Macro and Flows Update: August 2022 - e08
Summary
TLDRThe video discusses the current market dynamics, emphasizing the importance of heeding the Federal Reserve's signals on interest rate increases to combat inflation. It highlights the disconnect between the market's reaction and the Fed's communications, the impact of China's unexpected interest rate cut, and the potential for increased market volatility. The video also touches on the risks associated with the 'never short a dull market' adage, the influence of seasonal liquidity on market flows, and the significance of options expirations on market behavior. It concludes with a cautionary note on the potential risks in the upcoming period, especially with weak dealer positioning and the backdrop of a rally seeking an excuse to reverse.
Takeaways
- 📉 The market is currently ignoring the Federal Reserve's calls for increased interest rates.
- 💡 The 10-year yield is sitting at about 2.8%, which is significantly below the trimmed CBI and PCE deflator.
- 🛑 To truly trim core inflation, interest rates need to be positive in real terms, suggesting an increase from current levels of 3 to 5%.
- 📈 Despite the Fed's statements, the market is reacting with bonds selling off and yields rallying.
- 🇨🇳 China unexpectedly cut interest rates by 10 basis points and plans to increase stimulus in the coming months.
- 📉 The drop in CPI was largely due to commodity weakness, while core CPI and sticky CPI continue to rise.
- 💹 The mantra 'don't fight the FED' is crucial for macro investors to keep in mind, as it has significant long-term effects on equity markets.
- 🔄 The removal of low interest rates leads to margin compression, reduced demand for stocks, and increased volatility.
- 📊 The upcoming fall quarterly expirations are typically the most bid, with high open interest and concentrated risk premium.
- 🚨 The period around options expirations can be a critical inflection point, and dealer positioning can turn weak.
- 🔍 Investors should be cautious in the coming weeks, as the rally may be looking for an excuse to reverse.
Q & A
What does the phrase 'don't fight the FED' generally imply in financial markets?
-The phrase 'don't fight the FED' implies that market participants should not go against the monetary policy actions of the Federal Reserve, such as interest rate decisions. It is often advised because historically, the market tends to react negatively when it ignores the FED's monetary tightening or easing signals.
How is the current 10-year yield compared to the trimmed CBI and PCE deflator?
-The current 10-year yield is sitting at about 2.8%, which is approximately 22% below the current trimmed CBI and PCE deflator. The trimmed PCE deflator is running in the 4 to 6% range, depending on the indicator used.
What does it mean for interest rates to be positive in real terms, and why is it important for trimming core inflation?
-For interest rates to be positive in real terms means that they are above the inflation rate. This is important for trimming core inflation because it indicates that the cost of borrowing is higher than the rate at which the purchasing power of money is decreasing, which can help to curb inflationary pressures.
What are some market reactions to the FED's comments, despite the equity market remaining relatively stable?
-Despite the equity market not showing significant reactions, other areas such as the bond market are responding to the FED's comments. The yield on bonds is rallying, and bonds are selling off, indicating a shift in investor sentiment and expectations regarding future interest rate changes.
What was the unexpected action taken by China recently regarding interest rates?
-China recently cut interest rates by 10 basis points, which was unexpected. This action has contributed to supporting commodities and is seen as a signal to the market of increased stimulus in the coming months.
How has the surprise CPI drop been influenced by commodity prices?
-The surprise CPI drop to 8.85% from 9.1% in the previous month was largely driven by weakness in commodity prices. This has helped to alleviate inflationary pressures to some extent.
What are the three major effects of secular inflation on equity markets?
-The three major effects of secular inflation on equity markets are: 1) Multiple contraction, where there is less demand for investment due to higher interest rates; 2) Margin compression, as the stimulative effects of low interest rates on profit margins reverse; and 3) The reversal of the 'TINA' (There Is No Alternative) effect, where higher interest rates make bonds more competitive investments, leading to less demand for equities.
What is the significance of the upcoming September options expiration in the context of the current market conditions?
-The September options expiration is significant because it comes after a period of low liquidity and market activity typical of summer months. This can lead to increased volatility and potential market movements as dealers and entities adjust their positions, and as risk premiums may be re-priced in response to the changing macroeconomic landscape.
What is the impact of the new 1% tax on buybacks and how might it affect market flows?
-The new 1% tax on buybacks, set to take effect from January 1st next year, is likely to result in a decline in buyback activities. This could affect market flows as buybacks have been a strong supportive factor, and their reduction might lead to increased selling pressure in the market.
How does quantitative tightening affect market liquidity and what are its implications for the upcoming period?
-Quantitative tightening reduces market liquidity as it involves the central bank selling assets, which in turn can lead to an increase in interest rates and a decrease in the supply of money. For the upcoming period, this means that the market may face headwinds from reduced liquidity, especially when combined with the potential for increased market volatility and the end of the summer doldrums.
What historical analogy was drawn in the script that should make investors cautious in the coming weeks?
-The historical analogy drawn in the script is the period from February to March 2020, just before the COVID-19 pandemic had a significant impact on the markets. The analogy highlights the potential for market stress and decline following a period of ignored macroeconomic signals and low implied volatility, suggesting that investors should be cautious as the market enters a similar period of potential risk repricing.
Outlines
📉 Market Disregard for Fed's Warnings
This paragraph discusses the market's current disregard for the Federal Reserve's (FED) warnings about inflation and the need for interest rate increases. It highlights the mantra 'don't fight the FED' and points out that despite the FED's calls for higher interest rates, the market seems to be ignoring these signals. The speaker mentions that the 10-year yield is sitting at about 2.8%, which is significantly below the trimmed CBI and PCE deflator. To truly trim core inflation, interest rates need to be positive in real terms, suggesting an increase from the current levels. The speaker also notes the market's reaction to the FED's comments, with certain sectors like Dixie and bonds showing signs of change. Additionally, the paragraph touches on China's surprise interest rate cut and its impact on commodities and inflation.
📈 Long-Term Implications of Inflation and Market Trends
The second paragraph delves into the long-term implications of continued inflation on equity markets. It discusses the concept of multiple contraction, margin compression, and the reversal of the 'TINA' (There Is No Alternative) effect. The speaker emphasizes the importance of understanding the FED's intentions to raise interest rates not just for short-term effects but for long-term interest rate adjustments. The paragraph also highlights the potential dangers of increasing interest rates, such as increased market volatility, risk premiums, and the impact on investment opportunities. It warns of the possibility of a massive creative destruction and liquidation of malinvestment due to the shift from low to higher interest rates.
🔄 Flows and Seasonality in the Market
This paragraph focuses on the flow of investments and the impact of seasonality on market trends. The speaker introduces the mantra 'never short the adult market' and explains why slow markets are generally positive due to strong seasonality during periods of low volume. The paragraph discusses the significance of low liquidity in the summer and how it leads to vanana and charm flows, which can have a substantial effect on the market. It also touches on the role of short interest and the historical significance of high short interest levels in the context of market trends. Additionally, the paragraph highlights the upcoming changes in buybacks due to a new tax and the beginning of quantitative tightening, which will impact market liquidity.
📊 Options Expiration and Market Inflection Points
The final paragraph discusses the importance of options expiration and its impact on market trends. It explains that expirations are critical as they often coincide with high open interest and concentrated risk premiums. The speaker draws parallels between the current market situation and past events, such as the period leading up to the COVID-19 pandemic in early 2020. The paragraph emphasizes the need for awareness of potential market risks during expiration periods, especially when dealer positioning is weak. It suggests that while the current rally may continue, it is ultimately a rally to be sold and a time for caution, given the market's disregard for potential risks and the upcoming change in flow dynamics.
Mindmap
Keywords
💡Opex update
💡FED
💡10-year yield
💡trimmed CBI
💡PCE deflator
💡real interest rates
💡Dixie
💡Commodities
💡Core CPI
💡margin compression
💡TINA effect
💡discount rate
Highlights
The market is currently ignoring the Federal Reserve's calls despite the mantra 'don't fight the FED'.
Former New York Fed chair, William Dudley, publicly called for significant interest rate increases ahead, along with other Fed Governors.
The 10-year yield sits at 2.8%, which is 22% below the current trimmed CBI and PCE deflator, suggesting a need for higher interest rates to combat inflation.
Interest rates need to be positive in real terms to effectively trim core inflation, indicating a potential increase of 3 to 5% from current levels.
Despite the Fed's statements, the market is not reflecting expectations of significant rate increases.
The bond market is reacting to the Fed's comments, with bonds selling off and yields rallying, indicating a shift in market sentiment.
China unexpectedly cut interest rates by 10 basis points, signaling potential increased stimulus in the coming months.
Commodity weakness contributed to a surprise drop in CPI from 9.1% to 88.5%, but core CPI and sticky CPI continue to rise.
Labor shortages persist, driving higher labor costs, contrary to some media narratives.
Strength in rents and broad housing continues, impacting inflation calculations and contributing to economic challenges.
The adage 'don't fight the FED' is crucial from a macro perspective, with long-term effects on equity markets including multiple contraction and margin compression.
The 'TINA' effect, or 'There Is No Alternative', has driven equity investment; however, rising interest rates may reverse this trend.
Volatility and risk premiums increase as interest rates rise, affecting market dynamics and investor strategies.
Higher discount rates can lead to creative destruction and liquidation of malinvestments, impacting long-term investment opportunities.
The Fed's intention to raise interest rates is aimed at curbing secular inflation and not just a short-term fix.
The market's reaction to macroeconomic factors and flows, particularly during periods of low liquidity, can lead to significant shifts in market trends.
Options expiration is a critical time for market movements, with September often being a period of increased stress following rallies.
Investors should be cautious during the upcoming period, particularly as dealer positioning is expected to weaken.
The potential for a market inflection point exists as we move from summer to fall, with historical parallels suggesting increased vigilance is warranted.
Despite the rally, it is important to be prepared for potential market corrections and to manage risk appropriately.
Transcripts
hi and welcome back to another episode
of our macro and flows
Opex update this one is for August um
here we are at the end of the summer of
George uh right at
expiration um and there's a couple of
mantras I think uh need to be really
thought about at this moment in
time you often hear don't fight the FED
right um but oddly the market is is
completely uh ignoring the fed's calls
the last several
weeks uh William Dudley ex New York fed
uh chair um came out very publicly two
three days ago um on the heels of lots
of other current uh fed Governors uh
calling
for significant more increases that lie
ahead um currently the 10-year uh yield
is sitting at about
2.8% um that is currently sitting about
22% below uh the current uh trimmed CBI
and trimmed pce deflator which is
running in the four to 6% range
depending on the
indicator um in order to truly uh trim
core inflation it's well documented that
that interest rates need to be positive
on in real terms um that would mean from
the current levels an increase of three
to
5% um that's a significant uh increase
from where we currently sit and not at
all what the markets are expecting
despite what the FED continues to say
that's very important um you are
starting to see the market reacting a
little bit to the fed's comments uh not
the equity Market but you know Dixie is
is really picking up off its lows
rallying back towards the highs uh the
tenure is bottoming and and is off uh
you the uh the yield is rallying um and
the bonds are selling off um in in in a
market way so it's something to be
thoughtful of in June when we did see
the bottom and the market in the
reversal really was pre-aged by a top in
both the Dixie and um uh 10-year yields
at the time something to be aware of uh
importantly uh it's gotten very little
press um oddly so in the last week but
China surprised inly uh cut interest
rates it was only 10 basis points but it
was something that was entirely
unexpected um and they have talked it's
a signal to the market they have talked
openly since then about increasing
stimulus in the months to come this has
helped support Commodities which have
been the one uh Silver Lining that has
really helped inflation if you look at
that surprise CPI of 88.5% the dropped
from 9.1 last month that was so much so
heralded and celebrated it was almost
exclusively driven by commodity weakness
core CPI CPI sticky CPI has continued to
work its way higher uh labor shortages
continue to drive higher labor costs um
this is not slowing despite what you
might hear in the media it's also we've
also seen significant increases in
strength uh continuing in rents um as
well as broad housing um which is a
major part of the calculation about
oneir so don't fight the FED um from a
macro perspective it's very important to
to keep that in context if inflation
continues to be secular like we believe
and we've talked about in our quarterly
newsletter that hopefully you've all
been able to take a look at um that has
major major effects long term on Equity
markets like to reiterate those one
multiple contraction there's just less
dollars uh in demand for investment uh
there's so much much leverage that goes
to stocks and to investors uh via lower
interest rates when that is removed that
creates less demand and multiples um
come down in the equity Market uh two
margin compression there's tramatic
effects from low interest rates we have
increased globalization we have lower
cost structure uh for Capital um in the
market um not to mention uh you know uh
increases in technological innovation
because we can companies can go out the
the growth curve to to longer duration
Investments um that the removal of that
creates margin compression we are at
historic margins we are at historic
price to sales um we are at historic
leverage all of these things will
reverse U if we continue to get secular
inflation um three uh reverse Tina
effect you know so much was talked about
with the Tina effect and what that did
to drive Equity investment over the last
20 to 30 years um there is no
alternative
Tina guess what rates go up uh you know
interest rates go up the bond market
starts to compete away demand from the
equity market so it's not just about
broad demand for markets and assets that
we're seeing and the reduction in that
from um from increasing interest rates
but it's also just a simple pulling away
from equities to bonds that happens with
higher interest rates for volatility and
risk premum uh increases uh when you
have lower rates due to cap structur
Arbitrage and there's essentially a put
that's freely uh provided in a business
the value of uh you know risk premate
gets compressed this is a natural
reaction and it's structural in the
market volatility and risk premiums
increase as interest rates go up um this
creates uh more risk in the market and
hence reprices uh risk adjusted returns
and lastly what most people think about
the discount rate um if you uh if you
increase the discount rate that kills
investment opportunities for the future
but importantly it also after a long
time of low interest rates can create a
massive creative destruction and
liquidation of Mal investment um we have
uh there's been a lot more talk about
this lately but massive increase in
interest rates after significant decline
particularly long-term interest rates um
is likely to lead to a complete
liquidation of things that were invested
at too low uh long-term terminal um uh
return so these are all very dangerous
things long term again the FED is
telling you they're going to raise
interest rates uh not just because in
the short term but because they need to
get long-term interest rates um a bit
higher in order to slow their cular
climb um this is uh you know a long-term
issue it is not necessarily predictive
week to week month to month but it's
important to understand that in the
context of what is happening in this
counter Trend
rally now let's talk about flows you
know there's a new mantra here that to
to be thoughtful of uh the words never
short adult Market it's a well-known
Wall Street adage why why do people say
that why are slow markets generally
positive markets um for the same reason
seasonality is very strong during
periods of of low volume um when there's
low liquidity in the market you know on
average about uh 70 billion determines
which is a very low number if you think
about it given that it's a $50 trillion
domestic Equity Market but on average
775 billion is what determines the daily
incremental flows that move the market
uh that's about 0.15 of uh percent of
the actual underlying Market which is
kind of mind-blowing when you when you
think about it um but in the context of
the summer we're talking about more like
45 to 50 billion so significantly
smaller amount in that context V tends
to be lower in the summer because
there's just less activity which leads
to vanana and charm flows which I've
spoken so much about those V and charm
flows which can be anywhere from 5 to 15
billion tend to be on the higher side
when V is compressing during times of
low um lower volumes and that's going up
against a a a 45 to 50 billion total
liquidity so a much slower amount that
is a much bigger effect when these
things get going you have increased
momentum factors like CTA flows which
have been about 7 a half billion VA
targeting and risk parity and Trend
falling flows that kick in as well which
have been also six to8 billion depending
on on the
period and of course um you know short
covering we've had significant short
interest historic to some levels um that
were built up due to these macro risk
that people broadly understand um to be
clear the other times is the short
interest has has grown to these levels
that have been actually significantly uh
dangerous times and and generally
secular downtrends it's a big reason why
we get major counter Trend rallies um
you know during the 2000 Tech Bubble
Burst we had five rallies of greater
than 20% hard to believe right but
that's what happens this is fairly in
context of of what secular downtrends
look like so we're talking about $ 22530
billion of daily flows in a very low
liquidity $45 billion incremental flow
so very uh once they get going very hard
to stop um generally they find their
Terminus when two things happen one when
implied volatility bottoms when it gets
so low based on a slide up the curve in
the market Mark ring invol compression
happening that it simply can't go much
lower this dramatically reduces those
Vana flows that we've talked about and
stops these cyclical trend of momentum
trades when that happens it often marks
the top uh and end to these to these uh
cyclical flows because a lot of these
momentum flows can then turn the other
ways if ball starts increasing into a
decline uh you can get the reversal of
the all targeting flows risk parity
flows Trend following can turn the other
way CTA flows will turn and the Von and
charm flows that we talk so much about
will also turn so um short covering uh
generally can push these things for a
while but eventually that will fade as
well add to that uh a couple of other
important uh things that have happened
in the flows world one uh BuyBacks have
been quite strong record in fact and
they've been they're being encouraged by
uh this year even more by the fact that
a a new tax um on them of 1% uh will
take effect next January 1st but those
will likely uh decline early next year
something to be thoughtful of uh for
several reasons not just because of the
tax but also because of the increasing
interest rates and the decreasing
liquidity for corporations and
importantly here's September 1st uh
quantitative tightening which has been
very slow to get started um it was uh
scheduled at 47 A5 billion per month
which is about
2.4 uh billion dollars a day is now
going to double to uh negative flows of
closer to 4.7 at 90 um 95 billion per
month um that reduction will have
significant negative flows all in the
context now of those positive flows um
that would normally come also going up
against increasing liquidity as we
approach uh Labor Day uh and people be
come back from their summer vacations
both in Europe and here uh domestically
in volumes increase as well so this
expiration is an important inflection
point for many of those reasons again V
is bottoming as we hit hit this
1920 uh VA level uh people are willing
to step in and and buy it at these low
levels um and and we are starting to
reverse some of these other
factors let's talk about the options
expiration
very important um as well and I think
this is maybe the third uh kind of
tenant that that people need to to
really consider here as we enter um end
the summer leave the summer of George
and enter the fall quarterly
expirations um are generally uh the most
bid uh expirations where the most open
interest and where risk premum is is
most concentrated because of this um
dealers and entities who sell s ball are
generally short these Structured
Products and things and and options that
are are the highest out there um this is
true for March expiration June September
and December that said June and December
both fall in low liquidity periods like
we've talked about periods of much less
uh supply and demand and much lower
incremental flows uh given positive
structural flows um you know a a period
of General calm uh and stability March
and September however come after uh
broadly uh periods with higher liquidity
a um and more volume but also periods uh
where where more stress is likely to
come after some bullish periods um so we
have historically seen many uh Cycles U
corly OPC Cycles uh which we are
entering one right now for September
where we've seen significant stress um
in those periods um it in the context of
of the rally and the size of rally we've
seen the floor of the vix that we've
seen uh the macro landscape that that we
just talked about with the FED trying to
force a repricing of risk it's important
to note that uh dealer positioning is
about to turn very very weak as well a
historic analogy of this not to strike
fear in everybody's Hearts but one to
understand that's fairly recent is
February to March of
2020 yes uh we had a big rally similar
to what we are seeing now uh vix hit a
floor uh and really ball started going
higher much like we've seen more
recently um going into February
expiration and there was a macro uh
Force at work which was obviously Co
covid we knew about that for a year not
a year a month sorry a month and a half
going into that period this was not new
news um however the market ignored those
macro uh news much like it's ignoring
kind of the fed and the inflation issues
that we're seeing now um What it Took
was rolling over past that that February
expiration the day after February
expiration entering that March quarterly
cycle was the beginning of the decline
and not surprisingly again we've talked
about this that decline found its
Terminus at the day after March
expiration when all of that dealer
positioning which was massively uh short
and CA
significant stress it was a Tinder Box
to the spark of covid um really bottom
there um at the day after March
expiration these are not coincidences
we've seen many uh things like this as
well now to be clear this does not mean
a crash is coming this does not mean
that uh we are going to repeat um Feb
into March of 2020 um but it does mean
that we should be aware of the fatter
taale that exists in this window we
should be thoughtful particularly in the
next several weeks of of these risks
that uh people have been ignoring and
the market has been broadly ignoring in
the short term uh and we should be uh
watchful for a tale that could
potentially arise during this period if
we are able to get at through this cycle
um in in the early late August uh into
early September um and really get
through uh this this weak dealer
positioning period uh there's reason uh
to believe that that we can chop around
and even maybe uh make some new uh
counter Trend highs here um we believe
however that this is ultimately a rally
to be sold and a a rally looking uh for
an excuse um and a time to be very very
cautious um given the size and scale of
where we've gone the vix bottoming and
the flows uh likely turning here in the
month to come as always uh we we ask
that you uh you know don't be
dogmatic and wish that you be water
until next time thanks for joining for
the macro and flows August
update this does not constitute an offer
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