot sooner, which should also help to tighten financial conditions.
Ultimately, the short term may have been influenced by the expiration of the options, but the long term is going to be influenced by a further tightening of financial conditions. If that is the Fed’s intention, these conditions will tighten.