Oil Negative Gamma Event: Market Implications
- Dollar and US equity sentiment weighed down
- A potential debt ceiling crisis looms
- Financial contagion impact on oil markets
- Bullish play for OPEC amid weaker dollar
A healthy dose of policy skepticism, particularly towards those pulling the strings behind the red, white, and blue curtains at the Fed and Treasury, continues to weigh on the dollar and US equity sentiment.
And one of the reasons why the greenback hasn’t tapped out is that it is not supposed to do so when a recession looks imminent. Hence, some Funds “bank the buck” due to the US dollar’s safe-haven characteristics.
However, we are headed for one of the dollar’s most significant confidence tests in recent history if the bank crisis runs headlong into a debt ceiling crisis, especially with confidence in the US banking system so frail. Hence I’m not sure the dollar is the best “safe- haven” bet relative to gold.
Fed officials believe tighter credit conditions could substitute for rate hikes to slow the economy, but each policy produces a different arc for the US dollar.
Unlike a higher risk-free rate of return via 10-year bond yields, which typically support the US dollar when the Fed hikes, tighter credit conditions lower the expected real rate of return on domestic assets, deter portfolio flows and weaken the currency.
If the current headwinds fade, the dollar could strengthen a touch. Still, it is highly improbable it will return to its former glory, given the problems on Main Street, which suggests the Fed is unlikely to return to the previous rate hike path.
OIL’S NEGATIVE GAMMA EVENT
Financial contagion risk did not morph into contagion risk in oil markets. Still, it was perfectly understandable why oil traders drew a straight line from the oil market meltdown to the 2008 GFC. After all, the markets witnessed the most prominent bank collapse since 2008 and the quickest and most significant repricing of a Fed curve ever. The magnitude of the shock sent tremors across all pro-cyclical markets where oil was targeted, as it always is during any apparent macro meltdown.
We initially thought oil would hold up at the $ 73.50 -74.50 zone last Friday, but the cross-asset contagion was clearly underway when the VAR shock sent gold +2000.
While oil and commodities were initially resilient, financial contagion bled into the asset class because of high leverage and a poor start to the year. This created the initial sell-off across cyclical commodities like oil and base metals that were long. Once oil prices breached $80/bbl, where the largest volumes of puts are struck, the large short put position in the market created a pocket of negative gamma (an acceleration in option losses to writers of those puts), forcing further selling of futures and price declines towards the $70/bbl strikes. Despite this rapid deleveraging of commodity markets, with net managed money, it is important to remember that this financial contagion has not yet spilled over into real activity and commodity fundamentals despite the massive wipeout.
Negative Gamma Effects Exacerbated Oil’s Sell-Off
Brent option open interest (lots)
And peaked just below Friday’s close.
Dec 23 Put the example
But the market’s most considerable risk right now is tighter credit, which could negatively influence global oil demand. But, outside of a major global banking crisis, we see a relatively limited impact on supply or demand.
As markets stand right now, assuming US US bank risk fades and broader volatility drops, our bullish play is for OPEC to stay the course and with the weaker dollar allowing better China fundamentals to shine through. And bullish think we could enter a small global oil deficit as soon as June due to OECD skirting a 2023 recession, thirsty Asia buyers, and a fall in Russian production.