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.