Macro and Flows Update: August 2022 - e08

Summary

The 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

00:00

📉 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.

05:01

📈 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.

10:01

🔄 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.

15:04

📊 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.

Keywords

💡Opex update

The term 'Opex update' refers to an operational expense update, which is a report or discussion on the costs associated with running a business. In the context of the video, it likely refers to an analysis of financial markets and economic operations, as the transcript discusses various economic indicators and market trends.

💡FED

The 'FED' or Federal Reserve is the central banking system of the United States, responsible for implementing monetary policy and regulating the country's financial institutions. In the video, the FED's actions and communications are discussed in relation to their impact on market expectations and interest rates.

💡10-year yield

The '10-year yield' refers to the return on investment for a ten-year government bond. It is a key economic indicator that reflects investor sentiment about the health of the economy and expectations for future inflation. In the video, the 10-year yield is used to analyze the current economic climate and its deviation from the trimmed CBI and PCE deflator.

💡trimmed CBI

Trimmed CBI, or Core Consumer Inflation, is a measure of inflation that excludes certain items to provide a more stable and consistent measure of price changes over time. It is used to assess the underlying trend of inflation, excluding volatile items that can distort the picture.

💡PCE deflator

The PCE deflator, or Personal Consumption Expenditures price index, is an economic indicator that measures the change in prices of goods and services purchased by households. It is considered a more comprehensive measure of inflation than the CPI because it includes a broader range of consumption categories.

💡real interest rates

Real interest rates are the nominal interest rates adjusted for inflation, reflecting the true cost of borrowing after accounting for the decrease in purchasing power due to inflation. Positive real interest rates are often necessary to control inflation, as they ensure that the cost of borrowing is greater than the rate at which the value of money is decreasing.

💡Dixie

In the context of the video, 'Dixie' likely refers to an index or market indicator, possibly related to the Dow Jones Industrial Average, as it is often colloquially referred to as 'the Dow'. The term is used to discuss market trends and movements.

💡Commodities

Commodities are basic goods or raw materials that are used in commerce and can be traded on a commodities exchange. They often serve as inputs for other products and are subject to supply and demand dynamics. In the video, commodities are discussed in relation to their impact on inflation and the overall economy.

💡Core CPI

Core CPI, or Core Consumer Price Index, is a measure of inflation that excludes food and energy prices, which are considered volatile and can distort the true picture of price changes. It provides a more stable measure of underlying inflation trends.

💡margin compression

Margin compression refers to a reduction in the profit margins of companies, often due to changes in the economic environment or competitive pressures. In the context of the video, it is discussed as a consequence of higher interest rates and their impact on corporate profitability and stock market valuations.

💡TINA effect

The TINA (There Is No Alternative) effect refers to a situation in financial markets where investors, facing low or negative interest rates in traditional fixed-income investments like bonds, are compelled to invest in riskier assets such as equities in search of higher returns. This can lead to increased demand and higher valuations for stocks.

💡discount rate

The discount rate is the interest rate used to determine the present value of future cash flows. In the context of central banks, it refers to the rate at which they lend money to commercial banks. An increase in the discount rate can affect investment decisions, as it makes the cost of borrowing more expensive and future profits less valuable in present terms.

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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