The research note below was written by Tier 1 Alpha and Presented by Hedgeye®.

Powell did not disappoint, sending a relatively dovish message with an acknowledgment of significant uncertainty. However, the dot plots were much more hawkish, as we'd suspected, but rates markets were clearly less prepared and 2yr bonds sold off sharply leading to a bearish FLATTENING of the yield curve (further inversion with 2yr yields rising more than 10yr yields) rather than the bear steepening most bond bulls anticipated. As a result, significant pain was evident across the rates universe. Some of that is reversing this morning, but this remains an interest rate-focused market rather than an equity option-dominated one as we saw for much of this year.

While volatility targets were not met (yesterday's implied 16 vol equates to a slightly greater than 1% expected move and we say 0.94%), the directional nature of the move lower certainly caught us by surprise even though it was our favored direction.

September 21st, 2023 | "FLATTENING" - 1

More concerning was the price action in the rates market where the "higher for longer" message has been deeply absorbed, but yield curves still remain inverted across virtually all tenors. This is not your father's rate steepening cycle. In both spot and forward markets, a virtually unprecedented degree of inversion persists.

Jobless claims are on deck with expectations for further modest deterioration. A minor uptick in mortgage purchase applications suggests we may have seen an increase in home sales from their deeply depressed levels. Overall, none of the economic data will play as important a role as continued bond sell-offs which are beginning to spook market participants.

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Gamma Exposure:

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Dealer gamma is negative and we've seen a pickup in realized volatility alongside it. As we'd emphasized yesterday, 4400 seemed a likely barrier and here we are. Of course, being a dynamic market, we saw an increase in hedging activity push the gamma trough a bit lower toward 4300, but as we noted yesterday, we are not yet at a point where dealers exhaust liquidity and begin to push implied vol (VIX and short-dated) markedly higher.

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Should we break below 4400, 4350 and 4300 become the new magnets.

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Probable Volatility Bands:

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Yesterday, we noted the 4400 strike was back in play for the first time this month, and SPX didn't waste any time getting there. Now, our bottom PV band has shifted even lower to the 4375 strike, which suggests another push lower is more than possible.

A quick note: when the spot price is in the middle of our bands, it's difficult to infer a directional bias. Instead, these strikes offer areas of support and resistance based on actual positioning and hedging activities via the options market.

Today, those key strikes are 4375 to the downside and 4450 to the topside.

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Bearish but at support is how the NDX will be characterized today. The index will likely need to retest the 15000 strike to continue down to the lower band at 14831. We currently sit at 14898 when writing this (4:50 am EST).

Zooming out a bit farther than just today, NDX is now confirming a big daily lower high; this implies a lower low beyond 14696 in the coming days. To be clear, this is not an endorsement to short at support; sound risk management always applies.

September 21st, 2023 | "FLATTENING" - 10

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Russell 2000 has been bearish to very bearish the past few months; we sound like a stuck record on this. The Dow Jones U.S Micro-Cap Index is now down almost -3.5% YTD and -7.2% over the last year, and a lot more downside is probable on a tail duration.

The top of today's R2000 band is at 1867, and the lower band at 1783. The 1800 strike is likely to act as support in the very short term.

S&P 500 Market Breadth:

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Our MBAD indicator was particularly interesting yesterday, so we thought it was worth highlighting how the breadth profile changed throughout the day.

We started the session off with bullish breadth, with around 80% of the index advancing before the FOMC decision. That said, there was some notable weakness from the mega caps early on that was holding the index back from further gains.

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Then, after the rate hike decision at around 2 pm EST, we started to see the broader market fade to the left, which pushed the cash index into negative territory for the day. At this point, there were still more stocks advancing than declining, but since the mega caps were pretty deep in the red, spot SPX was easily pulled lower.

This is a good example of market cap distortion, where the actions of just a few large companies can outweigh the returns of the majority. It's also suggestive that post-Fed activity was concentrated in liquid futures and broad market ETFs rather than an attempt to distinguish relative winners and losers.

September 21st, 2023 | "FLATTENING" - 14

After Powell's comments, intraday breadth started to deteriorate at a faster pace. This was happening at the same time we saw dealers being pushed deeper into negative gamma, as well as selling picking up from both Vol control funds and CTAs, which contributed to the shift in market breadth.

By the end of the trading session, breadth had flipped from 80% bullish, to 65% bearish, and SPX had fallen -1.3% from its intraday peak. This vividly illustrates the intricate dance between market breadth, systematic selling, and risk events like the Fed, and highlights how quickly things can change when these underlying dynamics start moving in the same direction.

Quant Fund Implied Rebalancing:

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As option dealers fell deeper into negative gamma, we saw a fresh supply of volatility hitting the equity markets. This led to around a 4.2% jump in the 1-month realized volatility, which meant vol control funds had to rebalance out of equities in order to maintain their risk targets.

Remember, while Gamma Exposure acts as a Throttle for volatility, Volatility acts as a Toggle for equity exposure.

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We estimate there was around $8.6 billion in equity exposure sold, which put a lot of extra pressure on the equity market and likely contributed to the sharp decline heading into the close.

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CTAs were also net sellers for around $2 billion in US equities, which was caused by a combination of the bearish trend and increasing volatility. In fact, CTAs have been steadily dumping equities over the past two weeks and have wiped out an estimated $17 billion in risk exposure over that time.

Overall, yesterday was a classic example of a systematic sell-off, where Gamma exposure exacerbated volatility, which forced quant funds to adjust their risk exposure by selling equities, further contributing to the move.

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Luckily for the Bulls, we're less confident vol control funds will continue selling into the end of the week, as the 1-month vol is set to lose two exceptionally large returns from its trailing sample window. Of course, if we see another large return entering the sample, then all bets are off.

Assuming we don't, we could see up to $13 billion in bullish flows hitting the tape today, which should have a soothing effect on volatility. On the other hand, if we push out of a +/- 1.5% return window, then these funds will quickly turn back into sellers, with some strong flows coming in at around a ~2% move.

May the odds be in your favor.

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Bonus Chart:

If you tuned into Monday's Tier1 webcast, we leveraged the US dollar correlation for insights on the FOMC. We anticipated the Euro and Pound would rise leading up to the announcement, then decline, pulling equities down with them. You can listen to the webcast here if you missed it.

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Lately, there's been a surge in BRICS headlines, onshoring news, and crypto enthusiasts predicting the USD's decline. However, today's bonus chart suggests such pessimism might be premature. Also, there's limited evidence backing the onshoring narrative.

The traditional DXY is primarily Euro-centric against the dollar, complemented by the Pound, Yen, CAD, and Swissy. In contrast, the real broad dollar index is comprehensive, including countries like Sweden, Mexico, China, Hong Kong, Brazil, Venezuela, South Africa, and India, in other words, the BRICS, among others.

As we navigate this recession, we anticipate a stronger USD. The Fed states that the dollar represents 96% of trade invoicing in the Americas, 74% in Asia-Pacific, and 79% globally. Furthermore, banks use the dollar for about 60% of all international transactions. Candidly, estimates do vary, but the dollar's dominance remains clear—no currency matches its liquidity.

Research by American University’s Valentina Bruno and the BIS's Hyun Song Shin indicates that a rising U.S. currency makes trading costlier for other countries, overshadowing the benefits of a weaker domestic currency. With the U.S. less reliant on global growth, dollar-denominated assets appeal more to foreign investors, reinforcing the dollar's supremacy and driving its value. This reinforcing cycle, termed the "imperial circle" by the Fed, emphasizes the dollar's lasting significance.

The big takeaway here is the dollar isn’t going anywhere yet; it’s traditionally been an excellent allocation through recessions; we expect it to perform well this go around as well.


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