September 20th, 2023 | "Negative Gamma Dynamics"

"Darling, you got to let me know. Should I stay or should I go?"
– The Clash

Sometimes we don't get it wrong. As suggested yesterday, 14 vol was simply not enough and we saw markets move lower on pursuit of incremental hedges. The initial narrative was interest rates moving higher on higher oil prices, followed by interest rates moving higher "because" as oil retreated. After significant intraday mileage, the S&P ended lower and short-dated vol has now moved into fairly deep backwardation even as the VIX was unchanged. This makes vol selling relatively unattractive and yet also indicates that our "hedged kettle never boils" is now the operative play.

The obvious "news of the day" is the Fed meeting. Consensus has firmly settled on unchanged for this meeting (we can't imagine this is wrong), while the emphasis on the 2pm will shift to deciphering the "dot plots" for 2024. A link to the report can be found on the Fed's website. The focus will be on the "longer run" projections and any indication from the Fed that the longer-term neutral rate has risen above the historical mode at 2.5%. Theoretically this would cheapen (higher interest rate yields) the belly of the curve between 7-10 years and likely lead to new YTD highs in most yields while steepening the curve. Bad for housing, theoretically good for banks.

While the SEP will be available on the release at 2pm, the real action will of course be tied to Powell's press meeting. Stay glued to your seats, the Grand Priest will be speaking.

Gamma Exposure:

Dealers remain in negative gamma, with yesterday's intraday chase almost textbook. Expect more of the same today, punctuated by last-minute hedging activity around the Fed's release. With significant gamma expiring today, the most likely outcome is high intraday vol and a rush to monetize hedges following the Fed. All else equal, this biases us higher as volatility exits the equity market.

Should a hawkish Fed send us lower, the most obvious support is 4400, which coincides with our lower PV band on the S&P500.

Probable Volatility Bands:

SPX played our lower PV range perfectly yesterday before reverting later in the session back to the 4450 strike. This move was enough to push that lower band back down to just above the 4400 strike, putting that level back into play for the first time this month. With the upper band shifting down to just above the 4500 strike, we suspect the September consolidation window will likely continue until further notice.

Tech saw a similar dynamic play out, with the 15,200 strike being the level to watch. Above there, we could revisit the 15,500 level, with a move lower, likely finding support at around 15,000. Overall, the broader consolidation is still intact, albeit with a slight favor toward the downside.

Yesterday, we wrote that lower was likely for small caps, and we continue to suspect the bearish trend will continue. For today, we will be closely watching the Russell's reaction to the FOMC data, as small caps tend to be particularly sensitive to changes in economic policy. If the reaction is negative, we expect to see some support around the 1800 strike, and if Powell surprises us with a dovish stance, a revisit to the 1850 level seems likely.

S&P 500 Market Breadth:

Despite some intraday volatility, breadth was fairly stable throughout the trading session. By the close, only 59% of the index was still in the red, and the average gain and decline was well under 1%.

While there was an active tug-of-war between Apple and Amazon, the mega caps were still well distributed, which also helped to neutralize some of the volatility. Overall, things could have been slightly worse, but a balanced market saved the day.

Short-term breadth saw a slight push lower as just 38% of the index is still higher than their respective 20-day moving averages. Over the past week or so, we've been highlighting that our longer-term breadth models never recovered from the August drawdown we had, so we're not surprised to see our short-term model pushing lower. This is also why we suspected last week's jump was a false signal, which ultimately proved to be true.

Until we see a strong improvement in market breadth, it's hard to imagine SPX moving much higher from here.

Quant Fund Implied Rebalancing:

While there was a slight uptick in intraday volatility, our close-to-close models were less exciting. In fact, the 1-month realized volatility fell around -1.4% yesterday, which means vol control funds had to purchase around $3 billion in equities in order to meet their volatility targets.

Typically, even a modest $3 billion in bullish flow can have a soothing effect on volatility, vol control funds were going head to head with CTA funds yesterday, who were net sellers for around $2 billion in equities.

CTA's have been selling as a response to the trend component in their calculations, as SPX has largely been stuck in consolation for most of the month. Overall, this left our systematic positioning index largely unchanged.

To be clear, the market is much bigger than just Vol control and CTA flows, but we focus on these types of rules-based strategies because there is an inherent predictability of how they'll react under different market conditions. Particularly with Vol control and CTA funds, they also tend to dynamically rebalance on a very short-term basis, typically daily, which means they can have a more immediate effect on the market when volatility starts to pick up (or vice versa).

Looking ahead, we continue to expect vol control funds to purchase large sums of equities on both Thursday and Friday, creating a supportive environment for the market towards the end of the week.

Today, though, we'll still have to deal with some selling risk around the Fed, especially if SPX pushes outside of a +/- 0.5% range. From there, we could see between $7-9 billion in equity selling taking place, with that number growing exponentially as we move out into the tails. If the move is lower, expect these selling flows to magnify volatility, which could make for an exciting day.

Bonus Chart:

Today's bonus chart focuses on the availability of vacancies in rental properties. Due to the imbalance between supply and demand, the national vacancy rate for multifamily has climbed 200 basis points, from a historic low of 4.7% in Q3 2021 to 6.8 percent in 2023. Vacancy for combined single and multifamily bottomed out closer to 5.6% in Q2 of 2022 and has moved up 100 basis points. Such shifts in vacancy rates were also observed during the recessions in the 70s and 80s. The GFC had its distinct flavor, characterized primarily by individuals losing homes and subsequently seeking rental places.

While this topic is extensive enough for a book, we'll aim for brevity. Data from Fannie Mae suggests urban submarkets have seen an average inventory spike of 8.9 percent. In contrast, despite recording the highest rent growth, suburban submarkets have experienced a minor average increase of 5.3 percent in multifamily units since 2020. This divergence suggests that while suburban rents have risen, the supply-demand dynamic remains comparatively stable.

Nationally, the rise in submarket vacancy rates showcases the waning demand for multifamily units, hinting at an impending oversupply. In Q1 2023, only 42,000 units were absorbed, a significant drop from the pre-pandemic five-year average of 82,000, while 109,000 new units entered the market. That is not good news, considering all the CRE paper to be rolled over in the next 24 months at much higher rates.

Given that the median US mortgage now stands at a record $2,800 a month, inclusive of taxes and insurance, home ownership is becoming more of an ambitious dream. As homeownership rates dip and vacancy rates surge, it's evident that there's a growing preference for multigenerational homes. With tighter credit and stricter lending standards, even first-time homebuyers opt for multigenerational living to economize. The National Association of Realtors notes that 28% of first-time buyers are seeking larger homes that multiple incomes can afford, a statistic that drops to 18% for those purchasing their subsequent homes. The trend toward multigenerational living, alongside rising rental vacancies, reflects our current era. The NAR published no data on divorce rates after living with the in-laws, we think realized Vol north of 70 on that one.

Disclaimer:

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