The U.S. dollar and Japanese yen moved in tandem
After stocks got pummeled once again on weaker-than-expected monthly employment numbers, flashbacks to Aug. 2 and Aug. 5 immediately came to mind. In this period, the S&P 500 Index (SPX — 5,408.42) fell sharply from the Aug. 1 close of 5,446 to the Aug. 5 morning intraday low of 5,119, a 327-point decline that occurred over a couple of trading days.
The catalyst was a weaker-than-expected July employment number that weakened the U.S. dollar. Plus. word of a carry trade unwinding and what I believe was a pre-market, delta-hedge selloff on Aug. 5 caused the broader indices to gap lower as big put open interest (OI) strikes became magnets.
“Carry Trade That Blew Up Markets Is Attracting Hedge Funds Again”
– Bloomberg/Business Week, August 16, 2024
$ weakness vs yen around time of monthly employment number emerges again. In fact, today’s USD/Yen low is around 8/5 low. More carry trade unwind and delta-hedge selling risk next week (a repeat of early Aug)? $SPY 9/20 540-strike put heavy and important into 9/18 FOMC meeting
— Todd Salamone (@toddsalamone) September 6, 2024
After reading an article in mid-August about the carry trade returning as the dollar strengthened against the Japanese yen, and then watching the dollar weaken against the yen into and after the August employment report, my immediate reaction was to think a repeat of early August was occurring.
While it may not necessarily happen in the same exact manner, the risk is still there. As such, a break of the dollar/yen August low at 141.66 could be a factor that puts bears in even more control.
Plus, I am watching the SPDR S&P 500 ETF Trust (SPY — 540.36) in the days into the expiration week Sept. 18 Federal Open Market Committee (FOMC) meeting. Per the first chart below, if the SPY breaks below the put-heavy 540 strike, it could set forced selling of SPX futures into motion, as those that sold puts hedge against puts at lower strikes increasing in value, and options become more sensitive to additional SPY declines.
This is called delta-hedge selling, which I think happened before the market opened on Aug. 5. Fast forward to the present and the closer the SPY is to the 540 strike, the more risk there is to bulls of another short-term, delta-hedge selloff.
The second chart below illustrates that put OI at multiple strikes is abundant all the way down to the SPY 405 strike, which is equivalent to 4,050 on the SPX. These big put OI strikes represent potential magnets on a delta-hedge selloff up until Sept. 20 standard expiration, but the risk is gradually lower as we get closer to expiration and the further the SPY remains above these strikes.
With nearly two weeks until expiration, SPY put OI at strikes down to the 405 level are very much fair game, especially if additional selling takes hold early this week. Put OI is relatively low between the 485 and 494 strikes, implying this could be another area that marks a floor if another delta-hedge selloff is imminent.
“…we are all wondering how the SPX will work itself out of the current range, with the arrival of negative September seasonality. One clue as the benchmark enters the week at the top of its range could be in the candle that emerged on Aug. 22 — a bearish outside day, as defined by the intraday high above the prior day’s intraday peak, but the intraday low and close being below the prior day’s intraday low… it has been six trading days since the bearish outside day surfaced without immediately triggering intense selling. But bulls are not yet out of the woods in terms of the implications of the Aug. 22 candle until new highs are carved out.”
– Monday Morning Outlook, September 3, 2024
The big bearish outside day on Aug. 22 was right on cue about warning market participants about upcoming weakness. This was a looming risk to the bull case that I mentioned last week in the absence of the SPX carving out new highs since that candle. Bearish outside day candles have been a warning in 2024 of upcoming weakness in the market, as I discussed last week.
What’s more, the cross back below the 30-day moving average in response to the weak employment number on Friday could be another short-term sell signal, as it was in April and July.
The emerging weakness is occurring within the context of an increase in put buying relative to call buying on SPX component stocks. When this ratio rises from a relatively low level, there is usually coincidental declines in the stock market, so add this as a risk to bulls, in addition to the increased risk of a decline driven by option mechanics.
The good news for bulls is that the increase in this ratio did not occur from the typical lows and, therefore, it is nearing readings that indicate an exhaustion in pessimism that is coincidental with troughs. For now, the direction of this ratio is bearish.
The risks to the bearish case include the dollar/yen holding the August low and the SPY holding above the 540 strike. In the latter case, any short positions related to put OI not far below the SPY will be covered as expiration approaches, lending support.
Obviously, market participants still fear a recession, despite FOMC members indicating interest rate cuts are coming. Inflation data is due out this week, and my guess is any extreme could wreak havoc on the market, as soft readings would confirm recession fears and high inflation might indicate stagflation and force the Fed to walk back cut talks.
Todd Salamone is the V.P. of Research at Schaeffer’s Investment Research.
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