S&P 500 Rally Runs Against Further Liquidity Tightening

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Stocks rallied on Friday, but I think it’s fairly clear that the gamma squeeze has run its course, and the market has largely returned to normal trading flows. Net options volume shifted back toward puts leading calls after the sharp surge in activity earlier in the week that pushed the market from a negative gamma regime into a positive one.

T-bill issuance will remain heavy over the next few weeks, so liquidity should continue to be an important driver of the market. Until the recent three-day rally, that relationship had been working quite well. This episode, however, shows that forces outside of liquidity can still dominate market direction. Overall, as the chart illustrates, the market has tended to move in a slow, grinding fashion, and I would not be surprised to see that downward-tilting grind resume.

The next chart shows what happens when the S&P 500 is shifted back by 12 days. The correlation strengthens from -0.10 to -0.49, with the R² increasing to 0.24. If the effects of the liquidity drain are strongest roughly two weeks after the actual drain date, then we are only now entering the period when the market should feel the greatest impact.

Additionally, equity repo financing activity, as tracked by the New York Fed, has declined in recent weeks. While the data currently only extends through July 29, the reports for the weeks ending August 6 and August 13 will be particularly important. We’ll have to wait for those releases, but if the market continues to rally without a corresponding pickup in equity repo financing, it would suggest that forces other than liquidity are driving the advance.

Additionally, we have begun to see some activity in the five-year USD/JPY cross-currency basis swap. While the move has been modest, it could be an early sign that hedging demand is increasing. With both U.S. and Japanese policymakers seemingly unwilling to tolerate further yen weakness, increased currency hedging could divert dollars away from the equity market and reduce a source of liquidity for risk assets.

The same is true for the five-year USD/CHF cross-currency basis swap.

So, if liquidity continues to tighten as it has been, and the gamma squeeze has indeed run its course, I would expect the market to return to the environment that existed before the squeeze began.

Anyway, I guess we’ll see where things stand when I return next Saturday.

-Mike

Michael Kramer publishes independent macro and options research read across 10+ platforms and by institutional desks.

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Glossary by ChatGPT

Cross-currency basis swap — A derivative that exchanges funding in two currencies, with the basis reflecting relative demand and funding conditions between them.

Equity repo financing — Short-term secured financing backed by equity securities, often used as an indicator of leverage and funding availability in equity markets.

Gamma squeeze — A market move amplified when options dealers must buy or sell the underlying asset to hedge rapidly changing options exposure.

Negative gamma regime — A positioning environment in which dealer hedging can amplify market moves by selling as prices fall and buying as prices rise.

Net options volume — The relative balance of options trading activity, such as put versus call volume, used to assess positioning and directional demand.

Positive gamma regime — A positioning environment in which dealer hedging tends to dampen market moves by buying declines and selling rallies.

R² — A statistical measure showing how much of the variation in one variable is explained by its relationship with another variable.

T-bill issuance — The sale of short-term U.S. Treasury securities, which can affect financial-system liquidity by absorbing available cash.

USD/CHF cross-currency basis swap — A cross-currency funding instrument whose basis reflects relative demand to exchange U.S. dollar and Swiss franc funding.

USD/JPY cross-currency basis swap — A cross-currency funding instrument whose basis reflects relative demand to exchange U.S. dollar and Japanese yen funding.

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