Since the rally in Q1, the S&P 500 has been stuck within a 150-point range between 4050 and 4200. As we inch closer towards middle of June, that range has narrowed down to almost 50 points. If one were to just look at the market index, one would be forgiven for thinking that all is well and the markets are just making their way through the summer months.
But if one were to look underneath the surface, there have been quite a few discrepancies in terms of themes, rotations and several consensual trade unwinds. Leaving behind the shenanigans of AMC (AMC) and GameStop (GME) , the market is stuck between chasing Growth or Value, even the reflation trade is now taking a pause. So, what is really going on?
June is one of the quarterly quadruple witching months where stocks and index options, and the futures all expire. It is quite an important moment given the importance and amount of money that tends to be invested in each of the quarterly futures contracts. A lot of funds who have downside portfolio protection need to decide whether to let their puts expire worthless or roll them forward. This "technical adjustment" does cause a bit of fun and games in the futures and options markets, as the market makers who are short the options need to buy back the front month and short the further out months to adjust their exposure.
This has delta effect that can potentially be bearish at times given the delta of the time value of the options further out on the calendar. More importantly, as we get closer and closer towards the expiry, which is June 18th, the gamma effect makes it such that the dealers are incentivized to keep the market as close to "strike" as possible to minimize their losses into expiry. In this case, the open interest is significant around 4200. In layman terms, it means that the dealers have every motive to see market close at or near this level, called the "pinning effect".
June has been a quiet month so far, but as we head into key CPI data this week on Thursday and the Fed FOMC next week, the market may be in for some volatility ahead. The big debate in the market right now is that of inflation being transitory as the Fed keeps claiming or something more sinister. The jury is out but as we wait for the May CPI print.
When one looks at all the components that make the core index, like user car prices and rents, it won't be surprising to see a shockingly high print even in excess of 4.9% in the month of May, up from 4.2% in April, as this would be the highest level since September 2008! Core inflation is expected to surge from 3.4% to 3.6%. The fact of the matter is the Fed really does not know if this inflation is transitory or secular in nature. It is hoping. The amount of fiscal and monetary stimulus has been unprecedented this past year and just because it did not happen in the past decade, it does not really mean it cannot happen this time around.
If one were to look at supply bottlenecks in shipping and chip shortages, there is a severe constrain on what goods and inventory can be sourced currently, hence the high shipping day rates. The demand surge has come at a time when supply just cannot catch up. It can take a while, and the only question is, can the market and world handle it especially as the labor market is still shy of eight to 10 million jobs. They are not incentivized to start a job as they prefer living off on the stimmy checks. The Fed may have saved the markets, but it has created a monster.
As the Fed's balance sheet heads towards $8 trillion, and the ECB balance sheet towards 7.7 trillion euros, the Fed's balance sheet is now equal to 36% of U.S.'s GDP vs. the ECB's 77% and the BoJ's 134%. These central bankers are not accountable in any way whatsoever, as they clearly keep printing more to boost growth. When will it stop? How much can they possibly print the next time the repo market has a wobble or if we have another LTCM or mortgage crisis?
We shall wait and see how Fed Chair Powell addresses the market and investors' anxiety as they preside over the June FOMC. We know the Fed members have been talking about some sort of tapering, but the market has been on life support since last year, so it will be interesting to see if it will be able to hold its own as the Fed takes away the liquidity punch bowl.
Investors are torn here on the subject of inflation vs. deflation. This week and next can cause some big moves, given the level of open interest around 4200. One needs to be mindful that the market may seem calm for now, but if we get any surprise, the move away from 4200 can be quite violent and fast, in either direction as it breaks away from strike, given the level of open interest. Then again, the market does seem to be running out of ammunition here, if it were not for the futures gamma pinning effect. June does tend to be a weak month, seasonally speaking.
