With the Fed on Deck, Something’s Got to Give

Yesterday in Like a Hot Knife Through Warm Butter we posited the $SPX was setting up for a potentially dangerous corrective move into the .618 retracement of the first leg off the top and that the subsequent decline could be violent.  We think this rally off the 1357 low has been a classic option expiration week premium burn and that sets up for a move lower when the shorts are covered/expired.

Next week we have a Fed meeting (Wed 4/25) and by all accounts it’s expected to be a snoozer with no change in policy.  That’s what has us concerned.  We have been pointing to the large short position out of the large speculators and the potential for a short squeeze to take us to new highs.  We also thought that it would coincide with a stock market decline.  As of last week’s COT report, the net short position in the TY contract is 207m, this while the market sits just below major overhead cycle top resistance at 132-00 where no doubt a lot of buy stops are placed.

Chart: Bloomberg

This week we also noticed there is a sizable open interest difference in the June TY contract between calls and puts.  The 132 calls have 53m contracts open while the 131 puts only have 24m open.  Clearly the market is positioned or hedged towards higher prices and while some of this could be the record spec shorts, the market is very unbalanced.  We think Murphy’s Law could be in the works and that the Fed being on deck next week might be the catalyst to break out of this tug of war.  If the stock market takes another leg lower, expect the bond market to rally and run the 132 stops and calls (someone is short them) to get the book more balanced.

In 2010 the short squeeze that resulted from the Greece & Gulf of Mexico events eventually spooked the Fed into thinking the market was discounting deflation which prompted them to launch QE II.  The bond market was the tail wagging the dog.  We could see a similar scenario play out where another squeeze vaults us to new highs on stock market weakness which again prompts more Fed action.  It is from here where we would look for a market top and intense reversal.  After all Bernanke loves blowing up his own trade.


About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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