Delta Skelta to the Gamma Hammer

In automotive terms, if the delta of the option is its speed, then gamma is the acceleration. Overnight, Bank of America made an interesting observation that the recovery time from 2 standard deviation drawdowns in US equities is at an all time low. The (obvious) conclusion is that this is a function of reflexive volatility selling and equity dip-buying supported by the implied Federal Reserve put.

Overnight, the FOMC took an initial tentative step towards normalization. The committee acknowledged that progress had been made. While there was very little in the way of a firm commitment on the time frame to taper, what we can say is that future meetings are more “live” than previous ones. Put another way, this represents a change from the autopilot messaging of previous communications. The Fed did not appear concerned about the recent growth scare or growth induced slow down related to the COVD-19 delta variant.

From our perch, the longer the Fed waits, the more reflexive volatility selling will build up and the greater the eventual “gamma” driven sell off will likely be. In the short term, the way price responded to news suggests that there was little additional information from the July meeting. Future short rate expectations did not shift very much, liquidity beneficiaries (or long duration growth stocks) outperformed and the US dollar index eased (chart 1). That is a short term positive for EM/Asian assets.

As we have noted recently, price action in the US credit markets, broad financial conditions and volatility has also been relatively calm (chart 2 and chart 3). The credit markets tend to lead at major turning points. US credit spreads are only modestly higher over the past few weeks in spite of the up-tick in equity volatility and the 19% correction in Chinese equities. Of course, the episode in China is a lens into what might happen if (or when) liquidity and credit tighten in the United States. Clearly, the correction in Chinese equity is also an idiosyncratic response to the regulatory threat on future profits and the perception of future earnings. However, it has also been a function of the reduction in the rate of change in credit growth.

In the US context, the rate of change in the Fed’s balance sheet has also slowed. That is a form of tapering and tapering is tightening. But it highlights the potential risk once there is a real reduction in the balance sheet or genuine rise in the cost of capital. Stated differently, reflexive volatility selling could rapidly pivot to a self-reinforcing increase in volatility and sell-off in equity prices. For now, the real cost of capital remains extremely low and the Fed is not yet actively reducing balance sheet and liquidity.

The Federal Reserve has been clear over the past few months that the labour market holds the key to policy normalisation. Chairman Jay Powell reiterated that on Wednesday. US employment is still around 6 million below peak. Substantial further progress would likely require further robust gains over the coming months (trend payroll gains between 500,000 to 1 million per month) before the Fed would likely consider a “taper” of the balance sheet. While that is plausible over the coming months given leading indicators of the labour market and re-opening of the US economy, the Fed is likely to remain re-active rather than pre-emptive. For markets, that suggests the Fed is unlikely to be a threat financial conditions in the near term. However, in the medium term, the more the Fed supresses volatility today, the greater future volatility and the gamma hammer is likely to be.