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.

Outlines

00:00

📈 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.

05:00

📉 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.

10:02

🌐 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.

15:04

📊 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.

Keywords

💡Macro

The term 'macro' in the context of the video refers to macroeconomic factors that influence the overall performance of economies and financial markets. It is a key concept as it sets the stage for understanding the broader economic environment within which financial decisions are made. The video discusses how macro factors like the Federal Reserve's policy, inflation, and geopolitical tensions between the US and China, impact market flows and investor sentiment.

💡Flows

In the financial context of the video, 'flows' refers to the movement of money in and out of various financial instruments or markets. It is central to the discussion as it helps explain market dynamics and potential investment opportunities. The video emphasizes the importance of understanding these flows, especially in relation to options markets and significant events like the FED meeting and the US midterm elections.

💡Options Markets

Options markets are financial marketplaces where options contracts are traded. An option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price before a certain date. In the video, options markets are discussed as a key indicator of market sentiment and potential for significant price movements, particularly in relation to upcoming events.

💡Seasonality

Seasonality refers to the pattern of behavior in financial markets that repeats on a regular basis over the course of a year, often related to holidays, fiscal year-ends, or other recurring events. In the video, seasonality is important as it influences market behavior, particularly in terms of trading volume and volatility. The speaker notes that seasonality effects can drive certain market flows, especially towards the end of the year.

💡Short Interest

Short interest refers to the total number of shares that have been sold short but have not yet been covered or closed out. In the context of the video, it is a measure of bearish sentiment in the market. High short interest can indicate that many investors expect the price of a security to decline, and it can play a role in potential market rallies or short squeezes.

💡Long-Term Interest Rates

Long-term interest rates are the rates charged on debt that has a maturity of more than one year. These rates are critical in the economy as they influence borrowing costs, investment decisions, and inflation expectations. In the video, the impact of higher long-term interest rates is discussed as a fundamental structural problem for markets, contributing to reduced demand and potential market volatility.

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. In the video, inflation is portrayed as a persistent and increasing challenge for the economy, affecting market valuations and investor strategies. The speaker discusses how inflationary pressures are becoming more ingrained and difficult to address.

💡Market Liquidity

Market liquidity refers to the ease with which assets can be bought or sold without affecting the asset's price. High liquidity is generally favorable as it allows for smooth trading and price discovery. In the context of the video, the thinning of liquidity in key markets like the S&P 500 options and the ES futures is seen as a warning sign, potentially leading to increased market volatility and difficulty in hedging.

💡Long-Vol

Long-vol, short for long volatility, is a strategy where an investor takes a position that will profit from an increase in the volatility of a particular market or asset. In the video, long-vol strategies are discussed as a way to benefit from market conditions where there is a significant amount of hedging and underperformance, leading to potential market rallies and increased realized volatility.

💡Short Squeeze

A short squeeze is a rapid increase in the price of a stock or other asset, typically one that has been heavily shorted, as short sellers scramble to cover their positions. In the video, the potential for a short squeeze is discussed as a market event that could lead to a significant rally and a shift in market sentiment.

💡Geopolitical Tensions

Geopolitical tensions refer to the strained relationships and conflicts between different countries or regions, often leading to instability and uncertainty in global markets. In the video, the tensions between the US and Russia, as well as the US and China, are highlighted as significant risks that could impact financial markets and investor decisions.

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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