Short Squeeze Drives Sharp Two-Day Stock Market Rally

The recent two-day surge in the US stock market can be largely attributed to a phenomenon known as a short squeeze, which forced many bearish investors to reverse their positions.

Hedge Funds Trigger Short Squeeze Amid Tariff Volatility

Data from Goldman Sachs’ prime brokerage indicates that hedge funds had significantly increased their short positions across individual equities and broader macro-linked securities. This trend was largely in response to early-April market volatility, sparked by former President Donald Trump's surprise imposition of tariffs followed by an abrupt 90-day suspension.

As bearish bets piled up, the market became increasingly susceptible to a short squeeze—a sharp upward price movement caused by short sellers scrambling to cover their positions. When prices unexpectedly rise, short sellers are forced to repurchase the assets they had bet against in order to minimise losses, which creates rapid upward pressure on stock prices.

Rally Fueled by Policy Rhetoric, Not Fundamentals

The recent market rebound didn’t coincide with any major economic developments. Instead, it followed a softening of rhetoric from Trump regarding trade tensions with China and a less aggressive stance toward Federal Reserve Chair Jerome Powell.

Traders, including Goldman Sachs Managing Director John Flood, noted that the market had been “coiled” for a relief rally. Many hedge funds found themselves on the losing side of their bearish positions, and the resulting wave of short-covering added to the buying frenzy seen on Tuesday and Wednesday.

Flood remarked, “Squeeze risk is very real today,” echoing a sentiment shared across Wall Street.

Trade Optimism Provides Temporary Boost

While no concrete agreements have been reached, signs of easing trade hostilities between the US and China contributed to the rally. Treasury Secretary Scott Bessent stated there was "an opportunity for a big deal" on trade relations, which added to investor optimism.

Trump also appeared to reverse his stance on Federal Reserve Chair Jerome Powell, stating that he had "no intention" of removing him—days after publicly criticising the Fed chief. This reversal helped improve investor sentiment and added fuel to the ongoing market bounce.

Rally Momentum Already Slowing

Despite the initial surge, momentum began to fade by midday Wednesday, with the Dow Jones Industrial Average retreating from earlier highs and showing a gain of around 500 points. According to Flood, while short positions were being covered, hedge funds have yet to shift to aggressive long buying—a sign that confidence in the rally remains tentative.

“We haven’t seen any significant moves by longer-term investors to initiate long positions,” Flood noted. “That would indicate stronger conviction behind the rally, which so far is lacking.”

(Sources: CNBC.com)