Macro and Flows Update: April 2023 - e16

Summary

The 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.