Oil Breakout and Yield Pressures Point to Tightening Conditions
Stocks finished mixed, with the S&P 500 up 1% while the equal-weight RSP fell by 4 bps—dispersion to the max, it would seem. The DSPX closed today at 38.5, suggesting that the dispersion trade is becoming quite crowded. It is back within a range it does not reach very often, with only a few notable historical instances. (See more: Today’s Stock Market Rally On Divergent Path...)
This was driven by S&P 500 constituent implied volatility remaining elevated, while the VIX index declined today. That caused the spread between the two to widen, making conditions more favorable for the dispersion trade. That spread, like the dispersion index, is extremely wide. It will begin to narrow as we move through earnings season, but until we get through the mega-cap results, it is likely to either remain at current levels or widen further. (See more: How the Volatility Dispersion Trade Moves the Stock Market)
Technically, nothing for the SPX has changed, except that we now have a gap likely to be filled at lower levels from today’s open. Straight-line declines into the close, followed by a gap open the next day, tend to be unstable patterns and are often filled fairly quickly. It would not be surprising to see that gap filled in short order.
In fact, tomorrow is a good candidate for that, given the sharp move higher into the close. It would not be unusual to see the index gap lower at the start of the day.
In the meantime, Brent oil prices rose by almost 3% on the day to nearly $102. At this point, the falling wedge has been broken, and oil now appears to have formed an inverse head and shoulders pattern on the intraday chart, along with a smaller bull flag. I think if we see Brent move above $104, it could very well be on its way to $110.
The 2-year also rose by 2 bps on the day, finishing at 3.8%. A move above resistance would likely set the 2-year up to climb back toward 4%.
In the meantime, the spread between Italian and German 10-year rates widened by 2 bps. Again, this spread is very tight, but if it continues to widen, it is a signal that other spreads may begin to widen as well and, more importantly, that financial conditions are starting to tighten.
Additionally, 1-year inflation expectations appear to be coiling here, with a bullish-looking flag of their own, suggesting higher inflation may be on the way.
I just don’t think it is possible for oil to rise the way it has without financial conditions tightening.
-Mike
Glossary by ChatGPT
Bull Flag: A continuation chart pattern indicating a brief consolidation before a potential upward price move.
Dispersion Index (DSPX): A measure of the difference between index volatility and the volatility of its individual components.
Dispersion Trade: A strategy that profits from differences between index volatility and individual stock volatility.
Equal-Weight Index (RSP): An index where each constituent is weighted equally rather than by market capitalization.
Financial Conditions: A broad measure of market liquidity and economic stress, influenced by rates, spreads, and asset prices.
Gap Fill: A technical occurrence where price returns to a previously untraded range created by a gap in the chart.
Implied Volatility: The market’s forecast of a likely movement in an asset’s price, derived from option prices.
Inverse Head and Shoulders: A bullish reversal pattern signaling a potential upward trend after a downtrend.
Spread (Yield Spread): The difference in yields between two bonds, often used to assess relative risk or financial conditions.
VIX Index: A measure of expected volatility in the S&P 500, often referred to as the market’s “fear gauge.”
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