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Volatility

The risks roll in but the world is happy and well-hedged

Chris Weston
Head of Research
May 16, 2023
The low volatility in markets has been focused on extensively of late. Many have asked why this is the case given we are seeing economic data roll in on the soft side, US banks remain vulnerable, and the US debt ceiling is getting ever closer.

Case in point, China’s data today came lightweight again, with industrial production (5.6% vs 10.9% expected) and retail sales (18.4% vs 21.95%) below expectations, continuing to show that the transition from Q1 to Q2 is losing momentum. We haven’t seen too much market angst though – maybe it comes in European trade – but the bears would want to see USDCNH push markedly higher, with these USD flows then resonating in a weaker EUR and AUD. However, on the day, we’ve only seen modest appetite to sell CNH (yuan), and this has had a limited effect on the AUD.

Looking ahead, we see President Biden meeting Congressional leaders in US trade, but expectations are low – we may hear a constructive tone, but naturally, we’re not close enough to the ‘X-date’ and haven’t seen enough financial market volatility to get something tangible that can be put to Congress.

(US500 daily chart)

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The world is already well hedged

We see that in the US500, where the index is barely able to pull away from 4130. Options portray a story here, where traders have been far bigger buyers of downside hedges and we see the implied volatility in 1-month S&P500 ‘puts’ moving sharply higher vs ‘call’ volatility. We can also see this in the open interest in the GLD (gold ETF) and TLT ETF (20YR Treasury ETF) where we see a significant bias to own calls to capture upside in price over puts.

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We can also see big open interest in S&P500 calls at the 4100 strikes – given the low volatility world traders/funds would be selling calls to collect premium and either enhance the returns (yield) in their core underlying equity positions or use the premium to fund buying a put.

This means they can ride their underlying equity position but have hedged themselves against drawdown (through owning a put) – essentially for free.

It also means that when the US equity market falls intraday market makers – who bought the calls – hedge their delta (sorry it's technical) by buying the underlying futures and if the index rallies, they sell the S&P500 futures. This is a major contributor to why we see these strong intra-day reversals playing out, with the US equity index often closing unchanged.

We see options expiry this Friday, so once a chunk of this open interest expires maybe the index can move around a bit more.

I see everyone expecting volatility because of Congress not getting a deal away by 1 June, but few are prepared to act – why would they, it’s still too far off and many have hedged their exposures through put options or long gold/UST treasury upside (through ETFs).

This is no good for us spot or cash market traders, but I think we’ll need to be closer to June to see a bit more life due to debt ceiling uncertainties. It will be close though – by 9 June if there is still no agreement, we should see Treasury cash balances around $40b - perhaps lower – so 1 June to 13 June is our window of uncertainty, where we price risk on whether Treasury can get through to 15 June without deferring or missing a payment. That is where we get vol.

For now, everyone is hedged….there is cash to come off the sidelines and options market makers are causing intraday mean reversion to work a dream.

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