Macro and Flows Update: October 2022 - e10

Summary

The video discusses the current macroeconomic situation and market flows, highlighting the Federal Reserve's consideration of pausing interest rate hikes and its impact on the market. It also emphasizes the significant event risk in the options market related to the upcoming midterm elections and the Fed meeting, suggesting potential market rallies. The script warns of structural issues in the market due to high long-term interest rates and inflation, and the thinning liquidity in key financial instruments. It advises increasing allocations to long volatility strategies and remaining cautious of potential geopolitical risks involving Russia and China.

Takeaways

• 📈 The Federal Reserve is considering pausing their policy changes to assess the impact, which is a significant shift in communication strategy.
• 📊 There is a significant event risk in the options markets related to the upcoming November Fed meeting and the midterm elections, indicating heightened demand for hedges.
• 🔄 Market volatility is expected to be driven by seasonal factors, such as holidays and end-of-year window dressing, potentially leading to a late-year rally.
• 📉 Despite short-term potential for market recovery, fundamental structural issues persist due to higher long-term interest rates and inflationary pressures.
• 🚨 Liquidity in key markets, such as S&P 500 options and ES futures, has thinned significantly, raising long-term concerns for market stability.
• 💸 The underperformance of long volatility (long-vol) strategies and the closing down of some funds indicate a shift towards a potential market capitulation.
• 📈 Q1 is anticipated to be a critical period for a potential market squeeze, which could be followed by a more volatile and painful market downturn.
• 🏦 The SPR's (Strategic Petroleum Reserve) impact on commodity inflation has been significant, but the government's recent announcement to buy back at higher prices might indicate future inflationary pressures.
• 🔝 The Fed's control over the long end of the yield curve is slipping, which could lead to more inflation and market volatility.
• ⚠️ Geopolitical risks from Russia and China are increasing, with potential scenarios such as a tactical nuke explosion and the invasion of Taiwan being considered as real possibilities.

Q & A

What does the phrase 'interesting times' refer to in the context of the video?

In the context of the video, 'interesting times' refers to a period of significant change, uncertainty, and potential challenges. It is used to describe the current economic and geopolitical landscape, which is marked by events such as the Federal Reserve's policy decisions, political developments, and market volatility.

What is the significance of the Federal Reserve's consideration to pause their policy actions?

The Federal Reserve's consideration to pause their policy actions is significant because it indicates a potential shift in the central bank's approach to managing inflation and economic growth. This pause is intended to assess the effects of previous policy changes, which could have a substantial impact on financial markets and the overall economy.

How do options markets reflect the upcoming events related to the S&P index and other equity indexes?

Options markets reflect the anticipation of significant events by showing an elevated demand for hedges during specific periods, such as the November 2nd Fed meeting and the November 11th expirations. This elevated demand, or 'event ball', indicates market participants' expectations of increased volatility and potential price swings associated with these events.

What is the impact of short interest and bearish sentiment on market flows?

High levels of short interest and bearish sentiment can lead to market flows that are heavily influenced by negative perceptions. This can result in a self-fulfilling cycle where negative sentiment drives down prices, leading to more short selling and further bearishness. However, significant events that do not realize the worst-case scenarios can lead to positive market flows post-event, as seen in past market occurrences.

Why is seasonality important in understanding market behavior?

Seasonality is important in understanding market behavior because it accounts for the predictable variations in market activity due to factors such as holidays, reduced trading volumes, and investor behavior at certain times of the year. These seasonal effects can drive market trends, particularly at the end of the year when investors may engage in window dressing or position adjustments to avoid underperformance.

What are the structural problems for markets mentioned in the video?

The structural problems for markets mentioned in the video include the removal of demand due to significantly higher long-term interest rates, an inflationary push that has been more persistent than expected, and the long-term effects these factors have on market stability and performance.

How has the liquidity in the ES Futures and S&P 500 options changed, and what does it signify?

The liquidity in the ES Futures and S&P 500 options has become thinner than ever, with the market depth significantly thinning to below the fifth percentile historically. This reduction in liquidity is a long-term warning sign, particularly in places that have been the most liquid, as it can lead to increased market volatility and potential instability if left unchecked.

What is the significance of the long-end of the yield curve and its relationship with the Federal Reserve's actions?

The long-end of the yield curve is significant because it reflects investors' expectations for inflation and economic growth in the future. If the Federal Reserve is losing control over the long-end of the curve, it suggests that the market is not convinced by the Fed's narrative or actions to manage inflation. This can lead to higher inflation expectations, increased market volatility, and a shift in investor behavior towards protecting against higher future interest rates or inflation.

What are the implications of the recent SPR (Strategic Petroleum Reserve) announcement for commodity prices and the market?

The recent announcement by the government to buy back for the SPR at $70 per barrel effectively puts a put option on commodities. This can be seen as a tailwind for certain stocks that perform well when oil prices are above $50 or $60. However, it also suggests that commodity costs are likely to increase next year, driving additional inflationary pressures across the market.

What are the 'two elephants in the room' mentioned in the video, and how do they pose risks to the market?

The 'two elephants in the room' refer to Russia and China. Russia has been vocal about blaming the US for a potential explosion of a tactical nuke, while tensions between the US and China have escalated due to the passage of the CHIPS Act. These geopolitical risks can lead to retaliatory actions from China, potentially affecting global markets and increasing uncertainty.

What is the recommended investment strategy for the short and medium term based on the video?

The recommended investment strategy for the short term is to be long on long-dated calls in anticipation of a major counter-trend move. For the medium term, the strategy should focus on asymmetrical ways to bet on the downside, taking advantage of convexity to the downside given the under-hedging happening in the market.