Good Morning,
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Yesterday, we had a continuation of Monday's trend where a growing number of investors decided to abandon their geopolitically motivated tail hedges from the previous week. This enabled market makers to repurchase their deltas by buying SPX futures, which injected bullish flow into the market, consequently driving both markets and volatility higher.
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This serves as another compelling illustration of dealers' hedging strategies operating in both directions, with the net outcome being a general increase in volatility. In fact, we finally started to see an uptick in realized volatility, as yesterday's rally lacked the typical late-day mean reversion that we saw play out most of last week.
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Nevertheless, dealers remain in a negative gamma regime, which implies the elevated volatility will continue, at least until the SPX surpasses the 5130 strike, which is a little over 1% away.
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While we've been focusing a lot on CTA funds the past week, we're now starting to see Vol control funds step up their selling as well. Just yesterday, we estimate that these funds were forced to sell approximately $15 billion in equity exposure in response to the surge in upside volatility.
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This marks one of the most significant single-day selling events of the year for Vol control strategies and something we view as a major red flag for the market. Now that CTAs and Vol control funds have both started the deleveraging process, there is a higher probability it may lead to a mechanically-driven feedback loop where selling leads to even more selling, until these funds risk mandates are met.
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Despite the recent strength in equities, our warning from last week remains in effect. The setup continues to present significant risks, and if volatility continues to rise, so will the probability of these flows destabilizing the markets.
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-Tier1 Alpha
