The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
Stocks ripped higher the week ending October 15. The spark stemmed from a sharp decline in the dollar index, as the currency market grew concerned about hotter than expected wage growth as part of the US Consumer Price Index the morning of October 13.
The move in the dollar happened days before the monthly options expiration, creating an ideal situation for a countertrend move-up in the equity market. The dollar and the global markets have been highly correlated since Jackson Hole, where Jay Powell indicated the Fed was likely to begin the process of winding down its asset purchase program by the end of the year. A weaker dollar can sometimes be associated with a risk taking sentiment in markets, resulting in equity markets rising.
The Dollar Sparks The Equity Rally
Global markets are tied to the dollar due to its potential impact on global growth. Economies conducting business in dollars see higher inflation rates as their local currency loses purchasing power against the dollar as it strengthens. Hence, these higher inflation rates slow global growth, shift market sentiment, and weigh heavily on equity markets. So, when the dollar suddenly weakened, it resulted in a move higher in foreign equity markets on October 14.
However, as SpotGamma noted on several occasions in its daily AM and PM Founder’s Notes, the US options market was positioned bearishly heading into options expiration on Friday, October 15. So, when the dollar dropped and Asian and European markets rallied, US futures moved higher too, resulting in a sharply higher open. It sent the VIX (Volatility Index) plunging as put options began to lose value very quickly and were being closed out.
Vanna Model Indicated Buying
The SpotGamma Vanna models showed how skewed the NASDAQ 100 ETF (QQQ) had been for lower prices. All it took was that spark from the dollar reversal and sharp rally in foreign markets to get the market makers scrambling to unwind those bearish positions.
The Vanna model showed that as the QQQ ETF rose from $363 to $368, many put options would begin to decay. Market makers hedged against these put options and were forced to buy Nasdaq futures to bring their books back to delta-neutral. Additionally, the decline in the VIX index on Thursday was an indication that put options had been closed out, which further added to the need for market makers to buy back Nasdaq futures. It spilled into the other major indexes as well.
The Vanna Model Shifts
However, now that setup has become less favorable, with delta shifting and rising as the QQQ begins to rise above $373, resulting in the market makers needing to sell futures. It is not by chance that the QQQ ETF rally on Monday and Tuesday of this week began to slow as the ETF price climbed above $374.
What’s Next
Last week’s rally on October 14 and 15 was nothing more than a big, short-covering event, also known as a short-squeeze. All that was needed was a spark to set off the fuse, and that spark was a dollar that weakened due to economic data that spooked the currency market.
With the Fed likely to begin the tapering of QE at the next FOMC (Federal Open Market Committee) meeting in early November, we could see yields on the short end of the curve continue to push higher. That means it may only be a matter of time until the dollar begins to rise again. With that, global markets may start to feel the pain of a strong dollar as investors once again worry about global growth, and the US markets would not be immune to such a change in sentiment. With worries creeping in, it would seem natural for investors to start looking for protection, pushing the VIX higher, and starting the cycle all over again.
