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, reportedly by Catalyst Funds' Hedged Futures Strategy Fund (HFXAX), that has almost perfectly correlated with the linear surge in US stocks.
As RBC's Charlie McElligott, who dug deeper into the details behind this move, notes the melt-up in the S&P is the result of "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 trade was going well, until the S&P rose above 2,300. At that point the "convexity seemingly ‘kicked-in’ as witnessed by market participants, the short-gamma ‘take’ since has been nothing short of astonishing."
He notes that "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.
Tying the synthetic move to fundamentals, the RBC head of cross-asset strategy then notes that "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" and adds:
I think there is a two-fold rationale here:
- 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
- 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
What, according to RBC, is the catalyst that could 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.
As he concludes: "This could lead to a scenario where a market can “collapse under their own weight." Indeed, because if one removes the forced buying from the "blowing up fund" (which as noted above is allegedly the Catalyst Funds' Hedged Futures Strategy Fund), 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 trading desk contact noted earlier - "something snapped" - and the ammo for this mechanical move is out on Friday when the options expiration.
Finally, for those wondering, here is the relationship between aforementioned culprit for the market meltup, the HFXAX and the S&P. One can see where things started to get weird.