Some Quick Thoughts About Fear and the Fed

Yesterday was quite an odd one for US equity traders. After an attempted rally in the first hour of trading, we sank steadily throughout the session, only to rally back to a small gain in the final hour. All in all, it meant there were 2.5% round trips in the S&P 500 Index (SPX) and NASDAQ 100 Index (NDX). 

2 Day Chart, SPX (red/green 1-minute bars), NDX (blue)

(Click on image to enlarge)

Source: Interactive Brokers

I was asked why the rally appeared seemingly out of nowhere. My hypothesis is that we had the usual institutional buying that is said to arrive on the first of each month, but that during most of the day those buyers had no need to be aggressive. They could work their orders by buying on the bid with stocks under pressure.  Yet many institutional traders hold back a disproportionate piece of their buy orders until the end of the day to better their odds of beating either the VWAP or close. They needed to become more aggressive to complete their orders, and the mere act of turning from passive to aggressive in a poor liquidity environment was enough to turn the market around completely. 

I also believe that many traders realized that stocks had become quite oversold ahead of two major news events this week. Those are the FOMC meeting tomorrow and the Payrolls Report on Friday. I believe that there are traders who intuitively believe that an oversold market is prone to a “sell the rumor, buy the news” rally after Chair Powell’s press conference and used yesterday as an opportunity to either cover shorts or establish long positions. It is entirely possible that they utilized the line of thinking that we discussed yesterday when we wrote:

“It would not surprise me in the least if we get a snapback rally after Wednesday’s FOMC meeting. Traders have tended to get ahead of themselves before recent Fed announcements. As the table below shows, as the Fed was busily adding liquidity to the economy at a record pace since March 2020, we saw SPX close lower in the three-day period following 10 of 12 meetings. This came in the face of a huge rally in stocks during that time. When the Fed began to switch to less accommodative rhetoric in September 2021 that shifted the pattern. Since then 4 of 5 post-meeting periods have seen a higher close. If that pattern holds once more amidst this current negativity and volatility, we could get a short-term snapback.”

(Click on image to enlarge)

Source: Interactive Brokers

Yesterday’s bounce also relaxed the CBOE Volatility Index (VIX) somewhat. The VIX futures curve remains in backwardation, though the absolute levels are below those we saw during the midst of last week’s decline. Remember that VIX is constructed as the market’s best estimate of 30-day volatility, so it is not surprising to see it front-loaded ahead of a period with events that could certainly induce volatility:

VIX Futures Term Structure, Today (yellow), Yesterday (orange), Last Week (red)

(Click on image to enlarge)

Source: Interactive Brokers

Let’s end on this note. When we do the same sort of analysis, only substituting the curve from 2 weeks ago for yesterday’s curve, we see how quickly the mood changed in just a week. From 2 weeks ago to 1 week ago we saw the curve to from contango to backwardation and spot VIX rise about 12 points. It is an important reminder about how quickly the market’s mood can change – especially when the mood gets negative.

VIX Futures Term Structure, Today (yellow), Last Week (red), 2 Weeks Ago (green), with changes (bottom)

(Click on image to enlarge)

Source: Interactive Brokers