Britain Bounces Back

Here are some of the biggest stories from last week:

• US inflation unexpectedly accelerated in February.
• UK wage growth slowed by more than forecast.
• Britain’s economy rebounded in January.
• Trading in options of semiconductor stocks has exploded.
• The world’s biggest digital currency could be on the verge of a big move.

Dig deeper into these stories in this week’s review.

Macro

Investors got another bad surprise this week after the latest US inflation report showed the pace of price gains unexpectedly accelerating in February. Consumer prices rose by 3.2% last month from a year ago, up from 3.1% in January and surpassing economist forecasts. Core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, ticked down slightly to 3.8%, defying expectations for a bigger slowdown. On a month-over-month basis, headline and core inflation matched forecasts, with both coming in at 0.4%. The former was particularly worrying as it marked an acceleration from January’s pace and was the highest reading in five months, adding to evidence that inflation is proving to be stubborn, which is keeping the Fed wary of easing policy too soon.

Over in the UK, new data this week showed wage growth eased by more than expected, confirming the Bank of England’s view that inflationary pressures are easing in the economy. Average annual growth in regular earnings, excluding bonuses, fell for a fifth straight time to 6.1% in the three months to January. Growth in earnings including bonuses, meanwhile, came in at a less-than-expected 5.6% – down from 5.8% in the three months to December. Finally, the unemployment rate unexpectedly ticked up slightly to 3.9% – a further sign that the labor market is cooling, which prompted traders to increase their bets on the BoE cutting interest rates this year.

For what it’s worth, the BoE has said that it’s in no rush to begin cutting interest rates, especially with the UK economy rebounding a bit and not seeming to be in desperate need of the boost that comes from lower borrowing costs. Case in point: new data this week showed Britain’s economy returned to growth at the start of 2024, helped by an expansion of the services and construction sectors. GDP rose by 0.2% in January from the month before (following a 0.1% decline in December), matching analyst forecasts. The figures leave the UK on track to grow over the first quarter as a whole, which would bring the mild recession that hit the economy at the end of last year to an end.

Stocks

Trading in options of semiconductor stocks is exploding as investors bet on the hottest theme in markets these days: AI. The average daily trading volume, measured in "notional value," in single stock options for members of the Philadelphia Semiconductor Index exceeded $145 billion in February. Note that notional value here refers to the total value covered by an option contract, calculated by multiplying the underlying asset's market price by the contract's size (usually 100 for stock options). To put that $145 billion figure in perspective, it’s roughly double the average seen at the end of 2023 and is seven times higher than the same month a year earlier. Nvidia – the chipmaker at the heart of the AI bull market – accounted for almost four-fifths of the options trades in February.

While options trading often goes hand-in-hand with big stock-market moves, the recent surge could be a sign that investors who missed out on last year’s semiconductor rally are trying to play catch up. What’s more, options offer traders not only a way of betting on further price gains, but also provide protection should the rally run out of steam. All valid reasons, sure, but some skeptics may point at the surge in options trading activity as a sign that the AI frenzy could be going too far and approaching bubble territory…

Crypto

The price of bitcoin has surged this year to hit a new record high. And now, soaring demand for options on the world’s biggest crypto has left it on the verge of another big rally or a steep decline, due to a concept called “gamma squeeze”. Allow us to explain.

Let’s take a step back: a call option on bitcoin gives the buyer the right, but not the obligation, to purchase the token at a specific price (called the exercise price) within a certain timeframe. When investors buy these contracts, the sellers (usually market makers at big financial firms) need to hedge their exposure. That’s because the big worry from their perspective is that bitcoin shoots up. If that happens and investors exercise their call options, market makers would have to buy the token at a high price, sell it at the lower exercise price, and take a big hit on the difference. To hedge against this risk, market makers immediately buy some bitcoin whenever they sell a call option contract.

But here’s the thing: the amount of bitcoin that market makers need to hold to remain hedged doesn’t stay the same. In fact, it increases when the price of the token rises and causes options that were “out of the money” (i.e. when bitcoin’s price is lower than the option’s exercise price) to become “in the money” (the opposite). Put differently, as bitcoin’s price increases and approaches the options’ exercise prices, market makers are forced to buy more of it to remain hedged. And if there’s a huge amount of call option contracts open, as there are now, all that forced purchasing activity from market makers pushes bitcoin’s price up, which necessitates even further buying to remain hedged. This self-perpetuating loop is called a gamma squeeze.

It’s important to note that this can also work the other way round. That is, a fall in bitcoin’s price encourages market makers to sell some of the underlying crypto they’d previously bought as a hedge. This could lead to a loop of more price declines and a further unwinding of hedges.

Today, the number of bitcoin call option contracts expiring on March 29 has soared to above 70,000 – way higher than contracts expiring on other dates, according to crypto derivatives exchange Deribit. Most of the money in these call options – covering roughly $5.7 billion of the token – is clustered around exercise prices between $65,000 and $85,000. And with bitcoin’s price somewhere in the middle of this range, these options can quickly turn from being out of the money to in the money (and vice versa), making the world’s biggest crypto ripe for a gamma squeeze in either direction.

Next week

• Monday: China retail sales and industrial production (February), eurozone trade balance (January).
• Tuesday: Bank of Japan interest rate announcement, US housing starts (February). Earnings: Xpeng.
• Wednesday: Fed interest rate announcement, China one-year loan prime rate announcement, UK inflation (February), eurozone consumer confidence (March). Earnings: Micron Technology.
• Thursday: Japan trade balance (February), Bank of England interest rate announcement, US existing home sales (February), global PMIs (March). Earnings: FedEx, Nike, Accenture.
• Friday: Japan inflation (February), UK retail sales (February).