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.