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The Bond Column

Fiscal Stimulus Plans Get Mired in AHCA Vote and Options Market Musings
Updated: 2017-03-27, 08:55:33 ET
Analyst: David Kelland

I've been writing frequently both here and on the bond page about the proper sequencing of legislation that Congress must pass and get signed into law in order to accomplish their goals. It now appears that the American Health Care Act will not become law and that makes corporate tax reform more challenging. The rate reductions may have to be smaller. The idea of a destination-based cash flow -- while appealing from an efficiency perspective -- will have a tough journey through the Senate. Trying to do corporate tax reform by starting with only 52 Republican senators is a tall order and so movement on that front might not happen unless the two parties can cooperate. It isn't clear that this is a possibility.

At least some of this big jump in U.S. interest rates since November was based, according to the punditry, on expectations for larger deficits and higher nominal GDP growth. Fed policymakers, however, have not priced in any fiscal stimulus to their forecasts and this week reminded us why.

The eurozone economy is improving though, even without fiscal stimulus in the United States. Years of ultra-easy monetary policy appear to be finally producing results.. Purchasing managers' index data (both manufacturing and services) for the single currency bloc jumped to 71-month highs in March and the readings are supposedly consistent with 0.6% q/q growth. The probability that the European Central Bank hikes its deposit rate by the end of 2017 is now about 50%.

In the minus column, money markets in China are seeing signs of greater stress as the People's Bank of China tries to reintroduce some prudence into its financial markets. The seven-day repo rate jumped to a 26-month high of 5.01% on Tuesday and continues to remain elevated. Repurchase agreements allow owners of securities to sell them for cash in transactions that are unwound (the securities are 'repurchased') at a specified future date. In essence, short-term funding is become more expensive and as George Magnus notes, sometimes it is the liability side of the balance sheets -- not the asset side -- that is the one to watch.


I wrote this on Wednesday but wanted to re-post it because I rarely discuss options and this is academically interesting although probably hard to apply to trading:

The timing of Tuesday's sell-off in equities and rally in Treasuries looked more random than anything, but maybe that wasn't the case. ZeroHedge reported on Tuesday that JPM quant Marko Kolanovic noted after Friday's quadruple witching, "the gamma imbalance shifted towards puts for the first time in about 5 months and the market was 'free' to move again." Gamma is the variable used to describe how delta varies as the underlying asset's price moves higher or lower. Delta describes how option prices change as the underlying asset's price moves higher or lower. For calculus students, gamma is the second derivative with respect to the price of the underlying asset where delta is the first derivative.

In layman's terms, here is what happens: Investors are typically buyers of puts and sellers of calls, trying to insure their portfolios of stocks against declines and trying to pick up income from appreciated stock that they don't want to pay capital gains on. Dealers will sell the put options to those investors (let's leave the call-buying half aside) but to hedge against losses on the short put position, the dealers sell some stock. A 2,350 put option on the S&P 500* when the index is at 2,350 will have a delta of -0.50, meaning that for every point the index declines, the put option goes up in value by half a point. So the dealer sells the proper amount of stock (SPY or S&P futures) to hedge against a one-point decline in the index. As the index declines though, that delta will gradually move towards -1.00, meaning that the dealer is left exposed. In order to hedge himself, he has to sell more stock. If a lot of dealers are on the same side of the market, their collective action can create significant selling pressure. Dealers always strive to be delta-hedged, but they could have gamma risk on and this is what Kolanovic was referring to. The expiration of a lot of options could leave dealers with a much different gamma position which they would need to hedge if the market moved.

Back when I traded euro currency in the very dull days of late 2009 and early 2010, the ranges were brutally tight and our manager would attribute the dullness to "gamma hedging." He was saying that dealers were long both puts and calls and that when the market moved a little higher, they would sell euro to hedge their calls (which had just gone up in value). If the market went lower, they would buy euro to hedge some gains on their puts. The net result was that the euro traded in a very tight range. Were the active traders positioned another way, the market could have been more volatile

* which gives the owner the right but not the obligation to sell the index at 2,350 at or before the expiration date

- David Kelland,