JPMorgan: Massive Short Squeeze Risks Hawkish Fed "U-Turn"

Just three weeks ago, when the S&P was on the verge of a bear market down nearly 20% from its Sept. 20 all-time highs, JPMorgan provided a simple explanation for the relentless selling pressure: widespread institutional capitulation as deleveraging coupled with margin calls forced hedge and mutual funds to dump exposure and hit virtually any bid in a panic scramble to meet a surge in year-end redemption requests.

As JPM's strategist Nikolaos Panigirtzoglou noted then, extrapolating spec positions to capture the latest open interest changes - the red dots in the chart below -showed a reading that was not far from the previous capitulation levels of January/February 2016.

Additionally, the short interest on the SPY - the biggest equity ETF used by institutional investors to express equity views - had jumped to the levels previously seen also during the capitulation episode of January/February 2016. This happened just as momentum chasers and trend followers such as CTAs had finally flipped short for the first time in three years in mid-December.

What was notable about these observations is that according to Panagirtzoglou, this widespread capitulation was "creating a window of opportunity for equity markets into Q1 assuming the Fed reacts to market stress and skips the March meeting" with one caveat:"beyond March, a much bigger dovish shift would be required by the Fed to unwind the inversion at the front end of the US yield curve" something we noted earlier. And, as the JPM strategist adds, "if such dovish shift does not materialize and the yield curve inversion fails to improve, any equity rally in Q1 would most likely be short-lived."

Well, Panagirtzoglou was spot on, because just two weeks later, Chair Powell indeed made a surprising dovish reversal "responding to market stress" as the S&P hit the "Powell Put" level of just above 2,300 which was later confirmed by the FOMC's December Minutes, which in turn sparked the biggest market rally in years as traders scrambled from one extreme to another and in the last week, the capitulation was clearly over and was replaced by manic BTFD euphoria as investors bought a little bit of everything including international equity funds ($3.8bn), government bonds ($3.6bn), EM bonds ($2.4bn), EM stocks ($2.4bn), and HY bonds ($1.5bn) (even as they still sold financial stocks ($1.5bn), IG bonds ($1.4bn), and tech stocks ($0.6bn).

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