S&P 500 could drop sharply as VIX surge nears (SP500)

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Stocks finished the week well, thanks to option expirations. But if it hadn’t been for the monthly options expiration, last week would have been a disaster. The S&P 500 (SP500) was down more than 4% at its Thursday morning low but ended the week down about 1%. The weekend rally was helped by the slow decline of the VIX index (VIX).

The options expiration was successful in keeping markets afloat and did not allow the S&P 500 to drift too far from significant open interest levels around the 3,800 and 3,850 levels. of the week, the severity of higher strike prices helped drive the index higher through Thursday and Friday.

SPX Open Interest by Strike (July 15, 2022)

CBOE Live Theft / Commercial Alert

This is mainly why the S&P 500 was stuck between 3,845 and 3,860 on Friday after 11 a.m. It only managed to climb higher in the last 5 minutes of the trading session and closed just above 3,860.

S&P 500 Chart July 15, 2022

Commercial view

Monday begins a new options cycle, which means that the pushing and pulling of options will begin again, and the market will be free to move much easier. Open interest levels for the S&P 500 will be nearly halved with the removal of the July 15 trading date.

SPX Open Interest by Strike - July 15, 2022)

CBOE Live Theft / Commercial Alert

Additionally, there has been a steady decline in implied volatility levels in the S&P 500 throughout the week. The large intraday rebounds seen on Wednesday and Thursday were helped by lower implied volatility throughout the day. This would suggest that the intraday price action was more mechanical and options related than due to the underlying macroeconomic backdrop.

Implied volatility

Bloomberg

Forgot macro factors for now

The macroeconomic backdrop over the past week has been very negative. The CPI report came in much hotter than expected. The market is now betting on a rate hike of 75 and 100 bp at the end of July. The probability of a 75 basis point rate hike is now around 70%, while a 100 basis point rate hike is around 30%.

Target rate probabilities for the July 27, 2022 Fed meeting

CME

Although retail sales were better than expected, rising 1.0% month-over-month from estimates of 0.9%, they were still well below the CPI’s gain of a 1.3% month over month. This means that retail sales fell 0.3% month over month in real terms. Even on an annual basis, retail sales were negative, rising 8.4%, below the CPI’s 9.1% year-over-year gain. In real In other words, retail sales fell 0.7% year over year and were negative for the fourth month in a row. While declines at this point are modest, it is rare for retail sales to be negative year over year in real terms. This has only happened before in recessions.

RSTAYOY Index

Bloomberg

On top of that, data out of China was equally bad, with second-quarter GDP largely missing consensus estimates, rising just 0.4%, well below forecasts of 1.2%. This news went unnoticed in US markets during Friday’s trading session. Yet this has not gone unnoticed in Asia, with the CSI 300 index falling around 4% in the past week and the HK Hang Seng index down around 6.6%.

Hong Kong Hang Seng Index

Bloomberg

If that wasn’t enough, Europe had its problems, with Italian Prime Minister Mario Draghi announcing his intention to step down. The news sent Italy’s 2-year yield skyrocketing, causing the euro to fall sharply against the dollar.

Italian return over 2 years

Bloomberg

The euro is trading at its lowest point against the dollar in nearly 20 years and at par with the dollar. Add to that weak economic data from China and Japan’s reluctance to abandon its negative interest rate policy and control of the yield curve, the dollar also strengthened against the Japanese yen and the Chinese renminbi. .

Euro and Japanese yen currencies

Bloomberg

Implied volatility saves the day

The macroeconomic backdrop did not support the rise in equities and was a key reason markets fell sharply on Wednesday and Thursday morning. But once implied volatility and the VIX began to melt, stocks were boosted through Friday’s close.

VIX index

Bloomberg

Stress builds up

But all is not well under the surface. As the spread between the USD 3-month Libor rate and the effective US federal funds rate shows, a sign of tension may have emerged in the overnight lending markets. The gap is not large compared to the peaks of 2018, 2019 or 2020, but it is at its widest point since Russia invaded Ukraine and should be watched closely. The widening of the spread may signal increased equity market volatility.

USFO Map

Bloomberg

Against this backdrop, the meltdown in implied volatility is set to change this week as the market moves past VIX options expiration and begins to focus on macro issues with a meeting of the European Central Bank and Bank of Japan this week. , as well as the FOMC meeting on July 27.

The FOMC cycle should start

The period after the FOMC meeting tends to be bullish. The only period that did not see a post-FOMC rally came after the May meeting. Otherwise, we have seen relatively large rallies after the FOMC meeting this year. But the lead up to the FOMC meeting can be very hectic, especially 6-9 days before the meeting.

FOMC cycle

Commercial view

Volatility on the rise?

Rallies after the FOMC meeting are usually due to the VIX being high heading into that meeting. After all, the FOMC meeting creates event risk. As a result, traders look to set up hedges by buying put options, pushing implied volatility higher and thereby causing the VIX to rise and stock prices to fall around 6-10 days. before the FOMC meeting. Once the event risk has passed, there is no longer any reason to hedge, leading to a decline in implied volatility and a rally in the market.

The VIX appears to be set up the same way it was at the June FOMC meeting. With volatility falling, it is possible to push significantly higher between now and the FOMC meeting.

Volatility S&P 500 Index

Commercial view

Interestingly, there has been an increase in the 10-day realized volatility in the S&P 500. When the gap between the 10-day realized volatility and the 30-day implied volatility of the S&P 500 widens by about 5 points percentage, it tends to push realized volatility. higher, pushing implied volatility higher, which is bearish for stocks.

SPX index

Bloomberg

Can the market continue to rally, of course? But there continue to be plenty of other reasons for him not to rally. Given several geopolitical factors, as well as an upcoming central bank ECB and BOJ meeting this week and the FOMC next week, the risk of further downside headwinds has not yet been ruled out.

About Myra R.

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