That Escalated Quickly

The words of Ron Burgundy succinctly summarized yesterday afternoon’s market action: “that escalated quickly.”

It was an amazing example of the type of move that can occur in a thin market.  Around midday, we were already noting the scope of the rally.  With the S&P 500 (SPX) up 0.75% and Nasdaq 100 up 1.5%, we wrote:

[Tuesday] morning, we had a reminder of what can happen when an unexpected pair of economic reports hit thin markets.

Those indices advanced further, closing up 1.45% and 2.15% higher, respectively.

In a week when we were focusing on more widely watched reports like GDP, the PCE Core Deflator, and Nonfarm Payrolls, the JOLTS job openings report jolted stuporous markets into rally mode.  Equities got plenty of assistance from big drops in bond yields, with the 2-year note falling 15 basis points, from 5.05% to 4.9%.  That is a stunning move.  The move in 10-year bonds was not too shabby either, with those yields dropping by “only” 8 bp.  In turn, the lower yields led to a drop in the US dollar against many of its key peers, with the USDX index falling about 0.5% yesterday.  On their own, those should have been sufficient to propel US stocks higher, since lower borrowing costs and weaker dollars are beneficial to US companies, especially multinationals with significant sales abroad. 

But if you throw a bit of good news into a thin US equity market, the positive vibes can take on a life of their own.  We have seen several times this year how equity market rallies can become turbocharged.  One recurring theme of this market environment is that speculators are primed to pounce on modest rallies and push them higher throughout the day.  Zero-dated (0DTE) options have certainly abetted some of the one-day upswings since they provide ready opportunities for aggressive traders.  As we noted in a recent podcast:

I think there is the potential for sort of one day, not gonna say hiccups even, but exacerbated moves on an intraday [basis]. And I do think we’ve seen that particularly on some of the big upside days. 

That said, I’m not inclined to agree with those who might be inclined to blame 0DTE options for the extension of yesterday’s rally.  The rally would have been powerful no matter what.  Was it overdone?  Perhaps, but the normally staid world of short-term fixed income had a seismic shift in a manner that benefitted equities.  Even if that was abetted by thinly staffed bond trading desks, a substantial move in rates and currencies should have boosted stocks. 

We’ll learn over the coming days whether the moves in various asset classes are indeed sustainable.  As of now, the dollar index is about 0.4% lower, Treasury bond yields are down about 2-3 bp across the yield curve, and equity indices are up about 0.4%.  Neither the second-quarter GDP revision from 2.4% to 2.1%, the mixed August ADP Employment report (177k vs 195k expected, but with a revision from 324k to 371k), nor the stronger than expected July Pending Home Sales report (+0.9% vs -1.0% exp) proved to be sufficient to derail yesterday’s activity.  We’ll see if that holds true tomorrow when we will learn whether the Federal Reserve’s preferred inflation measure, the PCE Core Deflator, meets, exceeds, or misses the 0.2% month-over-month consensus rise for July.  And we have a further test on Friday when the August Nonfarm Payrolls (+170k exp) and Unemployment Rate (3.5% exp) are released.

We stand by the points raised in the conclusion of yesterday’s piece:

[Tuesday’s] jump is another reminder that liquidity considerations are more important to stock traders than the health of the economy.  The market is reacting positively to reports that point to economic weakness.  In theory, economic health is a key element for positive stock prices.  In reality, traders are willing to sacrifice economic growth if it brings them another hit of the monetary accommodation that they truly crave.

The takeaway for the rest of this week is that markets can respond very aggressively to economic reports.  But of course, we don’t know if the plethora of upcoming reports will be market-friendly or not.  Volatility markets seem to believe that today’s numbers are the start of a trend, with VIX dropping to levels not seen since the start of August.  Remember, volatility is non-directional – upward moves count exactly the same as downward moves – but volatility indices tend to reflect the market’s mood.  The mood has brightened today, even if the economic picture hasn’t.

The markets’ mood remains relatively bright this morning, though hardly euphoric.  And with VIX falling further, to a current 14.10 level, it is clear that there is little demand for protection from suddenly sanguine equity investors.  Let’s see how that pans out over the rest of the week.