Market Musings (15 Dec 2023): Everything Rally

 

·        Monumental week for all asset classes as Fed confirms pivot to rate cuts

·        Broad rallies across the board in equities, fixed income, currencies, precious metals and cryptocurrencies, setting up for a December to remember as 2023 comes to a close

·       Amid a likely melt-up in US equities into year-end, there are signs of protection-buying

Equities

US equities rallied to fresh YTD highs as the Fed confirmed its pivot to rate cuts. Major indices come within striking distance of their 2021 all-time highs, with the S&P500 and NASDAQ100 just 2% and 1% below their prior zeniths respectively. Small caps were the biggest winners with the Russell 2000 index surging 5.5% on the week (up over 3% on FOMC day itself). Littered with unprofitable names often saddled with debt, the affirmation of rate cuts were undoubtedly a welcome reprieve for battered small caps this year. The surge was likely exacerbated by generally poor liquidity in many names and dealer delta hedging-related buying from a large jump in call options open interest on the index.

Over in Asia, the surging Japanese yen took its toll on Japanese equities (well-known inverse relationship between the yen and Japanese stocks) as the TOPIX lagged US counterparts to end the week only marginally higher. Hong Kong shares fared better, helped by an 800bn yuan liquidity injection from the People’s Bank of China (PBoC) on Friday, the largest on record, which helped markets glance over weak retail sales data released the same day. Mainland Chinese shares however were not uplifted by this (temporary) shot in the arm, closing the week down 1.7% at a fresh YTD low.

Cryptocurrencies

BTC and ETH steadied after the FOMC decision on Wednesday, following a wave of liquidations triggered by a sudden plunge on Monday. This did not derail the general bullish momentum across the asset class however, as several Layer-1 coins (SOL, AVAX, ADA) touched new YTD highs on Friday. It is evident that retail interest is returning to the cryptocurrency market, and it is probably only a matter of time before crypto makes headlines in mainstream media once again (hopefully for the right reasons this time).

Although only a local anecdote, one may noticed the increasing number of posts on reddit forum r/sgcrypto, which was largely devoid of activity for much of this year. A simple search on Google trends for “bitcoin” shows a gradual uptick in interest since September. While not certainly fodder for a bullish crypto thesis (always too many of these anyway), it does suggest that the space is not (yet) mired in a speculative fever pitch despite the recent run-ups in crypto prices, as was the case in 2021, and we are not in a “bubble” thus far.

Commodities

Gold mostly took cue from interest rates and the US dollar, regaining the $2000 level post-FOMC after testing resistance-turned-support at $1980 earlier in the week. Palladium was the highlight, surging over 20% on concerns over UK government sanctions targeting Russian metals. Although palladium was not targeted, the news prompted concerns over supply disruptions and was sufficient catalyst for a short squeeze in the metal, which has been mired in a deep bear market this year on weak demand from auto manufacturers.

Elsewhere in commodities, bullish bets on a squeeze in uranium that peaked in popularity during the meme stock mania of 2021 are now paying off handsomely after spot uranium prices hit the highest since 2007. Uranium prices have been on a bull run this year, fanned by rising US-Russia geopolitical tensions frequently spurring concerns of a US import ban on Russian uranium.

Spot FX

Tracking USD interest rates lower, the USD sank after the Fed’s dovish pivot on Wednesday, in a resumption of the weak-dollar theme since late-Oct. The Norwegian Krone was by far the biggest winner this week after Norges Bank (Norway’s central bank) surprised markets by unexpectedly hiking interest rates by 0.25% a day after the pivotal FOMC decision on Wednesday, ostensibly in direct defiance of the increasingly dovish stance taking hold across major central banks.

Volatility

The quarterly “triple witching” took place on Friday as single stock options, equity index futures and equity index futures all expired at once. The day saw an estimated $1.3 trillion delta notional (~$5.4tn notional) expire, most of which likely cancels out. While options dealer positioning after this week is still likely long gamma, thus continuing to dampen market moves in both directions, this sizable expiry should “loosen up” US equity markets to make larger moves in the weeks ahead.

Current narratives contemplate the possibility of a “spot up, vol up” market dynamic in which US equities continue to rally but implied volatility (IV) instead picks up rather than comes lower (opposite of what IV usually does in a rally). This would suggest the current rally could be on its last legs and needs a pause or consolidation phase.

Indeed, there are some signs of protection-buying creeping back into markets after the euphoric rally since late-Oct. The SDEX Index (measuring the relative cost of out-of-the-money options to in-the-money options, or skew) shows signs of a short-term bottom after declining sharply over the last 2 months. Indeed, selling downside protection (eg. selling cash-secured puts) has been a beloved strategy of retail investors this year, and the increased supply of left tail gamma may be one factor weighing on skew.

Similarly, the ratio of VVIX to VIX – ie. ratio of the implied volatility of implied volatility to implied volatility, is now at the highest level since mid-July, a month which marked a near-term top that kicked off a 3 month-long 10% correction in US equities. History may not necessarily repeat itself, but this does suggest the opportunistic purchase of relatively cheap equity hedges by investors in the form of volatility topside (and therefore the relative unattractiveness of selling puts by extension, as downside vol is cheap).

Interest Rates

Central bank decisions were in the spotlight this week as decisions from the Fed, European Central Bank (ECB), Bank of England (BoE), Swiss National Bank (SNB) and Norges Bank were due on Wednesday and Thursday. Undoubtedly Powell’s pivotal press conference was by far the single most important event and a major market-mover.

In an about-turn from his resolute no-cuts stance just over a month ago, Powell acknowledged that the FOMC discussed rate cuts at its December meeting, although the exact timing and magnitude of which are still up in the air. In alignment with the Chairman’s dovish pivot, the Dot Plot surprised markets as FOMC participants pencilled in a median of three 25bp rate cuts for 2024, more than the 2 cuts markets had expected them to signal. It was a clear proclamation of the end of the current tightening cycle. The market reaction was emphatic – the policy-sensitive US 2-year note rallied to touch a low of 4.28% on Thursday, marking a nearly 100 basis point move since the late-Oct highs. STIR futures moved to price in more than 220bp of cuts over 2024 and 2025, with an 80% chance of a 25bp rate cut by the March 2024 FOMC meeting.

Unfazed by the Fed’s pivot a day before, Thursday saw renewed attempts at pushback from the ECB and BoE, both reiterating that it was too soon to consider rate cuts. While President Lagarde appeared moderately successful at first as interest rates ticked higher following her press conference, bond bulls stepped back into the fray to reverse the move by Friday’s close.

Apparently unsettled by the market reaction, Fed President Williams appeared on a CNBC on Friday to push back against market pricing, insinuating that markets had gotten ahead of themselves, and it was “premature” to be considering a cut in March. While bond yields briefly rose after Williams spoke, his efforts were in vain as traders once again called his bluff and interest rates quickly reversed course.

Short Term Interest Rate (STIR) Futures moved quickly to price in additional rate cuts following this week’s developments. Markets now expect ~140bp of Fed cuts in 2024 – nearly six 25bp cuts spread across 8 FOMC meetings, a huge jump from the ~80bp priced for 2024 just 6 weeks ago.

As a rough measure for the distribution of rate cuts between 2024 and 2025, the SOFR H4-H5-H6 butterfly surged to touch a high of 120bp on Thursday on back of the intense front-loading of rate cuts into 2024 (see chart below). Pricing for the Fed’s terminal rate now sits at ~3.25%, expected to be reached around 1Q2026.

From an economic perspective, rate cuts are the logical next step given that recent data shows inflationary pressures have diminished and holding interest rates far above neutral (the r-star) for too long risks dragging the economy into recession. Central banks are, as always, treading a difficult path – pivoting too late and too little risks causing an economic slowdown, while pivoting too early and by too much risks the return of inflation, and even more so it risks inciting the markets’ worry that policymakers foresee a sharp slowdown ahead and acting pre-emptively (“do policymakers know something about the economy that we don’t?”).

The following graphics visualize the changes in rate cuts priced by markets over the past 6 weeks.

USD SOFR

EUR 3M EURIBOR

GBP SONIA

The Week Ahead

As markets wind down into year end, thinning liquidity and favourable seasonality (“Santa Claus rally”) should keep risk assets supported, especially in equities. While signs of froth may be emerging and there are emerging signs of protection-buying, it will take a lot to derail the current bullish momentum in markets. Many investors were under-invested throughout 2023 and may be resigned to chasing the market melt-up into year-end. Markets love a target and the 2021 all-time highs in US Equity Indices are likely to be breached in the final two weeks of the year. Santa Claus is coming to town.

The final major event of the year is the Bank of Japan on Tuesday (19-Dec), which will be closely watched by the Rates market for additional signs that confirm a committed shift toward normalising interest rate policy. UK inflation data is also due on Wednesday (20-Dec), which will be instrumental in influencing the priced path of BoE interest rate cuts for 2024.

Market Musings (8-Dec-23)

Equities:

The slow grind higher in US equities persists with the S&P500 touching a fresh YTD high on Friday. Market volatility remains subdued as the index remained within its ~1.5% trading range over the last 2 weeks. Paradoxically, sentiment indicators and volatility gauges suggest a whiff of complacency setting in as the festive season is around the corner.

 
Things were not so sanguine in China. The CSI300 and Hang Seng extended last week’s selloff and sank to new YTD lows, in part catalysed by Moody’s credit rating downgrade (which was fiercely rebutted by Chinese authorities). Commentators then quickly seized the opportunity to contrast the growing rift between India’s roaring stock market and Chinese markets stuck in the doldrums. In Japan, the age-old negative correlation between stocks and the JPY returned to the fore, with equities taking a hit as the yen surged (more on this below).
 
Commodities:
Energy markets continued their tumble following last week’s disappointing OPEC+ cuts announcement and renewed doubts about Chinese demand as the economic situation remains soft. Slight reprieve came on Friday after the US Department of Energy announced plans to purchase 3 million barrels of oil for refilling the Strategic Petroleum Reserve, helping WTI crude close the week above the psychological $70 level.
 
Spot gold kicked off a dramatic week in precious metals, surging to a record high above $2100 in usually-lethargic Asian Monday morning trading, taking out many stop losses along the way. Inflicting even more frustration, the entire surge higher was retraced within the same day by the time Europe opened for trading. While gold managed to hold within a trading range for most of the week, silver continued to slide throughout the trading week before escalating into a full-blown crash on Friday following stronger-than-expected US payrolls, capping off a bruising week down 9%. No doubt the whacky price action in precious metals caught the attention of mainstream media – I recall seeing searches for “gold price” trending on Google.
 
Cryptocurrencies:
Another banner week for crypto as Bitcoin pushed above $44,000. Other large-cap L1s surged to fresh YTD highs (eg. ETH, SOL, AVAX). Mainstream interest in crypto is resurfacing, based on empirical and anecdotal evidence (own observations), and the stars appear to be aligning for a new bull run. Planning to pen my thoughts on crypto if I can find the time.
 
Spot FX:
The US dollar regained some luster this week after a soggy November, gaining ground against most major currencies except the JPY, which saw the largest one-day surge since last December after speculation of an earlier-than-expected BoJ policy normalization following Deputy Governor Himino’s comments that a properly executed exit from negative rates would reap economic benefits. JPY strength was further catalysed by Thursday’s extremely weak 30-year Japanese Government bond auction which saw the biggest tail on record.

Interest Rates:
Front-end rates in major markets largely reversed the previous week’s rally after US NFP, while persistent buying interest in long-dated government bonds kept downward pressure on long-end yields. Japanese Government Bonds (JGBs) were in the spotlight after yields jumped on a ferocious selloff following Himono’s comments and lackluster 30y auction. Notably the selloff in 10Y JGBs opened a rift with 10Y Treasuries, leaving one to muse whether the tail (JGBs) could soon wag the dog (Treasuries) in spurring a reversal of last month’s sharp Treasury rally.

Over in short-term interest rates, markets walked back pricing for a March FOMC cut following a firm employment report on Friday. Rate cut pricing for the European Central Bank (ECB) however remained sticky as markets continued to look through ECB officials’ often half-heated attempts to pushback against cuts pricing.

US inflation breakevens tracked the trajectory of oil prices, bouncing higher after touching the lowest levels in 2 months. In the cross-market space, Australian 10y bonds outperformed their US counterparts, as traders were unimpressed by the neutral tone struck by the Reserve Bank of Australia (RBA), following a softer-than-expected inflation print last week and promptly set about fading what remained of the rate hikes priced for early-2024.

Credit spreads remained priced for a no-landing economic scenario, with high yield spreads continuing to tighten as sentiment remained buoyed into year-end. US CCC spreads (in deep junk territory) continued to tighten from their late-Oct highs.

Volatility:
Reflecting the subdued realized volatility in large-cap US equities, the VIX closed at a new YTD low on Friday. Perhaps another sign of market complacency setting in, S&P500 options skew (as measured by the Nations SkewDex Index) cheapened to a new low this week – hedging tail risk has never been cheaper on a relative basis.

The Week Ahead:
Next week brings a litany of central bank meetings. Among the G10, the Fed, European Central Bank, Bank of England, Norges Bank and the Swiss National Bank are due on Wednesday and Thursday.

US CPI on Tuesday will be closely watched and will likely determine market direction for the remainder of the year. A 3.1% y/y headline reading is expected. A slight miss or in-line print would likely reinforce the notion that inflation has been beaten and rate cuts can now commence in 1H2024, likely sparking another rally into year-end should the Fed maintain its current posture at the following day’s FOMC decision. It would take a large beat on the inflation front to shock markets into reversing the rate cuts priced, given how deeply entrenched the disinflation narrative (albeit well-supported by data) has become.

Market Musings (1-Dec-23)

It has been quite the week in financial markets, wrapping up a month that saw financial conditions ease drastically as an “everything rally” took hold – easily one for the history books. The “higher-rates-for-longer” narrative evaporated quickly, as a one-two punch from unusually dovish Fed Governor Waller and soft Spanish and Germany inflation figures on Tuesday reinvigorated bond bulls, who amid frenzied buying pushed key interest rate benchmarks through major technical levels. Other central bank speakers’ attempts at pushing back against the rapid pricing of additional rate cuts failed to convince market participants, who called their bluff by instead pricing in an additional ~50bp of rate cuts in USD and EUR. As if adding further insult to injury, a small chance (5%) of a rate cut is now priced into this month’s European Central Bank meeting scheduled 2 weeks from now.

Further aided by the confluence of accommodative seasonality and momentum chasing, this development emboldened risk assets and precious metals to the detriment of the US dollar, which fell against nearly every major currency except the EUR, itself weighed down by an even more rapid pace of rate cuts priced and a darkening economic outlook in the Eurozone. While a pullback seems increasingly likely given the velocity of recent moves, it will be hard to shake the disinflation-driven easing narrative now deeply entrenched into market pricing (try as they might, central bankers). The pain trade in risk assets is still to the upside, and the tail risk of a late 1999-esque NASDAQ “melt-up” is now non-negligible. Concurrently, any upside surprises in upcoming inflation prints can quickly turn the complacency-fuelled disinflation narrative on its head and a sharp market reversal could ensue.

This week amplified the ongoing bifurcation of US and Chinese equity markets – US equity indices continued their push toward YTD highs while Chinese markets languished in the red. The old playbook of fading any stimulus-driven pop higher in Chinese equities maintained its relevance this week, as both the CSI300 and Hang Seng slid toward October lows amid pessimism on the myriad of economic problems and the continued lack of “bazooka” stimulus measures sought by the market, after an attempted move higher last week on back of news that Chinese regulators cleared a list of real estate firms to tap cheap financing.

US tech stocks lagged their cyclical and small-cap peers this week – rightfully so as cyclical names are potentially the biggest beneficiary of an easing cycle. The fact that the rest of the market lagged the Magnificent 7’s performance this year is well understood, and this week saw emphatic price action toward reversing this trend. The Equal-Weight SPX vs SPX ratio (proxied by the RSP/SPY ETFs) encapsulates this reversion, while persistence of the soft-landing/no-landing narrative leads one to wonder if this shift sets up for a cyclical rally/outperformance in 2024.

Over in commodities, WTI oil failed to push above $80 in the aftermath of OPEC+'s 1m barrel-per-day output cut and ended the week 1.9% lower, with the market clearly unimpressed by the lack of detail on distribution of output reduction among members states. Conversely, things were upbeat in precious metals with spot gold building on its recent winning streak to hit a new YTD high on Friday – no doubt the biggest beneficiary of a weak USD and rapid decline in front-end interest rates, with the stockpiling of gold by global central banks another major tailwind.

The mood in cryptocurrencies was fairly upbeat with many major crypto assets advancing. Bitcoin notched a new YTD high after successfully clearing resistance at $38,000 on Friday, paving the way for a challenge of the $40,000 psychological level in December. Ethereum initially lagged the mothership as the $2100 level proved a tough nut to crack, although it managed to clear this hurdle over the weekend.

The ferocious rally in Fixed Income amid disinflation excitement saw almost 2 additional 25bp Fed rate cuts now priced for 2024, and a total of close to 200bp of cuts now priced for the upcoming easing cycle. Major yield curves generally bull steepened on the front-end led rally. Over in Credit, spreads continued to tighten alongside the rally in risk assets.

Ultimately, this week (and November by extension) was a stark reminder that financial markets turn on a time and often take no prisoners. In the space of barely more than a month, the narrative took a drastic 180-degree turn from higher-for-longer to full on disinflation, almost to the point of complacency. A litany of central bank decisions are due in mid-Dec (Federal Reserve, European Central Bank, Bank of Japan etc.) before markets slowly wind down into year-end, offering one final chance this year for policymakers to push back on cuts pricing and make clear their stance on the rapid easing of financial conditions. Barring data surprises, one suspects that the market will force their hand to deliver on rate cuts in 1H2024 (except the BoJ), rather than in 2H2024 as initially envisaged by many participants.

More thoughts on the market to follow (hopefully).