Playing devil's advocate - how S&P 500 could stay buoyant

The S&P 500 and Nasdaq have stayed buoyant despite the start of liquidity drain from the Treasury General Account (TGA) this week. I still believe that the liquidity drain will be a headwind for risk assets this summer, but it’s worth performing a “pre-mortem” analysis on what the reasons would be if this view doesn’t pan out. There are a few factors on my radar that will complicate the path towards equity downside and volatility upside:

1. There is a large cluster of option strikes at 4300 that is acting as a magnet for the market. In the absence of significant fundamental news, these strikes may keep the market sticky at current levels until the monthly options expiry on Jun 16.

   

2. Every quarter a large client of JP Morgan’s equity derivatives desk puts on a large option structure on the S&P 500 index called a put collar where they buy a put spread and sell a high strike call against it, expiring on quarter end. The size of the strikes tend to create a magnetic affect as the market nears quarter end, resulting in the market finishing each past quarter end near one of the strikes in the structure. The call strike that expired on Mar 31 was 4065, and it just so happened that the market opened at 4056 that day before pushing higher into the close due to hedging flows related to the strike. The call strike expiring on Jun 30 is at 4320 and could have a magnetic effect on the market until then.

3. I believe the risks to next week’s CPI print are towards a softer number, and the risks to the Fed meeting are to the dovish side. If both events result in dovish outcomes, that will support the S&P 500 regardless of the offsetting effects of liquidity drain.

4. Substantial changes in net liquidity have had a lagged effect on the S&P 500 of anywhere from 0 to 4 weeks. It’s possible that we may have to wait until the end of this month to see volatility come back to the market. That timing lines up with the large option strikes finally rolling off.

5. The liquidity drain is already well telegraphed. What if everyone is already sitting overweight cash or short the market looking for the TGA liquidity drain to trigger a selloff?

6. What if the Treasury bill issuance is met with demand coming out of the reverse repo facility? That would mean that the funds are not coming from bank reserves, and therefore liquidity is not being drained. So far we haven’t seen any evidence of funds leaving the RRP to purchase Tbills. The RRP barely moved a blip this week despite over $200b in Tbill issuance and yields being at least 15 bp above the repo rate. I’ll be keeping an eye on this chart below to see if that line starts to move lower.

   

   Reverse repo facility

A recap of recent positions, and a new trade