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This coming week will feature earnings from five of the mega caps — Apple, Microsoft, Alphabet, Meta, and Amazon — along with three major central bank meetings: the Fed, ECB, and BOJ. But while all eyes will be on these events, the Treasury will be draining another $100 billion in liquidity from the market in the background.
On October 28, $26.0 billion is scheduled to settle, followed by $25.1 billion on October 30 and $58.3 billion on October 31. Settlements in recent weeks have led to greater strain in the funding markets and increased usage of the Fed’s overnight standing repo facility.
It’s also month-end, and with the added liquidity drain, overnight rates are likely to rise, tightening available market liquidity even further.
Determining the potential impact on risk asset prices from the ebb and flow of liquidity is no easy task. However, when more volume passes through the repo market in the form of Treasuries, repo activity in equities tends to decline.
We also know that equity repo financing tends to be bullish for stocks when it rises and bearish when it falls. Therefore, if higher rates and Treasury settlements increase volumes in the overnight markets for Treasury securities, we should expect weaker equity prices.
Additionally, this week, because of earnings season, we should see the end of most of the volatility dispersion trades that have been taking place since mid-September. We’ve already started to see that process unfold in recent trading days as companies have reported results. The S&P 500 dispersion index has already turned lower, and it should continue to decline through the week as more company results come in.
We’ve also already seen constituent volatility in the S&P 500 start to come down, and it’s likely to fall further this week.
This would mean that implied correlations are also likely to reverse and begin to rise. The 1-month implied correlation index is already back below 8.
We know that when correlations rise faster than dispersion, the spread between the two contracts narrows, and stock prices tend to fall.
Also, realized volatility metrics remain historically low, as previously noted, and that hasn’t changed. In fact, patterns show that when 3-month realized volatility begins to rise, it’s often followed by new highs in the S&P 500, as in 2018 and 2020.
We did see the S&P 500 rally modestly on Friday, gaining around 80 bps, although it once again finished with a weak close. We’ve seen this same pattern several times over the past two weeks — a weak close followed by a gap higher, and then an eventual fill of that gap. Friday was no different. The question, of course, is whether we gap up again on Monday or simply drop and fill Friday’s gap. The pattern suggests that the gap does get filled rather soon.
Liquidity in the market has fallen sharply since July, and funding conditions have tightened. Meanwhile, the dispersion trade that has helped support the market since September is coming to an end and is likely to unwind, while realized volatility is rising. The only question that remains is whether all of this will finally lead to the market decline I’ve been expecting.
One way or another, we’re about to find out.
Mike
Defined Terms and Jargon by ChatGPT
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Mega Caps – The largest publicly traded companies by market capitalization, typically including firms such as Apple, Microsoft, and Amazon.
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Liquidity Drain – The process by which cash is withdrawn from the financial system, reducing the amount of available capital for short-term funding and investments.
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Settlement – The completion of a financial transaction where securities and funds are exchanged.
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Repo Market (Repurchase Agreement Market) – A short-term borrowing market where one party sells securities to another with an agreement to repurchase them later at a higher price; a key source of short-term funding.
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Standing Repo Facility – A tool used by the Federal Reserve to provide liquidity to the financial system by offering overnight loans secured by Treasury securities.
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Overnight Rate – The interest rate charged on short-term (usually one-day) loans between financial institutions.
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Volatility Dispersion Trade – A strategy that exploits differences in implied volatility between an index and its individual components.
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Implied Correlation – A measure of how much individual stock options are expected to move together; rising implied correlation often signals less diversification benefit.
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Dispersion Index – A measure of how much individual stock volatilities differ from each other; high dispersion often reflects stock-specific movement, while low dispersion suggests index-wide moves.
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Realized Volatility – The actual volatility observed in an asset’s price over a specific period, as opposed to implied volatility derived from options pricing.
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Gap Fill – A technical market term referring to a price returning to a previous gap between trading sessions.
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Funding Conditions – A measure of how easily financial institutions can borrow money in short-term funding markets.
Disclaimer
This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr. Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer’s views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer’s analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer’s statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment.
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This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr. Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer’s views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer’s analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer’s statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment.
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