Key Takeaways:
- Financial Conditions Are Tightening Across the Board: Rising oil prices are driving inflation expectations higher, strengthening the , pushing rates up, and pressuring risk assets — the “four horsemen” of tightening financial conditions are all in play.
- S&P 500 Broke Below Pennant Support With Further Downside Risk: The broke lower from a pennant pattern and is now sitting around 6,350, with the put wall at 6,300 and the next support region near 6,200. Systematic selling flows and negative gamma positioning suggest more downside risk lies ahead.
- Oil Remains the Key Macro Variable: closed at its highest level of the current move and appears to be consolidating rather than topping, with the $84–$86 range acting as a floor — continued strength here would keep upward pressure on inflation swaps and tighten financial conditions further.
Introduction
It was another interesting week in markets, and there are a lot of things in a position where, if you start looking at them closely enough, you can begin to see how close we are to certain things really starting to move in a much bigger way than what we’ve potentially seen thus far.
Just scrolling through the charts, you can get the sense that this is a really important spot for us — from a technical perspective, from a sector perspective, and from an overall market perspective. You can get a feel for lots of different pieces moving in the market right now. And at the end of the day, the underlying theme here is that financial conditions are tightening.
Oil: The Driver of Tightening Financial Conditions
We spoke a couple of weeks ago about the “four horsemen” of tightening financial conditions, and that is certainly what we’ve been seeing. The underlying reason for that goes back to oil prices and what’s happening there.
When we look at oil, you can see it closed on Friday at really its highest level of this entire move. It certainly doesn’t seem like oil is at a point where it’s potentially topping. It looks like oil may be in a position where it’s just consolidating.
Last week, I had noted that the ten-day exponential moving average was serving as a support area and the upper Bollinger Band was serving as resistance. This week, we actually saw a bit of a change. Oil prices fell below the ten-day exponential moving average and did hit the twenty-day simple moving average. But as I noted during the week in the member area, it looked like the twenty-day exponential moving average was really now acting as support.
When you broke it down a little further, you could see that oil prices were trying to find some sort of base or floor in the $84 to $86 area. We made a nice double bottom, and now we’re right back to the highs of where we were on the 23rd before that big morning announcement.
Oil is the key piece here because with oil going higher, you’re seeing financial conditions tighten. And financial conditions, for the most part, are the enemy of risk assets.
The Shift in the Oil–Financial Conditions Relationship
Historically, it was always kind of viewed that when financial conditions tightened, oil would come down, because oil was a growth proxy. When financial conditions were tightening, it was an indication of global growth slowing, and therefore oil prices would decline.
That all changed after COVID. All of a sudden, oil became the driver of the tightening of financial conditions. It was leading to inflation, and financial conditions tightened as a result. Oil coming down ultimately led to the easing of financial conditions — which, looking back at it in hindsight, makes you think, “I wish I had realized that sooner.” But it wasn’t really the most obvious thing, considering historically that just wasn’t the way it used to work — except maybe in 2007–2008, when oil prices traded inversely to financial conditions.
Now we’re seeing the effects of higher oil prices starting to weigh.
US Dollar Index and Financial Conditions
People will say, “How can we track financial conditions?” You can do it a lot of different ways. I think one of the easier ways is just by looking at the US dollar index, which tends to be one of the indicators of financial conditions.
If you look at the right now, it looks like it’s getting ready to make a breakout and potential move higher. We’re sitting right around resistance at 100.50, and a breakout here could potentially push us significantly higher than where we are right now.
Interest Rates and the Yield Curve
When you look at the ten-year, that is also in a position to potentially start moving. We tested the breakout around 4.43% on Friday, and that didn’t hold.
On Fridays, it’s hard to say what exactly markets are thinking about. It could be that people who were short interest rates going into the weekend didn’t necessarily want to maintain those positions over a weekend where an event can happen and rates get pushed lower on Monday. So you could have been seeing short covering. You could also have been seeing people taking a more defensive position into the weekend.
You also saw the move up over 4% and then close lower by nearly seven basis points to 3.92%. This led to the yield curve steepening quite a bit on Friday, going up by around eight basis points to around 51 basis points.
It’s not entirely clear to me because you also saw gold going higher on Friday, and gold has really been underperforming more recently. There was a bit of a flight-to-safety feel to Friday afternoon, especially when you consider that the dollar was stronger as well and risk assets like the S&P 500 really got hammered. We’ll have to see how things play out on Monday to determine whether the movements we were seeing in rates on Friday were actually meaningful or not.
S&P 500 and the Pennant Breakdown
I noted even in the free blog during this week that we saw what looked like a pennant pattern forming in the S&P 500, and that played out fairly well. Here’s the pennant pattern — we clearly broke lower and gapped lower again.
Now we’re sitting around 6,350, which isn’t a super important level, and it suggests there could still be some further downside.
Options Market Positioning and the JPMorgan Collar
I think the most interesting thing is that Monday and Tuesday we’ll have the JPMorgan collar, with the put sitting out there around 6,475. A lot of people expected that to act as support, and it just really didn’t, because when you looked at the size of the gamma that was actually out there and negative, it was a rather small part of the overall gamma positioning.
As of right now, 6,300 is the put wall, and that’s the next major area that could offer some support for the market, while the next region is probably around 6,200. The JPMorgan collar at 6,475 is likely not going to have a meaningful impact on the market at this point.
From an options market perspective, there is still further potential room to go lower.
Systematic Flows and US Dollar Strength
The other piece here is that we still have these systematic flows in the market that are likely to lead to more selling pressure in the S&P and probably also in the , because I don’t think we’ve really seen that all play out.
More importantly, the charts look bullish on the US dollar, probably for a reason — it looks like those systematic flows are also suggesting the continues to strengthen versus some other currencies. You’re seeing some positioning in futures markets, which suggests we still probably have some systematic flows going through the marketplace, where these systematic funds probably get more short and more bearish on these indicators.
Fed Expectations and Inflation Swaps
Finally, we have going up because the market is beginning to go through this process of thinking about what the Fed is going to do when it comes to raising rates if we continue to see oil prices going higher.
You can see that Fed fund futures have repriced to around 3.70%, which isn’t indicating a rate hike, but it’s certainly not indicating any more rate cuts.
When you look at what the term structure of inflation swaps is telling us, inflation swaps right now are pricing in significantly higher inflation, and then maybe it begins to steadily come down over time. This is, of course, assuming that oil prices don’t go any higher or only stay elevated for a period of time — because clearly, if oil prices continue to go up or stay elevated for a longer period of time, you’re going to continue to see these inflation expectations lift.
I modeled what these three or four months would look like because there was really no data in the CPI swap repositories. But you can get a sense that if we were coming down already and were in this region in January, February, or March, then we had to start seeing it come down at some point over the summer.
Again, this is where we are right now. I still think that ultimately, where oil goes dictates where financial conditions go, which dictates where risk assets go and just about everything else.
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