Negative Gamma and Tightening Liquidity Raise Downside Risk For Markets
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Key Takeaways
The Four Horsemen of Tightening Financial Conditions Are All Active: Rising rates, a strengthening dollar, surging oil prices, and widening credit spreads are converging to create a hostile environment for equities — and until at least one of these factors reverses, the pressure on stocks is likely to persist.
S&P 500 Faces Critical Technical Support at 6,520: The index is sitting on support near 6,630, but a break of the key 6,520 level — which aligns with the mid-September breakout and the November lows — could open the door to a move into the 6,200s or lower.
Negative Gamma and CTA Momentum Flows Compound Downside Risk Into OPEX: The S&P is in negative gamma territory with a put wall near 6,600, and the gamma flip up at 6,850, through Friday’s options expiration. Meanwhile, the CTA models suggest systematic funds may be transitioning from selling to outright shorting equities while going long the dollar and two-year futures, adding a mechanical layer of selling pressure on stocks and pushing rates and the dollar higher.
Video
Fully Edited Transcript By Claude
Overview: A Busy Week Driven by Volatility
It was a pretty busy week in the marketplace, and not really surprising given that volatility is high and there’s a lot going on around the world. Oil prices have surged, and during the week — in both my free blogs and my membership area — I spoke about the four horsemen of tightening financial conditions: rising rates, a rising dollar, higher oil, and wider credit spreads. Those things together are going to make this environment really tough for stocks. Until at least one of them basically flips, the tightening of financial conditions is likely to continue.
S&P 500 Technical Levels and Downside Risk
When we look at the S&P, we’re sitting right on a level of support around 6,630. This level is of some importance because it was where the gap was created back in late November. After that, we’re looking at a position where we could probably move down to around 6,520.
That 6,520 level is very important in my mind because of what it represents. It was the breakout and the gap fill back in mid-September, and it also represents the November lows. If we were to see a break of the 6,520 area, I think you could probably see the S&P drop all the way into the 6,200s — maybe even lower than that. But we’ll have to see how things play out. Right now, the environment is really right for a bigger drop in the S&P.
Oil Prices as the Key Macro Driver
I pointed out in my write-ups over the week that oil prices have been rising. Interestingly, if you take a look at the chart, the upper Bollinger Band is acting as a resistance zone and the ten-day exponential moving average is acting as a support level. It’s almost like we’re in this range right now where, as long as the Bollinger Bands keep rising and oil prices don’t break the ten-day exponential moving average, we’re probably looking at a scenario where oil could continue to go higher — especially if the war just continues to go on.
The Dollar and Its Relationship to Oil
From another perspective, what this is doing is leading to the dollar going higher. Why is the dollar going higher? Because oil trades in dollars. You need dollars to buy oil, and if oil prices are going up and getting more expensive, you need more of those dollars.
The dollar index has risen to around 100.50, and this is a very important level in my view. It suggests that if we get above this area, we can maybe see the dollar move up towards 101. For the most part, the dollar index has really just traded with oil over the past four years or so, starting all the way back during the Ukraine war in 2022 with the Fed tightening cycle. That’s basically been the pattern.
Oil prices have obviously gone much higher, much faster than the dollar index, which also points to the idea that the dollar could probably go a lot higher too.
Two-Year Rates and the Inflationary Impulse
You’re also seeing this in the two-year rate, which basically trades with oil as well. This is going to be an inflationary gauge, and it’s going to go higher as long as oil prices remain elevated. There’s probably a period of catching up that needs to happen as well.
Credit Spreads and Financial Conditions
Because oil is going higher, that’s going to make expenses rise, which could be a weight on the global economy and slow growth down. For the most part, you’re seeing the HYG weaken. What’s interesting is that if you take the HYG and just invert it, it looks a lot like a chart of oil as well — suggesting that oil has really been one of the biggest key drivers to the easing of financial conditions during 2022 and 2023.
It’s certainly not always the case, but you can clearly see that as oil prices rose, financial conditions tightened. Once oil prices peaked and started to come down, financial conditions started to ease.
There was a period where oil prices came down and financial conditions still tightened, but that was because we were seeing an economic slowdown and battling deflation in the US and other parts of the world. Global growth was really slowing, and so in that case, you didn’t see the typical relationship.
If you go back to 2007–2008, you could see how rising oil prices dictated the move in tighter financial conditions, and how once oil prices began to come down and the Fed started to do its thing, financial conditions started to ease. So I think oil is a really good gauge right now.
The point in time to watch for is when oil prices start going down and financial conditions continue to tighten. That would tell us and suggest that maybe there’s something else going on in the economy. But right now, I think the relationship is going to be driven by where oil goes — that’s largely going to dictate where the dollar, rates, and credit spreads go.
Cross-Currency Basis Swaps and Dollar Demand
The other thing I’ve been focusing on this week: cross-currency basis swaps have been starting to come back down, getting more negative, telling us that demand for dollars is getting bigger and the expense is becoming greater.
The S&P 500 largely trades along with cross-currency basis swaps. When those spreads are coming down and growing more negative, it’s telling us that it’s becoming more expensive to hedge dollars. Once that happens, that’s also leading to the tightening of financial conditions — and you’re seeing that happening in basically every single cross-currency pair at this point.
CTA Positioning and Momentum Flows
I think the other thing that’s at play right now is the CTA model I’ve built. I’m still calibrating it to some degree — I’ve been working with it for a couple of weeks now and the calibrations are continuing. But the most important thing is that at this point, you’re at an area on the S&P where it’s most likely that CTAs are probably done selling and are now going to start shorting the market. If that’s the case, then that could add another momentum layer to the market going lower, adding pressure from a stock market perspective.
From a two-year rate perspective, it looks like these funds are probably also going short the two-year, which means that if they’re going short the futures, the rate goes higher — and you can see that this probably just started recently. When we look at the dollar index, it’s also showing us that CTAs could be in a position where they’re basically getting long dollars, and that could be another factor — the momentum factor that’s just looking at moving averages diverging and converging and the momentum around it.
Negative Gamma and Options Dynamics Into OPEX
Another piece that’s going to weigh on the market this week is that we’re basically in negative gamma territory. With a put wall right now around 6,600, you can see that right below 6,600, the next level of support in the S&P is 6,500.
You’re at a spot where you have negative gamma, so you’re going to have market makers going with the direction of the market. If it’s going down, market makers are likely to be sellers. If it’s going up, market makers are likely to be buyers. The gamma flip area is up at 6,850, so there’s a lot of room right now for these negative flows into OPEX on Friday to continue to be a weight on the marketplace.
When we look at the volume and flows from Friday, there was a good mix of put activity going through on Friday afternoon in the S&P 500. The put activity was pretty widespread, even at some higher levels. Call volume was still very strong for Friday and for the twentieth. But you can more or less see that volatility is going to continue to rise into OPEX — at least that’s what the chart is showing. Then it begins to fade a little bit toward the end of the month.
You also obviously have the Fed meeting this week, which is also going to drive implied volatility higher. Right now, you’re just in a negative gamma position for the S&P, and that’s going to be a weight.
Liquidity Drain From Treasury Settlements
So right now, we’re in a position where we have a lot of momentum flows that are basically going to continue to favor tightening financial conditions. As long as financial conditions tighten, I think that’s going to be a major headwind for the stock market and for risk assets in general.
On top of it, we’re going to get settlements this week as well. You have about eighty billion settling on Monday, a net paydown on Tuesday of a couple billion — not a lot — and then another settlement of about twenty billion on Thursday. Settlements are going to continue to drain liquidity out of the market, tightening things further.
Closing Thoughts: Financial Conditions vs. the S&P 500
I think this is just where we are right now. Just to finish up, I’ll show you the chart of the Nasdaq National Financial Conditions Index and how it basically goes opposite of the S&P 500. As long as we’re seeing credit spreads widen, the dollar strengthen, and rates rise, those are going to be headwinds for stocks. I think that’s one of the most important things we need to continue to keep in mind as things move forward from here.
Defined Terms and Jargon
Bollinger Bands: A technical analysis indicator consisting of a moving average and two standard deviation bands above and below it, used to identify overbought or oversold conditions and gauge volatility.
CTA (Commodity Trading Advisor): Systematic, trend-following funds that use momentum-based models and moving average signals to take long or short positions across asset classes including equities, rates, and currencies.
Cross-Currency Basis Swap: A derivative contract in which two parties exchange interest payments in different currencies; a more negative basis indicates higher demand and cost for borrowing dollars in foreign exchange markets.
Negative Gamma: An options market condition where market makers’ hedging activity amplifies price moves — selling into declines and buying into rallies — rather than dampening them.
Gamma Flip: The price level on an index at which the aggregate dealer gamma position shifts from negative to positive, changing the dynamic from amplifying moves to dampening them.
Put Wall: A strike price with a large concentration of open put interest that can act as a support or magnet level, influencing dealer hedging flows and short-term price behavior.
HYG: The iShares iBoxx High Yield Corporate Bond ETF, commonly used as a proxy for credit conditions; weakness in HYG signals widening credit spreads and tightening financial conditions.
OPEX (Options Expiration): The date on which options contracts expire, often accompanied by elevated volatility and large hedging-related flows as positions are rolled or closed.
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