3 Big Events That May Blindside The Market Before The Week Is Up

Stocks aren’t the only things that have risen recently. Yields and the dollar have risen too, and both may still have much further to climb. The Federal Fund Futures market has reversed course and now sees higher rates than where they stood at the start of August and sees rates staying higher for longer. This message should be echoed for all to hear in the Fed minutes. After all, it has been the message of the governors and board members since the July FOMC meeting.

The equity market, as usual, has been oblivious to these shifts in Fed Fund Futures, which Treasury yields and the dollar have correctly picked up. Instead, equity prices have been led higher by short cover from CTA trends and Volatility control funds. These systematic funds have been estimated to have reallocated almost $28 billion.

The fund flows have helped to send the VIX sharply lower as well, but tomorrow marks a huge potential turning point. The VIX monthly expiration will come tomorrow (Wednesday) morning, followed by the Fed minutes at 2 PM ET. These two events are getting no attention but can play a significant role in where the market goes for the month’s balance and potentially stop the equity market rally dead in its tracks.

VIX

The spread between the VIX spot price and the 3-month generic VIX future, equivalent to the October contract, is around -5, which has historically coincided with tops in the S&P 500. The spread recently fell to as low as -5.7 on August 12, indicating that the VIX spot price may have fallen too far and is due to reverse higher, pushing equity prices down.

Open interest on the VIX is nearly non-existent for Wednesday’s expiration and future options expiration dates. Many August call options will expire worthless tomorrow.

Additionally, data from SpotGamma shows that the big gamma strike price for tomorrow’s VIX options expiration is at 20, which is helping to pin the VIX to 20. This also means following tomorrow’s expiration, the VIX will be able to move more freely, and given the current spread with the VIX’s futures contracts, it seems more likely that the move may be up, which is bad for stocks.

Fed Minutes

The afternoon poses another potential threat for stocks, as the FOMC minutes are likely to be more hawkish than how the FOMC press conference was perceived. Those minutes are likely to reflect all of the messaging of the July press conference, but they will also reflect the tone of all Fed governors and board members that have helped reshape the Fed Fund Futures curve since the FOMC meeting.

The Fed Funds Futures now see a peak terminal rate coming in April instead of February at a level of 3.62% versus a prior 3.26%. The shift in the outlook by the Fed Fund Futures is starting to reflect a more realistic message coming from the Fed, which is that rates are going higher and are likely to stay there for longer than the market had previously projected.

While the move higher in the futures market has already started, it will need to move much more, mainly if the Fed stays on target with its message of 3.8% overnight rates by the end of 2023. The spread between the December 2022 Fed Funds Futures contract and the December 2023 contract has risen from a -0.61% to -0.22%. If the Fed’s guidance is correct, the December 2023 contract needs to increase further.

The futures market shift has resulted in rates starting to move higher and the dollar strengthening. The 2-yr yield has moved up off its recent lows on August 1, while the 10-yr and 30-Yr have also started to move higher again, with the biggest moves coming at the front of the yield curve.

Meanwhile, this has allowed the dollar index to resume its path of strengthening versus major currency peers, such as the euro, yen, and yuan.

The move higher in rates, and the dollar on the back of hawkish Fed official talk, has been meaningful. But a similar tone from the Fed minutes will help accelerate the shift we have seen thus far.

A move higher in rates and the dollar would cause credit spreads to widen, leading to financial conditions tightening. Financial conditions have eased dramatically since the July FOMC meeting, which has also eased conditions around the ability to access margin and leverage, as measured by the Chicago Fed’s Leverage Broker-Dealer Debit Balances In Margin Accounts. These easing conditions have provided a tailwind to equities, but a “retightening” of financial conditions would help to stop the equity market rally dead in its tracks as access to margin would be cut off.

Just In Case: Options Expiration

Just in case stocks decide to continue to rally, the August stock and index options expiration date come on Friday, which again has historically served to mark turning points for markets. The only month that did not see a reversal of trend-following options expiration this year thus far has come in March.

So tomorrow could be a huge pivot point for stocks, as a scenario that leads to a VIX up, Dollar up, and Yields up would put the markets in a position of tightening financial conditions again and would likely stop the equity market rally dead in its tracks.