The Bear Market May Be About To Make A Surprise Return

Friday, June 16, was a significant point for the markets, with options expiration now behind. The expiry of June options was important because hedging and options flows have been the most considerable drivers of the rally over the past two weeks.

However, that is about to change with June opex now behind, the TGA refill underway, the Fed’s more hawkish outlook, and rising rates, the recent rally in equities could falter as volatility expands from its lowest levels in years. Additionally, just in case Powell feels his message at the June FOMC meeting last Wednesday wasn’t strong enough, he will be speaking in front of Congress on Wednesday and Thursday of this week to redeliver that message.

Options Flows Have Been the Main Driver

Most of the recent rally has been driven by constant options flows that have helped suppress equity market volatility, giving 0DTE options traders the ability to aggressively buy the dips, helping to keep markets propped up and moving higher. This is probably one of the primary reasons the largest stocks have been beneficiaries of the rally since they account for the most significant portion of the S&P 500 index.

Also, it probably isn’t by chance that the recent move higher in the market was accompanied by record amounts of daily call volume for the S&P 500 options.

What enables this massive grab for calls is falling implied volatility as premiums on call options get cheaper, allowing traders to buy the dip and take bets on the market rebounding intraday. More recently, the S&P 500 50 delta one-week option implied volatility fell to 9.5%, its lowest level since November 2021. This feature became apparent in mid-March when implied volatility dropped as call volume exploded to the upside.

Additionally, the VIX index has options expiring on Wednesday, and because of this, it has been pinned below 16 due primarily to options positioning, with many puts now in the money. Assuming customers have bought these puts, market makers are likely short these puts, which means they need to be sellers of volatility or buyers of equities to stay hedged. So the further the VIX index falls, the more volatility selling or equity buying market makers have had to conduct.

This creates a vicious feedback loop where low implied volatility fosters a risk-on 0DTE call buying frenzy coupled with implied volatility melting, forcing market makers to short volatility and buy equities, pushing prices higher, resulting in more risk-taking 0DTE trading activity. Additionally, call buying, in general, forces market makers to go long the market and remain hedged. So the more the market rises, the more market makers need to buy.

If this is the case, now, with equity market options expiration behind us and VIX options expiring Wednesday morning. Most, if not all, of this recent rally should unravel as implied volatility rises, killing off the 0-DTE call buying frenzy with it and hedging flows halt.

Liquidity Fade

Additionally, liquidity is slowly being withdrawn from the market, as has been noted by a decline in the size of the top-of-book for the NASDAQ 100 futures. This is likely due to refilling the Treasury General Account, which could lower reserve balances.

The TGA has been slow to refill to this point, rising by $227 billion since June 2, and has partially been offset by a dip of $131 billion in the reverse repurchase facility. This has left reserves to this point primarily unchanged, but entering the second half of June should result in cash flooding into the repo facility as it typically does heading into a quarter end, which, when coupled with the recent increase in the TGA, should lead to reserve balances dropping as liquidity in the broader markets drops as well.

It would appear that, to this point, the rally has been driven by market mechanics and nothing else. It probably has nothing to do with the market ignoring the Fed’s more hawkish monetary policy stance or the market’s fundamentals, which may be in their worst shape in a long time.

The Hawk Takes Flight

Those fundamentals will also be tested, with Jay Powell scheduled to speak in front of Congress on Wednesday and Thursday. If he delivers the same hawkish rhetoric and indicates that rates will have to go higher, bond yields and, more importantly, real yields should push higher. This is particularly dangerous for the NASDAQ 100 because it comes at a time when the NASDAQ is the most overvalued versus the 10-year real yield since 2007.

The idea that the market doesn’t believe the Fed will raise rates again is false because the December Fed Fund futures have moved higher following June dot plots. The most significant changes on the Fed Funds Futures curve came from the November 2023 to July 2024 time frame, increasing by 15 to 35 bps, a massive move in just a week. So indeed, the bond market is pricing in an even higher for longer interest rate path from the Fed.

It even pushed the yield curve inversion back to its steepest point since Silicon Valley Bank’s failure in mid-March to nearly -96 bps. An indication that the 2-year Treasury rate is again rising faster than the 10-year rate as the market prices in more rate hikes from the Fed over the near term.

So with the mechanical flows likely behind us, liquidity slowly being withdrawn from the market, and the Fed about to ramp up its hawkish rhetoric due to sticky inflation readings, the stock market should begin to unwind the recent gains very soon.