Daily Brief For April 18, 2023

“Meaningful expectations of cuts in the months ahead.”


Bank of America Corporation (NYSE: BAC) sees allocations to equities versus bonds falling. That’s amid recession fears. Per EPB, “the cyclical economy has just started to shed jobs today, and leading indicators signal the recession is likely underway.”

“To get advanced warning of recessions, you must look at the construction and manufacturing sectors, even though these two sectors are only 13% of the labor market,” EPB adds, noting traditional indicators’ weakening predictability is not so great to ignore the insight. “It’s clear that the composition of traditional leading indicators remains appropriate, and thus, the current resounding recessionary signal should not be ignored.”

BAC strategist Michael Hartnett said, though, that this “consensus lust for recession” must soon be satisfied. Otherwise, the “pain trade” would be even higher yields and stocks; the S&P 500 (INDEX: SPX) is enjoying an accelerated rally which Jefferies Financial Group (NYSE: JEF) strategists think portends a period of flatness, now, over the coming weeks …

Graphic: Retrieved from Jefferies Financial Group (NYSE: JEF) via The Market Ear.

… and through options expiration (OpEx), typically a poor performance period for the SPX.

Graphic: Retrieved from Tier1Alpha. 

Beyond the uninspiring fundamentals, the positioning contexts are supportive. Recall our letters published earlier this year. If the market consolidated and failed to break substantially, then falling implied volatility (IVOL) and time passing would bolster markets and, potentially, help build a platform for a rally into mid-year. A check of fixed-strike and top-line measures of IVOL like the Cboe Volatility Index or VIX confirms options activities are keeping markets intact.

Graphic: Retrieved from Danny Kirsch of Piper Sandler (NYSE: PIPR). “SPX May $4,150.00 call volatility, the lack of realized volatility weighing on the market. Volatility low, not cheap.”

Beyond the rotation into shorter-dated options, just one of the factors exacerbating the decimation of longer-dated volatility, traders’ consensus is that markets won’t move a lot and/or they don’t need to hedge over longer time horizons; traders want punchier exposure to realized volatility (RVOL), and that they can get through shorter-dated options that have more gamma (i.e., exposure to changes in movement), not vega (i.e., exposure to changes in implied volatility).

Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via Bloomberg.

Consequently, counterparties may be less dangerous to accelerating movement in either direction; hence, the growing likelihood of a period of flatness.

Graphic: Retrieved from SpotGamma.

“Despite the collapse in the 1-month realized volatility, we suspect most vol control funds have scaled into using their longer-term realized vols, which by design, lead to less aggressive rebalancing flows,” Tier1Alpha says. “For example, the 3-month rVol, which is currently driving our model, was essentially unchanged yesterday, which means volatility targets were maintained, and very little additional rebalancing had to occur. So even with the decline in the 1-month vol, overall risk exposure remained the same.”

With IVOL at a lower bound, the bullish impacts yielded by its compressing have largely played out. There may be more to be gained by movements higher in IVOL, in addition to the expiry of many call options this OpEx. By owning protection, particularly far from current prices, you are positioned to monetize on the market downside and non-linear repricings of volatility, as this letter has discussed in recent history. The caveat is that volatility can cluster and revert for longer; hence, your structure matters.

“I am concerned that VIX is underpricing the series of events that we know to expect over the coming weeks,” says Interactive Brokers Group Inc’s (NASDAQ: IBKR) Steve Sosnick. “While there is now an 88% implied likelihood of a 25 basis point hike, the likely path of any potential future hikes and assumed cuts should be more clarified at the meeting and in its aftermath.  And oh, has anyone ever heard the expression “sell in May and go away?”

Graphic: Retrieved from Interactive Brokers Group Inc (NASDAQ: IBKR).

With call skews far up meaningfully steep in some products, still-present low- and zero-cost call structures this letter has talked about in the past remain attractive. If the market falls apart, your costs are low, and losses are minimal. If markets move higher into a “more combustible” position, wherein “volatility is sticky into a rally,” you may monetize your call structures and roll some of those profits into bear put spreads (i.e., buy put and sell another at a lower strike). An alternative option is neutral. Own something such as a T-bill or box spread (i.e., buy call and sell put at one strike and sell call and buy put at another higher strike). Some boxes are yielding upwards of 5.4% as of yesterday’s close.

To end, though the short-dated options activity may prompt cascading events in market downturns, the main issue is the reduced use of longer-dated options; a supply and demand imbalance likely resolves itself with an implied volatility repricing of a great size where longer-dated options outperform those that are shorter-dated.

Our locking in of rates or using the profits of call structures to position for a potential IVOL repricing, particularly in the back half of the year when dealer positioning is less clear, buybacks are to fall off of a cliff, rates may fall, and the boost from short-covering has played its course, is an attractive proposition given the context.

Graphic: Retrieved from Bloomberg. “The S&P 500 (white line) is well above its levels from early March, while the yield on the 3m-2y spread remains in a deep inversion, signifying meaningful expectations of cuts in the months ahead.”


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