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Markets sink despite Fed tranquilizer

XM.COM

    • Stocks suffer, dollar shines amid whispers of hedge fund slaughter
    • Fed plays down tapering speculation, but unable to calm nerves
    • Euro on the ropes as ECB rate cut speculation returns
    • US GDP data coming up today amid peculiar earnings season


Short squeeze epidemic forces hedge fund liquidations

The sound you are listening to is the stock market cracking from within, as a few funds liquidate their books to cover losses on their short bets, which retail traders have pushed to the moon. Or at least, this is the popular narrative.

A coordinated army of retail traders has weaponized call options contracts lately to engineer some epic short squeezes in heavily shorted small cap stocks. Options have embedded leverage, so if small investors bet a stock will soar this way, they can push the price much higher as the market makers selling those options to them are forced to hedge their exposure, by buying the underlying asset too.

It is essentially a feedback loop, where buying bullish options forces big dealers to buy the stock as well, sending the price higher and leading short sellers to cover or close their positions to avoid bigger losses, adding more fuel to the rally. A few funds were apparently caught on the wrong side of this dynamic, sparking a selloff in the broader market as they liquidated long positions to cover their short losses. Some others may be simply de-leveraging.

The S&P 500 fell by almost 2.6% and futures point to another 1% loss at the open today.

Dollar shines despite dovish Fed

Even the Fed chief couldn’t calm investors’ nerves yesterday, despite being as dovish as he possibly could. He rejected the idea that the Fed will scale back its colossal QE program anytime soon, which normally would be great news for risky assets and bad news for the dollar, but investors had other things on their mind.

The dollar outperformed as traders looked for some insurance against a deeper correction in equity markets, though the reserve currency also capitalized on some weakness in the euro.

The fragility of the Eurozone economy has come back under the microscope, with the shortage of vaccines cementing fears that a double-dip recession is inevitable. Meanwhile, the ECB is actively trying to keep a lid on the exchange rate. Some policymakers have warned that another rate cut is possible, while others advocate for a Fed-style inflation overshoot regime, either of which would damage the euro.

Overall, it is difficult to find reasons to be optimistic on the euro nowadays. A slow vaccine rollout, an anemic recovery, and the lack of any impressive fiscal stimulus paint a stark contrast to America. The narrative of economic divergence could ultimately dominate, keeping the risks around euro/dollar tilted to the downside.

US GDP numbers and more earnings coming up

As for today, the preliminary estimate of US GDP for Q4 will be in focus. Forecasts suggest a 4% annualized increase, but the Atlanta Fed GDPNow model points to a 7.2% print, so there might be scope for an upside surprise.

The barrage of earnings will continue with McDonalds, Visa, and Mastercard. A worrisome pattern has emerged lately where market heavyweights beat their earnings forecasts, but their stock barely rises or even falls. Microsoft, Apple, and Facebook have all suffered the same fate this week. It could be a signal that too much good news was already baked in at these stratospheric valuations, and that investors are happy to take profits instead of reloading here.

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Source: https://www.xm.com/research/analysis/marketComment/xm/daily-market-comment-markets-sink-as-funds-liquidate-despite-fed-tranquilizer-134907
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