Macro and Flows Update: April 2023 - e16
Summary
TLDRThe transcript discusses the current low volatility in the market, attributing it to the Federal Reserve's actions in selling out-of-the-money puts and the underinvestment in positioning. It highlights the lag in monetary policy effects due to the vast amount of long assets and liquidity removal, predicting a potential increase in volatility and market challenges ahead. The speaker suggests that the Fed's actions and the structural inflation may lead to stagflation or a mild recession, emphasizing the importance of focusing on secular trends rather than cyclical fluctuations.
Takeaways
- 📉 The VIX, a measure of market volatility, is reaching new lows due to the Federal Reserve selling out-of-the-money puts, which is a form of liquidity provision but not quantitative easing.
- 💹 The Fed's actions are aimed at preventing extreme negative outcomes rather than injecting massive liquidity into the system, which is still positive for the market.
- 🔄 There is a significant lag in the impact of monetary policy due to the vast amount of long assets held by institutions and individuals, which are mostly illiquid.
- 📉 The sell-off in the left tail of the distribution, coupled with short positioning and a narrative of a short-term market, contributes to the reduction in volatility.
- 💰 The interest rate increases by the Federal Reserve from 0 to 5% in the US have a lag effect, meaning the full impact on markets and the economy is yet to be felt.
- 📈 Despite record buyback levels in Q1, projections for Q2, Q3, and Q4 show a significant drop in demand, indicating a potential decrease in market support.
- 🌐 The structural problem of liquidity coming out of the system is causing a slow but impactful effect on the economy.
- 🔄 The Fed is likely to continue selling calls to reduce liquidity, as the inflationary pressures are still high in the short term.
- 📉 The current market backdrop suggests a potential for stagflation or a mild recession due to margin compression and increasing interest rates.
- 🔄 The structural secular inflation is the key issue for markets, and cyclical waves should be seen as opportunities to re-enter the long-term secular trend.
- 📈 A counter-trend move and time will eventually diminish the impact of short positions, leading to significant market moves when they do occur.
Q & A
Why is the VIX index reaching new lows as the Fed sells out-of-the-money puts?
-The VIX index is reaching new lows because the Federal Reserve is selling out-of-the-money puts, which is a form of liquidity provision. This action is not quantitative easing (QE) but helps to stop the far left tail of the distribution, dampening the downside risk without pushing massive liquidity into the system.
What is the difference between selling out-of-the-money puts and buying stocks with the Fed's intervention?
-Selling out-of-the-money puts is a strategy to provide liquidity and manage risk, whereas buying stocks directly with Fed intervention would involve the central bank taking a more active role in the market, which is not the case here. The Fed's current actions are aimed at controlling the risk distribution rather than injecting liquidity into the market through direct asset purchases.
How does the current positioning in the market contribute to the low volatility?
-The current positioning is broadly underinvested, and the narrative is short, which means there is less demand for puts and more demand for calls. This imbalance in the market contributes to the compression of volatility as investors are not heavily weighted towards bearish bets.
What is the impact of the overhanging secular problem of liquidity coming out of the system?
-The overhanging secular problem of liquidity coming out of the system means that interest rates have been increased from zero to 5% in the US by the Federal Reserve. This liquidity removal has a significant lag, and its effects have yet to fully impact the markets or the economy, leading to a slow and potentially more damaging adjustment over time.
How does the lag in monetary policy affect asset prices and the economy?
-The lag in monetary policy affects asset prices and the economy by creating a delay in the response of financial markets and economic indicators to changes in interest rates. This lag means that the full impact of rate increases is not immediately felt, leading to potential mispricing and imbalances that may only become apparent over time.
What is the expected change in corporate buybacks and how does it affect market demand?
-Corporate buybacks were near record levels in the first quarter, but there is a projected dramatic falloff in demand for buybacks in Q2, Q3, and Q4. This decrease in demand can contribute to a decline in market support and potentially lead to increased volatility and downward pressure on asset prices.
What is the potential outcome of the Fed's actions in reducing liquidity?
-The Fed's actions in reducing liquidity could lead to a continuation of low volatility in the short term. However, this may ultimately result in a bigger problem down the road as the lag effects of monetary policy adjustments work through the economy, potentially leading to overextension of quantitative tightening (QT) or other measures that could exacerbate inflation and economic challenges.
What are the factors contributing to a more inflationary backdrop than a month and a half ago?
-The factors contributing to a more inflationary backdrop include the Fed's previous activism, higher yields in the back of the curve, cheaper oil before OPC, and a stronger dollar. These factors, combined with speculative assets being higher, indicate a more inflationary environment than previously.
What is the worst-case scenario for the market according to the script?
-The worst-case scenario for the market is stagflation or a mild recession. This is due to structural secular inflation, which is not addressed by cyclical changes, and a potential market weakening due to earnings contraction without a significant demand compression.
How does the script suggest investors should approach the current market conditions?
-The script suggests that investors should be aware of the structural secular inflation and not just focus on cyclical realities. It advises looking for opportunities to get back into the secular trend, recognizing that the current market dynamics may be an opportunity to rebalance and prepare for the next leg of the decade-long move.
What are the dynamics that could lead to a market decline?
-The dynamics that could lead to a market decline include a counter trend move that diminishes the lag and liquidity coming out of the market, a rally that shakes the resolve of short positions, and the natural effect of time causing over leverage and selling of other income-generating risks. These factors can build up potential energy that, when released, results in major market moves.
Outlines
📉 Volatility and Market Dynamics
This paragraph discusses the low volatility in the market, often questioned as the VIX reaches new lows. It attributes this to the Federal Reserve's actions of selling out-of-the-money puts, which is a form of liquidity provision but not quantitative easing. The Fed is managing the left tail of the distribution, which is positive for the market. However, it contrasts this with the fact that positioning is underinvested and the narrative is short, which is typical when markets face secular headwinds. The speaker notes that despite the dampening effect on the downside distribution, there are very secularly negative realities slowly working through the system due to liquidity removal and increased interest rates.
💡 Fed's Policy Lag and Inflation Concerns
The paragraph delves into the lag in the effects of monetary policy due to the vast amount of long assets held by institutions and individuals. It discusses the various types of assets and their liquidity, highlighting the significant lag in sectors like private equity, venture capital, and real estate. The paragraph also touches on the impact of interest rate increases on buybacks, which have a lag due to corporate board approval processes. It suggests that the demand for buybacks will fall dramatically in the future quarters, leading to a push-pull dynamic that reduces volatility. The speaker anticipates that the Fed will continue to sell calls to reduce liquidity, as the full impact of policy has yet to hit the markets, and inflation is likely to remain high in the short term.
📈 Market Positioning and Structural Issues
This section examines the challenges faced by the Federal Reserve in managing the economy, particularly the tension between taking money away from investment and the resulting margin compression at the corporate earnings level. Despite this, it does not reduce demand, and the speaker argues that the focus should not be on the potential for recession but on the structural issues at hand. These include labor strength, inequality rebalancing, populism, deglobalization, and resource scarcity. The speaker suggests that the current market weakness could be an opportunity to re-enter the secular trend, which is expected to last for a decade, and advises looking out for signs of counter-trend moves and time diminishing short positions.
🌪️ Market Rally and Short Squeeze Dynamics
The paragraph discusses the dynamics of market rallies and short squeezes, explaining how markets often rally in anticipation of an upcoming downturn. It describes the psychological and technical factors that contribute to market movements, such as short squeezing, low implied volatility, and the realization of potential energy from a stretched market position. The speaker suggests that the market is at an inflection point with potential for significant upward movement followed by a decline. The paragraph also touches on the effects of time on short positions, noting that the longer a short position is held, the more difficult it becomes to maintain, leading to potential market moves when these positions are covered.
📝 Final Thoughts and Disclaimer
In the concluding paragraph, the speaker provides a final analysis of the market situation, emphasizing the importance of not focusing on the potential for recession but rather on the structural issues that are causing margin compression and resource scarcity. The speaker suggests that the market may experience a counter-trend rally with increased volatility, which could be an opportunity to build short positions. The paragraph ends with a disclaimer, stating that the content does not constitute an offer to sell or a solicitation to buy any security or service, and that the information provided should not be taken as investment advice. The speaker reminds viewers to consult with their business, legal, or tax advisors for personalized advice.
Mindmap
Keywords
💡Volatility
💡Federal Reserve
💡Liquidity
💡Positioning
💡Secular
💡Inflation
💡Buybacks
💡Margin Compression
💡Stagflation
💡Recession
💡Counter-Trend Moves
💡Opex
Highlights
VIX reaching new lows as markets approach expiration, reflecting a dampened part of the distribution on the downside.
The Federal Reserve selling out-of-the-money puts is a form of liquidity provision, but not the same as quantitative easing.
Market positioning is underinvested, and the narrative is short, which is typical when there is a secular headwind to markets.
There's a significant lag in the effect of liquidity removal from the system due to interest rate increases.
The equity markets have seen a primary driver of demand in the form of buybacks, which also operate with a lag.
Expectations for a dramatic falloff in demand for buybacks in Q2, Q3, and Q4, indicating a potential shift in market dynamics.
The push and pull dynamic of put sale and systemic realities that are secularly bad are reducing volatility.
Inflation is likely to remain high in the short term, and the Fed may overextend its quantitative tightening due to this.
The structural secular inflation problem puts the Fed in a difficult position, as it may lead to stagflation or a mild recession.
The current economic scenario suggests a market weakening due to earnings contraction rather than a full-blown recession.
Fiscal policy, a strong labor market, and the reopening in China are factors that drive demand and contribute to an inflationary margin compression story.
The challenge for the Fed is to manage margin compression and corporate earnings issues without leading to stagflation.
The market may weaken due to short-term cyclical effects, but the primary driver is margin compression and resource scarcity.
The potential for a market decline is seen as an opportunity to rebalance and prepare for the next leg of the secular trend.
Markets often rally before a decline as people foresee what is coming and position themselves accordingly.
Short positions naturally lose money over time, and conviction is lost, leading to a dramatic market move once they do happen.
The current market situation is at an inflection point with potential for real energy to push higher and then potentially lower.
Transcripts
hello and welcome back to another
episode of the macro and flows update
here from Kai
volatility why is V so low I keep
getting that question right why is the
vix getting to new lows as we approach
expiration the FED just sold way out of
the money puts by backing
depositors this is not QE as some have
mentioned it is a form of liquidity but
there is a big difference between
selling out of the money puts and buying
stock with the fed is doing is back
stopping the far far left tail of the
distribution they are not pushing
massive liquidity into the system that
said that is still obviously dampening a
part of the distribution onto the
downside which is ultimately positive
you take that paired with the fact that
positioning is still broadly
underinvested and narrative is short
which tends to be the case whenever
there is a SE secular headwind to
markets markets are relatively efficient
they're forward
looking now you pair that also with the
fact that there is an
overhanging
secular problem which is liquidity is
coming out of the system the interest
rates have been brought from zero to 5%
here in the US by the Federal
Reserve there's a massive lag to that
liquidity removal um and that lag means
a lot of that policy has yet to hit the
markets or the economy so you have short
positioning the put being sold on the
left tail while the actual realities
which are very very secularly bad are
still slowly working through the system
this is the backdrop that we sit in why
is there such a lag how big is the lag
to uh monetary
policy for one you've heard me talk
about this before but there's about 400
to $450 trillion of long assets
institutions individuals we all hold
assets um what do they look like about
40 to 50 trillion is US domestic
equities about 40 to 50 trillion is
global equities outside the US so call
it 100 trillion but there's another
350 trillion dollars of other assets and
almost all of those are much less
liquid uh with with a significant lag
think private Equity Venture Capital
real estate right all of these operate
with a dramatic lag and as they rate to
lower prices at a much slower rate they
ultimately reduce collateral and
leverage and liquidity for the rest of
the market so there's that not to
mention in the equity markets themselves
a primary driver of demand has been
buyback
BuyBacks themselves operate with a
dramatic lag because they have to pass
through corporate boards right for
approval um ultimately we can see that
in the first quarter BuyBacks were still
near record levels equivalent to what
we've seen in the last year but if you
look forward to projections for Q2 Q3 Q4
there is a cliff a dramatic falloff of
demand in these BuyBacks so these are
great examples to how the lags prac
practically work through the economy of
interest rate
increases um and again in the meantime
the positioning for it does not wait for
that lag it is bearish and reflexively
causes counter Trend moves add to that
again they the put sale and you have a
push and pull Dynamic that is
dramatically reducing volatility the FED
is going to be forced back in to
continue to sell calls to continue to
reduce liquid liquidity because it is
not hitting the market yet and inflation
is likely to still be hot in the short
term while selling puts on the downside
so this selling of all ultimately has
compressed V the pressures at this point
in time um are Vol compressing but this
will ultimately only lead to a much
bigger problem down the road as that lag
Works through and likely the FED
overextends um its QT or the removal of
liquidity from other means as inflation
continues to run
hot if you think about a month and a
half ago the Fed was out here talking
down you know talking up interest rates
talking down uh uh rates uh talking up
yields um while we had
significantly higher yields in the back
of the curve we had cheaper oil right at
before OPC came in and underpinned oil
we had a significantly stronger dollar
right which is very important not to
mention markets are right back where
they were with speculative assets
significantly higher so a wealth effect
that is net inflationary to uh to
individuals as well so we start looking
at all of these factors and there's a
much more inflationary backdrop than
there was a month and a half ago when
when the Fed was much more activist
so I think we can expect the FED to
continue to step into the fry to try and
front run what is um you know a
structural inflationary um
concern so the FED will keep selling
these calls um we believe and again we
mentioned this about two weeks ago a
month and a half ago we continue to see
people like Weller Weller coming out and
and talking this up um you know whether
it's through the Wall Street Journal and
Nick timos or publicly
otherwise ultimately this difference in
timing of the different components of
monetary policy an economic policy um
are likely not to change this real story
which is a structural secular inflation
that puts the FED in a box people keep
talking about the
cyclical uh realities oh we're going
into recession that recession will mean
lower rates um so you know go out there
and and uh you know buy
bonds um you know that that is the the
the general kind of um the general view
right now the reality however is we
believe the worst case scenario um is a
stagflation or even mild recession why
is that the worst case scenario uh for
Market as opposed to a deep recession or
something much worse on the growth side
um one um there's a very likely scenario
we believe um of a market weakening due
to earnings contraction while GDP itself
continues to be strong margin
compression as we're seeing this earning
cycle is the primary problem in an
increasing interest rate environment
labor costs de globalization the higher
cost to fund projects are all
significantly margin compressing they
are not necessarily demand compressing
actually quite the contrary all the
fiscal policy not to mention strong
labor market drives relatively strong
demand add to that the reopening in
China right uh something that we've been
talking about for some time again this
weer dollar and you have some real
inflationary margin
compression story that can really hurt
earnings and hurt markets without
actually pushing us into a full-blown
recession that can continue to keep
inflation
sticky and not allow the FED to come
back into the fry to decrease interest
rates into a market
decline even worse than this is what it
could do is cause going into a new
election Seas season a
stagnation that will still give
politicians the excuse to do more fiscal
policy to do things that are politically
popular while the FED is still unable to
act because inflation itself is still
relatively high this combination of
factors has a name something we've
talked about for years which is
stagflation and stagflation itself is
the core problem to markets it is not a
two-dimensional game any more where a
cyclical downturn or a recession means
deflation or that a cyclical upturn
means inflation the bigger issue is that
there is a structural secular inflation
and yes we will have cyclical waves
along the way but ultimately the trend
is structurally higher for reasons
outside of the cyclical supply and
demand dynamics that is the important
takeaway and the more we end up in the
middle scenario the harder it is for the
FED ultimately the FED is taking money
away from planet paloalto they are
taking interest rates up they are taking
money away from companies away from
capital and
investment and ultimately that is going
to drive margin compression
that is going to drive issues at the
corporate earnings
level um but what that does not do is
reduce demand and ultimately even in the
short term if that creates small
cyclical effects on demand that is not
the primary driver ultimately the margin
compression the labor strength the
inequality rebalancing the populism the
uh deglobalization that that drives the
resource scarcity that that drives lives
are ultimately the issues at hand so
let's keep an eye on that not on whether
a recession is coming or not because
ultimately that is the important piece
as part of that it's important to note
that this might be the the cyclical
opportunity to dive back into the
secular
Trend a lot of people a lot of
institutions in the last 3 to six months
have begun to pile into this uh you know
shorting duration getting longer kind of
inflationary Hedges trade and it has
gotten unbalanced right during secular
trends like we saw the other way for 40
years you have many cyclical moves where
narrative changes and position changes
but those have to be seen as an
opportunity to get back into the next
leg of what is a much more decade long
secular
move and structural changes that is how
we see this potential period uh that is
coming we do believe that there could
very well be an equivalent liquidation
to value and commodities into the coming
decline once it comes but we want to be
clear that that is an immense
opportunity to really get back into
those names and those things that will
continue to work for the decade to
come how will this
happen how will this play out so this
very kind of structural secularly
bearish view um to to equities uh but
yet resilient economy
view how will this come to play in
markets generally it happens by
squeezing the positioning that is
foreseeing what is coming think about
1999 leading into 2000 for those that
were around think about 07 leading into
08 even think on a smaller scale of
2020 early January late December when
people were talking about covid but it
had yet to happen we had a month and a
half to two month rally in markets
before the decline came 07 not too
dissimilar longer period 99 into 2000
blowoff top these are all similar
Dynamics why do markets and this way
often the realities of lags of the way
these a lot of these things work mean
that people see things coming and react
quickly knowing that it's likely to be
coming that positioning counteracts
reflexively the secular realities of a
secular
outcome you have to shake the resolve
markets have to shake the resolve of the
shorts that see that secular outcome
coming that resolve has to be covered
whether it's a story narrative whether
it's just simple stop losses um it has
to be diminished before a decline can
actually occur there are really three
effects that ultimately drive this one
as I that simple short squeezing is one
two as markets go higher eventually
based on the option volatility smile
markets slide to a very low implied
volatility and pinning of all supply of
all which is usually very very strong um
towards the end of a cycle gets unpinned
as we slide to lower and lower vs and
buyers implied volatility at these lower
levels come in to rebalance and underpin
a low um and and Supply remove Supply
from the V markets lastly there is a
realized potential energy of a rubber
band stretching and the market going
higher and higher which ultimately leads
to a much further distance for a bigger
realized move these three effects are
one of the main reasons that this is the
way that markets
eventually fall um is is through a rally
ironically at the end if that is not the
way it happens there is one other way to
structurally diminish short
exposure time time itself will
eventually cause over leverage to
selling other income generating risk um
you know risk Premia uh selling modes
those will increase the potential energy
and potential risk um in a system on top
of that shorts are naturally um lose
money over time during the time due to
the time value of money due to um other
kind of earnings Etc so there is a
natural effect where the longer short
stay in the more difficult it is and
conviction is lost over time this is the
reason why often things take longer to
uh per you know to to happen than most
would ever expect but once they do
happen they happen very dramatically
with major uh moves happening all at
once these two dynamics of move in
counter price and taking of time are the
things that
diminish that ability to short market so
these are the two things that I would be
looking looking for we are looking for a
function of counter Trend move and time
to diminish what is a lag and liquidity
coming out of the market um and an
eventual secular reality of what that
means for markets as we sit here at Opex
um sitting squeezing near the recent
highs um we would expect again after a
week of shorter Vana charm flows right
we have a a little window of weakness
that we expect assuming there is not a
meaningful breakdown in the next four to
5 days for this rally to continue into
May Opex again brief
decline as long as it doesn't
materialize to something bigger
relatively shortly we would expect a
counter Trend squeeze uh back to New
highs with this time around V support We
Believe ball itself could very well come
up um if that were to
happen um we would generally expect uh
the FED to continue to try and fight
this the interest rates to continue to
be raised um and eventually that squeeze
to give away um somewhat more
dramatically either at May
Opex or if it doesn't time again if we
don't get that call Squeeze time it will
likely take um to for for shorts to be
diminished so again we're looking again
at that may Opex which we've talked
about for some time if in particular we
can get a big enough counter counter
Trend rally with market up V up which we
see is a higher likelihood than we've
seen in some time here um that would be
the sign uh to build shorts into this
market and particularly to look for
opportunities that we have not seen now
for a year and a half for more con
move again if we're unable to get that R
rubber band stretched instead we move
sideways there's continued V compression
um this will likely then push out longer
than that but again we'll talk in the
next month we'll see where things go
here in April but we sit at a very
interesting inflection moment with a
month of potential real uh real
potential energy uh to push higher and
then potentially V up and move lower um
will touch base next month as always
thank you for joining us for the macro
and flows update be
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