Macro and Flows Update: October 2022 - e10
Summary
TLDRThe 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.
Outlines
📈 Market Analysis and Fed Policy
The paragraph discusses the current market situation, emphasizing the interesting and tumultuous times due to structural changes. It highlights the Federal Reserve's (Fed) communication challenges regarding potential pauses in policy to avoid market overreaction. The speaker notes the significant event risk in the options market related to the S&P index and other equity indexes around the November Fed meeting and the midterm elections. The paragraph also touches on the market's positive reaction to past events that did not realize worst-case scenarios and the importance of seasonality in market flows, particularly the short interest and bearish sentiment currently affecting the market.
📉 Risks and Market Structure
This paragraph focuses on the dangers of shorting in the current market climate and the structural problems in the market, such as the removal of demand due to higher long-term interest rates and persistent inflation. The speaker mentions the thinning liquidity in key market places like the S&P 500 options and ES futures, which is a long-term warning sign. The paragraph also discusses the underperformance of long volatility (longV) and the gradual capitulation in the longV community, signaling potential market changes. The speaker advises increasing allocations to longV convex products as the year ends and warns of the potential for a painful second leg down in the market, leading to higher volatility and instability.
🌐 Global Macro Trends and Geopolitical Risks
The paragraph addresses ongoing global macro trends, including inflation and its impact on market valuations. It discusses the role of the Strategic Petroleum Reserve (SPR) in mitigating commodity inflation and the recent announcement of buying back SPR stocks at higher prices. The speaker warns of the Fed potentially losing control of the long end of the yield curve, which could signal more inflation and market volatility. The paragraph also highlights geopolitical risks involving Russia and China, including Russia's accusations against the US and the potential for China to take retaliatory actions after the midterms, such as limiting rare earth exports or even an invasion of Taiwan.
📊 Investment Strategies and Tail Risks
In this final paragraph, the speaker provides investment strategy advice, emphasizing the importance of being mindful of the market's structural issues and the potential for increased volatility. The speaker suggests looking for asymmetrical ways to bet on the downside and taking advantage of market underhedging. They recommend being long on long-dated calls for a possible counter-trend move and considering long-tail convexity for Q1. The speaker also warns of tail risks in the market, such as geopolitical tensions involving Russia and China, and advises investors to be prepared for potential market shocks. The paragraph concludes with a disclaimer that the content does not constitute investment advice and that investors should consult with their advisors before making any investment decisions.
Mindmap
Keywords
💡Macro
💡Flows
💡Options Markets
💡Seasonality
💡Short Interest
💡Long-Term Interest Rates
💡Inflation
💡Market Liquidity
💡Long-Vol
💡Short Squeeze
💡Geopolitical Tensions
Highlights
The Federal Reserve is considering pausing their policy changes to assess the impact of their actions.
Markets rallied 2.5 to 3% upon rumors of the Fed's potential policy pause.
There is a significant event risk in the options market related to the November Fed meeting and the midterm elections.
The market is expecting a positive reaction following the midterms and the Fed Meeting, similar to past events that did not realize worst-case scenarios.
Seasonality effects in the market are driven by factors such as holidays, shortened trading time, and window dressing.
Short interest and bearish sentiment are high, which could lead to a strong market rally.
Liquidity in the ES futures and S&P 500 options has thinned, raising long-term concerns.
Speculation in short-dated options with zero days to expiration is increasing, potentially leading to negative effects on the market.
Long-volatility (long-V) strategies have been underperforming, signaling a potential shift in the market.
Q1 is expected to be a 3 to n month window for a potential market squeeze.
The long end of the yield curve is increasing, indicating potential inflationary pressures and a loss of control by the Fed.
The US strategic petroleum reserve (SPR) has helped stabilize oil prices despite various supply disruptions.
The government plans to buy back for the SPR at $70 per barrel, effectively putting a put on commodities.
Geopolitical tensions between the US and Russia, and the US and China, present significant risks to the market.
The passage of the CHIPS Act by the US is seen as a provocative move against China, potentially leading to retaliatory actions.
An invasion of Taiwan by China is considered increasingly likely by US officials and experts.
Investors should consider increasing allocations to long-volatility convex products as we approach the end of the year.
Multi-strategy products continue to generate non-correlated yield, serving as a diversified approach in the current market environment.
Transcripts
hello and welcome back to our monthly
macro and flows of update
video may we live in interesting times
is uh an old Irish
saying well um these are definitely
interesting times this is a pivotal um
point and and what has been a uh a very
tumultuous year obviously um
structurally from a flows basis um we're
at the end of October
Opex um we have just received news this
morning uh via Nick timos the the FED uh
whisper uh in the Wall Street Journal
that the FED is now thinking about
thinking about pausing uh they're
struggling as they've said to
communicate this without driving markets
dramatically higher uh that is something
that they don't want so that's important
to note but they are uh wanting to stop
and see the effects uh that their policy
changes are having given that they have
a major lag and that's what they're
trying to communicate to the markets so
they've started to talk about talking
about it it's coming and that the market
sniffed that out and that led to a 2 and
a half to 3% rally uh today depending on
whether you're looking off the lows of
the overnight session or not importantly
I think I laid this out a couple times
before but I think the most important
thing laying in front of us flows wise
is the significant event ball that we're
seeing in options markets in the S&P
index as well as other uh Equity indexes
here
domestically um for the November 2nd fed
meeting uh through so uh uh through the
November uh 11th uh expirations and
that's primarily for the midterms and
the FED Meeting those uh significant
elevated BS uh show the amount of demand
that is being driven into those products
for Hedges uh during those times that
dramatic um event B we've seen it other
times now this is not as uh as large as
we saw
during uh brexit for example or the 2016
Trump election or the 2020 uh contested
election all of which were kind of worst
case scenarios as far as the market was
expecting for outcomes yet were all all
were significantly positive uh events uh
in the market post uh the occurrence of
the event and why is that because this
this event VA ultimately drives the vaa
flows when that V compresses um and the
event uh no matter how bad it is doesn't
realize the worst case scenario which is
again a high bar in that scenario so
positive flows coming off of these
events is highly likely as we've seen
before uh that sits out there not that
far away two to 3 weeks um out from
where we are
today um given the amount of short
interest out there uh and bearish
sentiment uh given the importance of uh
seasonality now again seasonality when
we talk about it is not this magical
construct of just the calendar days it's
a function of more holidays shortened
time uh sped up uh shorter volume
weighted time so there's less volume
because people are are not as much or on
holiday or taking breaks this increases
the Decay uh and the compression of all
during these periods which drives these
VF flows there's also window dressing
and a chase that happens due to a need
to catch up or or not underperform into
the end of the year these seasonality
effects these are the real effects that
drive uh the seasonality at the end of
the year and into early
January as well um are um are very real
and uh will have we believe again a
significant effect given particularly
that we have this event fall that's
likely to be the spark that drives that
initial um uh push here so a late uh
latee rally um something that could be
much stronger even than some of the
counter Trend rallies we've already seen
it's already seems to have
started here a bit of a front running um
of what people are seeing there we're
not the only ones who see this and
understand this at this point
um so we're beginning to see these
actions and being short into this type
of a uh you know a secular move is very
very dangerous at this point all of that
being said you know these are the flows
um over arching against these flows are
significant as we've talked about in
great detail fundamental structural
problems for markets uh the removal of
demand uh from markets broadly from
significantly higher long-term interest
rates uh that inflationary push which
has uh been been uh structurally
stickier and stickier than people ever
expected other than ourselves obviously
um uh you know and and the long-term
effects that they have are very real and
will continue to weigh on these markets
over time but in the short term um you
know there is a there's a good chance
that that this Market will first work
its way higher before those structural
effects will re re enter and dominate so
um now important to note from a bears
flow perspective uh that that top of the
book liquidity and the es Futures and
the S&P 500 options the two Bastion of
liquidity the two places the world comes
to hedge and and uh and actively manage
portfolios um has become thinner than
we've ever seen it so top of the book in
the es is thinner than ever and depth of
Market on the option side has
significantly thinned as well to below
the fifth percentile historically this
is a big long-term warning sign when the
places of the greatest liquidity have
fitting and less liquidity uh
particularly when there's lots of other
places in the world that are incredibly
vola and have been throughout the year
and this has been the 10,000 PB these
places have been the 10,000 PB gorillas
that have made maintain the stability um
and lowered the realized volatility
Market that this is reason for
significant long-term concerned there's
dramatically more speculation and zero
days to expiration options which are
driving short gamma among dealers that's
part of what's driving this lack uh
lowering liquidity and that speculation
can ultimately have delerious effects um
on on uh underlying markets in a
significant way if it starts to continue
continue to um roll out of control so
take those uh take those facts and and
pair with it the fact that as we
mentioned uh longv has been dramatically
underperforming and is leading to as
we've called for for several months the
gradual uh capitulation in the longva uh
Community uh one big manager emis uh has
has publicly come out and said they are
closing down and shutting down their
funds um that is another sign on on the
highway on the road to uh capitulation
um and it's something to take uh very
seriously these are the types of signs
and things we see as the pendulum swings
to uh complacency um on hedging the tail
all that is left is really to squeeze
the shorts um and to really uh get the
community uh on the on the stock side
broadly more positive and to create more
realized uh potential energy from a hot
markets being higher uh and and
significantly less hedged as we move
into um the coming uh coming months um
again we believe that q1 we've been
talking about this since June we said
likely to be a 3 to n month window we
said that in in late June uh again we've
entered that window we believe we are
getting to kind of the final stages here
in the next couple of months of some
type of uh squeeze that will ultimately
fail uh and proba fail in a much more
volatile fashion than we've seen um in
throughout the this this course of the
Year this second leg down which again
we've talked about in detail in our
newsletters and other other places is
likely to be much more painful and that
it will unpin um the volatility and
stability that we've seen from several
sources um like the S&P 500 options and
the es Futures so um something to be
very careful and mindful of our long
product has obviously done very well
this year particularly compared to other
longv entities it is an increasingly uh
good time uh as we get towards the end
of the year to increase allocations uh
to these longv convex
products uh longall hasn't had its day
yet uh although the market has had a bit
of a decline important to note uh long
Vol broadly and benchmarks have been
very very poor in the equity ball space
so you're actually buying low you're not
uh you know actually piling into this at
a poor time if you add um into a market
rally I think that's an important note
uh multi-strategy product continues to
generate non-correlated yield uh that is
uh been a diversified approach uh that
has broadly served us well uh due to
orthogonal exposures um and really
lowering volatility and increasing uh
returns um
uh lastly uh important to note that uh
those as I mentioned those macro flows
uh those macro effects of secular
inflation um continue to push along so
until those we can remedy those issues
um valuations are not nearly where they
need to be um based on the the demand
that is is coming off the
table um you this is particularly
important given How uh how much help
there has been for to counter this
inflation going into midterms is uh
cannot be uh overstated how much uh
draining the spr has helped with
commodity uh inflation during this time
uh despite OPEC plus reducing 2 million
barrels a day despite the nordstream
bombings despite crisis in Iran uh we
have seen prices of oil stabilize and
that really has been due to one major
source of additional Supply um uh you
know the spr release as well as uh
lockdowns in China so we have kind of a
a almost worst case demand situation uh
from the big second biggest economy in
the world the biggest uh driver um
historically uh of commodity consumption
and yet um here here we are um so the
government has recently come out and
announced that they will be buying back
for the spr at 70 tun dollars a barrel
uh they basically put a put on the
Commodities um which for certain stocks
which do incredibly well with oil
anywhere above $50 or
$60 um should be a major Tailwind um in
the face of uh you know headwinds to
other other stocks that that will be
hurt by by structurally higher commodity
costs um we believe next year that those
commodity costs will increase driving uh
you know additional inflationary
pressures
um across across the market um
ironically higher interest rates in the
long end of the curve which continues to
March dramatically higher um is
especially with the market now starting
to rally is a warning sign it is a
Divergence um given that the FED today
uh spoke about talking about talking
about pausing yet we saw 10year yields
still climb again that's something to
note and to be very very watchful of um
the FED is in the process of losing
control of the long end of the curve and
the more they do that the more
inflationary structurally it becomes
because that drives demand pulling being
pulled forward inventory builds
happening because it's better to buy
today than wait uh next year when it's 5
6 7 8 9 10% more expensive depending on
the inflation rate um also uh when when
real yields are negative you can Bor
borrow money and put in anything pinned
down that's going to appreciate more
than that and leverage it so we're those
things drive more structural inflation
so the long end of the curve going
higher something that the FED has tried
to manage and has been unsuccessful
doing so um is is an important warning
sign If the Fed is losing control at the
long end of the curve and their ability
to use narrative to uh convince the
market that it's transitory or other
things um that means there is broadly
more volatility coming and less demand
flowing to
stocks uh
lastly um from a from a macro
perspective um I'd be remiss if I didn't
mention the two elephants in the room
Russia and China um Russia has now in
local television stations begun to lay
the groundwork for blaming uh the US for
the explosion of a r a tactical nuke uh
that that might happen this is becoming
more and more vocal in the last several
weeks this is not um it sounds uh very
scary um this is this almost
unbelievable but these are real gray
rhinos out there these are no longer
black swans these are things that uh you
know Russia us intelligence is is
looking at and vocally talking about uh
and that is out in the open so these are
real risk that we need to be concerned
about uh with China uh we since we last
talked uh saw the passage of the chips
act U which is a a very blatant uh form
of aggression from the US against China
uh not you know probably necessary at
this point but um but definitely
provocative and not likely to lessen the
odds of uh Chinese actions that are
retaliatory those retaliatory actions
are likely to come after the midterms
because China does not want to affect
the outcome or create more bipartisan
outrage here in the US before the
election and that said um unequivocally
a retaliation of some kind is coming um
whether those are limiting um Rare Earth
exports uh or as far as uh you know the
again the elephant in the room which is
the invasion of Taiwan uh in the last
week we've had two warnings one from uh
Secretary of State Lincoln one from
Admiral gild the head of the Navy
um warning that an invasion of Taiwan is
increasingly likely in a much sooner
time frame than might be expected um
important to note I've had conversations
with others at firms such as paler and
others that would um would uh have have
a good view into into what's happening
in government government and all of them
seem to agree that this these uh these
possibilities of invasion are much uh
more not only likely but but likely
sooner Than People possibly imagine so
there are tail risks sitting out there
despite all these flows and the
structural um issues that we're seeing
in the short term the macro overhang
from inflation alone uh is very serious
and and uh we're likely to weigh on
these markets look for these divergences
as we've said um uh you know long-term
the trend medium-term the trend is still
um negative um and until we find
solutions to our inflationary problems
which only seem to be getting worse
until we seem to find solutions to the
the coming likely bifurcation between
China and the US um you know the trade
Remains the Same look for asymmetrical
uh ways to bet on the downside
increasingly that doesn't just mean uh
find ways to um to to get short into
rallies but also increasingly to take
advantage of convexity to the downside
given the under uh hedging that's
happening in the market um in the short
term uh the trade is be long long-dated
calls for what is likely a major counter
Trend move coming out of these events um
and then opportunistically as we get
into the end of the year um it is
important to start looking at that
longtail convexity for
q1 so until next time uh be water and
thank you for joining us once
again
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