Stocks’ post-Fed rally risks adding ‘accelerant fuel’ to sell-off
The debate about how low rates can go and how stimulative a cut actually is has just begun
WHILE the stock market rallied after the long-awaited US Federal Reserve rate cut last week, there is a sense of unease accompanying the gains.
Referring to the Fed’s shift to a bigger rate cut than had been expected even a week before the meeting, Charlie McElligott, cross-asset strategist at Nomura Securities, wrote in a note that the “‘fear of left-tail’ then self-fulfils the right-tail outcome”, and that it was “pushing the market out of recession trades, instead capitulating back into soft-landing” expectations.
That change in market perception is, in turn, causing a forced re-risking and exposure grabbing, he said.
Some of it is mechanical, with leveraged exchange-traded funds buying across products; meanwhile, market-overwriting funds are forced to snap backup short-call positions.
Other investors who reduced risk after the August volatility spike now have to purchase at record highs – an uncomfortable prospect with a hotly contested presidential election, an uncertain macroeconomic picture and corporate earnings approaching.
“A big repositioning ultimately sets the table for the next wobble,” said McElligott, adding that more risk-taking at some point necessitates downside hedging, which in turn changes the options market’s dealer positioning into something that acts as “accelerant fuel for ugly market events”.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
There are signs of that hedging in measures of volatility and skew, signalling that despite US equity gauges rallying to record highs after the Fed decision, investors are willing to pay more for protection.
The Cboe VVIX Index – measuring the volatility of VIX options commonly used to guard against a steep sell-off – remains about 20 per cent above its level from the beginning of June. And Nations SkewDex, which gauges the relative cost of bearish put options, is also elevated.
In other signs of tail-risk hedging, investors picked up buying of Cboe Volatility Index calls and call spreads – purchasing 85 and 90 calls, in particular – and of S&P 500 index put spreads. Going into the Fed meeting, non-commercial net-short VIX positions were the smallest since 2019.
A pickup in hedging, while protecting individual investors, may leave options dealers short gamma, forcing them to sell more to stay balanced in a sharp market drop. Gamma is a risk metric used in derivatives.
The central bank’s half-point rate cut raised the question whether the Fed’s hand had been simply forced, if the market’s big fear of a hard landing, best expressed during the August sell-off, was scary enough for policymakers to make a big cut and reassure the soft-landing narrative.
And while all the technicalities of the market play their own game, the debate about how low rates can go and how stimulative a cut actually is has just begun.
“We continue to believe that central banks will have less leeway to ease in 2025 than they and many investors believe,” wrote Berenberg economist Holger Schmieding. “Continued loose fiscal policy, persistent underlying inflation pressure and structural labour shortages are reasons against cutting rates too deeply.” BLOOMBERG
Copyright SPH Media. All rights reserved.
