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Daily Brief For May 12, 2023

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Bloomberg reports that if the US defaults on its debt, which could happen as soon as June 1 if President Biden and House Speaker McCarthy fail to reach a deal on raising the ceiling, homebuyer borrowing costs may surge to 8.40%. As a consequence, the typical home’s monthly payment would increase by 22.00% and cool property sales; the monthly payment on a $500,000.00 mortgage may rise to $3,800.00, compared to about $3,095.00 at the current rate of 6.30%.

Image
Graphic: Retrieved from WSJ.

In prior letters, we concluded that past monetary action made stocks less sensitive to interest rates, quoting JPMorgan Chase & Co (NYSE: JPM) strategists that the market would likely continue to “artificially suppress perceptions of fundamental macro risks,” barring surprises like a debt limit breach.

US Tech Stocks Outperform | The Nasdaq 100 has soared amid expectations of easier Fed policy
Graphic: Retrieved from Bloomberg.

With a debt limit breach a potential reality, Moody’s Corporation (NYSE: MCO) says a breach may compound recessionary pressures; expect a drop in equities, a volatility spike, and a disruption of funding markets.

Graphic: Retrieved from Nasdaq Inc (NASDAQ: NDAQ).

“Data show that short-term bonds have the most predictable reaction – with interest rates and default insurance costs rising significantly – before quickly returning to normal after the uncertainty has passed,” Nasdaq’s Phil Mackintosh writes. “In reality, a crisis was averted in all [prior] cases, with the government able to increase or suspend the debt limit before the X Date.”

Graphic: Retrieved from Bloomberg.

Notwithstanding the short-term uncertainty regarding the debt limit, Bank of America Corporation (NYSE: BAC) is adamant there will be a recession that manifests cracks in “credit and tech,” similar to the situation in 2008. BAC sees the bubble in technology, media, and telecommunication stocks soon deflating as they face higher-for-longer interest rates and a tempered earnings outlook.

Graphic: Retrieved from Societe Generale SA (OTC: SCGLY) via The Market Ear. While investors poured $3.8 billion into technology stocks in the week through May 10, $2.1 billion was pulled from financial equities, the most significant redemption since May 2022.

Compounding the recessionary pressures BAC sees, EPB Research adds, are banks’ funding costs, which have increased too much relative to prevailing asset yields. If the spread drops too low, bank lending tightens, and a recession occurs. Also, other data suggests tightening is finally starting to have an impact. Bloomberg reports that initial claims for unemployment insurance are on the rise. There has been a drop in overall wage growth to 5.1% last month, too, the biggest fall in the rate of increase since the series began.

Graphic: Retrieved from Bloomberg.

Separately, breadth divergences are becoming more frequent, with the Daily Advance-Decline (A-D) Line for the NYSE showing lower highs while DJIA and S&P 500 show slightly higher highs, McClellan Financial Publications writes. The bond CEF A-D Line is also showing a bearish divergence, indicating a shift in liquidity that could weigh on other stocks, including the big-cap stocks holding up the SP500 and the Nasdaq 100.

bond cef a-d line
Graphic: Retrieved from McClellan Financial Publications.

McClellan adds that the A-D Line originated from data collected by Leonard Ayres and James Hughes in the 1920s. It was made famous in 1962.

nyse a-d line 1929
Graphic: Retrieved from McClellan Financial Publications.

That’s when Joe Granville and Richard Russell commented on it in their newsletters, noting how it had shown a big bearish divergence ahead of the 1962 bear market.

a-d line 1962
Graphic: Retrieved from McClellan Financial Publications.

To end, the economic calendar next week is focused on manufacturing and housing. The housing market is showing some downside risk for existing-home sales for April due to a weak reading on pending sales, MCO says, adding that housing permits and starts are expected to move sideways as builders remain cautious amid high-interest rates and economic uncertainty. Regional Fed surveys in New York and Philadelphia will provide the first read on factory activity for May, with little hope for a significant rebound in manufacturing. Jobless claims will be critical, as continuing the recent trend would likely signal a rapid deceleration in monthly job gains. Other critical data to be released include retail sales, industrial production, and business inventories.

Should readers wish to hedge the debt ceiling debacle, June call options on the Cboe Volatility Index appear attractive, some suggest. But, with RVOL as low as it is, owning optionality is not generally warranted. The risk is lower lows in volatility.

Image
Graphic: Retrieved from SpotGamma.

About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

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Commentary

Daily Brief For May 9, 2023

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Sentiment calmer on the heels of some weaker-than-expected data from China. Generally speaking, markets are holding well, led by technology and innovation. 

Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via The Market Ear.

Price doesn’t tell the whole story, however. Breadth is softening while market boosters are slowly being picked off. Tier1Alpha says that “1-month realized volatility rose nearly 13%, [and] … if volatility continues to rise, it will have an outsized effect on the 1-month vol, as the sample is now largely filled by the smaller returns we experienced in April.” Altogether, this “could result in larger [selling] flows being triggered from systematic strategies that use volatility scaling as a means for risk control.”

Graphic: Retrieved from Bespoke Investment Group via The Market Ear.

“With that vol premium getting squeezed out, there is little room for error,” SpotGamma adds; uncertainties that may manifest pressure and compound weaknesses under the hood include inflation reports and the debt ceiling issue.

“The next big moment comes Tuesday, when President Joe Biden is scheduled to meet House Speaker Kevin McCarthy and other congressional leaders,” Bloomberg explains. “The meeting is high stakes. Republican leaders want promises of future spending cuts before they approve a higher ceiling, while Biden is insisting on a ‘clean’ increase.”

Further, traders expect increased chances of rate cuts. This may not be outlandish; “Looking at the past 17 hiking episodes, the two-year, 10-year Treasury yield curve bottoms out 108 trading days before the first rate cut.”

Graphic: Retrieved from Bloomberg.

“Using that guide, the 2s10s curve reached negative 111 basis points on March 8 and has since steepened to about negative 41 basis points. Assuming that marked the trough, 108 trading days lands in mid-August — sandwiched between the Fed’s July 26 and September 20 rate decisions.”

Graphic: Retrieved from Bloomberg. “Look at the gap between the three-month and the 10-year yields, generally regarded as a surefire recession indicator. It’s also a great indicator of imminent rate cuts. An inversion is also a timing signal because it makes little or no sense unless you’re confident that rate cuts will be starting soon. And over the last 30 years, the curve has never been as inverted as it is now.”

For better hedging participation in market upside, check out Physik Invest’s recently published trade structuring report.

Graphic: Retrieved from BNP Paribas (OTC: BNPQY) via Bloomberg. JPMorgan Chase & Co (NYSE: JPM) strategistsay that “the first quarter will likely be the high point for stocks this year, … adding that equities won’t reach lows until the Fed has pivoted to rate cuts.”

About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

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Daily Brief For May 3, 2023

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The S&P 500 (INDEX: SPX) recovered after a violent sell-off led by products like the SPDR S&P Regional Banking ETF (NYSE: KRE). This is before updates on the Federal Reserve’s (Fed) monetary policy today.

Graphic: Retrieved from Danny Kirsch of Piper Sandler Companies (NYSE: PIPR).

The consensus is the Fed ratchets up the target rate to 5.00-5.25%. Following this, it is likely to keep rates at this higher level for longer than markets expect, letting the effects of the tightening work through the economy and tame the still-sticky inflation (e.g., lenders eating the cost of interest to sell more goods, job vacancies dropping, and payrolls surprising higher).

Graphic: Retrieved from Citigroup Inc (NYSE: C) via Bloomberg. “The Fed’s own projections from March suggest rates will be only just above 5% by year’s end — implying a protracted pause with no cuts, after the most aggressive hiking campaign in decades. It’s marked in red in the chart [above].”

Strategists at JPMorgan Chase & Co (NYSE: JPM) think a “hike and pause” scenario prompts a push higher in stocks.

“Here, the Fed would be relying on a tightening of lending standards stemming from the banking crisis to act as de facto rate hikes. Any language that the market interprets as the Fed being on pause should benefit stocks,” JPM wrote. “This outcome is not fully priced into equities.”

This idea was alluded to in yesterday’s letter; stocks likely do “ok” in a higher rates for longer environment. Beyond economic surprises and the debt ceiling issue, the Fed’s balance sheet (not likely to be addressed in this next announcement) strategists like Andy Constan of Damped Spring Advisors are most concerned about, since the size of quantitative easing or QE made stocks less sensitive to interest rates. Ratcheting quantitative tightening or QT, the flow of capital out of markets, would prompt some increased bearishness among those strategists.

Graphic: Retrieved from Bank of America Corporation (NYSE: BAC) via Macro Ops.

JPM strategists add the market may continue “artificially suppress[ing] perceptions of fundamental macro risks,” prompting upside momentum.

“We expect these inflows to persist over the next two weeks, with several more large returns expected to drop from the trailing sample window,” Tier1Alpha explains. “Even if market volatility increases during this time, it would take exceptionally significant moves to trigger substantial selling. While these inflows are advantageous during market upswings, it’s essential to remember that they can be particularly brutal on the way back down once volatility inevitably returns.”

Eventually, “as recessionary conditions proliferate,” EPB’s Eric Basmajian says, asset prices will turn. Downside accelerants include the debt limit breach, which Nasdaq Inc (NASDAQ: NDAQ) and Moody’s Corporation (NYCE: MCO) think portends recession and volatility spike.

Trade ideas and more in our recently published report.

Graphic: Retrieved from Bloomberg.

About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

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Daily Brief For May 2, 2023

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First Republic Bank (NYSE: FRC) is in the news for its failure. FRC was known for handing out mortgages at rock-bottom rates. When interest rates rose, the bank’s book of mortgages was hurt and left it with not enough to suffice withdrawals. 

“FRC believed its business model of extraordinary customer service and product pricing would result in superior customer loyalty through all cycles,” wrote Timothy Coffey of Janney Montgomery Scott. “Instead, too many FRC customers showed their true loyalties were to their own fears.”

This “marks the second-biggest bank failure in U.S. history, behind the 2008 collapse of Washington Mutual Inc.,” reports WSJ; after the instability in March, the bank finally succumbed to the Federal Reserve’s (Fed) rate increases and depositor worry.

JPMorgan Chase & Co (NYSE: JPM) acquired the bulk of FRC’s operations.

Graphic: Retrieved from JPM. See a nice summary by @brandonjcarl.

Further, research shows money is getting tighter, a headwind for the economy, while inflation is sticky and the Fed’s bond holdings are preventing tightening from being effective; WSJ reports the Fed’s balance sheet loaded with bonds may be insulating stocks from interest rate policies. 

“Quantitative easing locked the Fed into a position that is difficult to unwind,” said Stephen Miran of Amberwave Partners. Quantitative easing, or QE, made stocks less sensitive to interest rates. “It’s made tightening both slower and less effective than it should have been.”

Graphic: Retrieved from Bloomberg. The Fed’s favorite measure of inflation, the core PCE index, has been consistently stuck around 4-5% since 2022. The employment cost index, which shows wage growth at around 4-5%, is inconsistent with a 2% inflation target.

Not “adjusting balance-sheet policy,” but raising rates to 5.00-5.25% as expected, ‘is akin to “hitting the same nail with a hammer over and over again.’” Therefore, stocks, which are higher alongside surprising economic and earnings data, though risky, can do “ok” for longer, comments Andy Constan of Damped Spring Advisors.

Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.

The sale of volatility bolsters the stability and emboldens upside bettors, adds JPM’s Marko Kolanovic, who finds “selling of options forces intraday reversion, leaving the market price virtually unchanged many days.”

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

“This, in turn, drives buying of stocks by funds that mechanically increase exposure when volatility declines (e.g., volatility targeting and risk parity funds),” he elaborates. “This market dynamic artificially suppresses perceptions of fundamental macro risks. The low hurdle rate and robust fundamentals bode well for 1Q earnings results, but we advise using any market strength on reporting to reduce exposure.”

At this juncture, yes, stocks can move sideways or higher for a bit longer as a function of “momentum, not value,” Simplify Asset Management’s Michael Green concludes. Traders can position for this and various levels of potential upset later with structures included in a report we published last week.


About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

Categories
Commentary

Daily Brief For April 19, 2023

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Big news includes Netflix Inc (NASDAQ: NFLX) beating earnings estimates but having a weaker-than-expected forecast, Tesla Inc (NASDAQ: TSLA) cutting prices the sixth time this year, Meta Platforms Inc (NASDAQ: META) and Walt Disney Co (NYSE: DIS) commencing layoffs, and mortgage rates edging higher to ~6.4%.

US Mortgage Rate Climbs by Most in Two Months | Increase in 30-year fixed rate ended string of five weekly declines
Graphic: Retrieved from Bloomberg. “US mortgage rates increased last week by the most in two months to 6.43%, denting already sluggish demand.”

Equity markets are down, and equity implied volatility (IVOL) measures, including the Cboe Volatility Index or VIX, are climbing. Notwithstanding, the trend lower in IVOL is intact, and that’s good for traders biased short volatility.

Graphic: Retrieved from Bloomberg via Danny Kirsch of Piper Sandler Companies (NYSE: PIPR). Call option volatility for the $4,150.00 strike. May monthly expiration.

“With all the focus [on S&P 500 (INDEX: SPX)] 0 DTE lately, I look at how expensive these have been since 2022,” IPS Strategic Capital’s Pat Hennessy says, referencing a backtest he conducted selling a 1 DTE straddle and holding till maturity.

“Performance since the November CPI has been stellar, with a 63% win rate and an average gain of $20.00.”

Graphic: Retrieved from IPS Strategic Capital’s Pat Hennessy.

Volatility trader Darrin John agrees, noting volatility remains expensive, a detriment to those who may be biased long volatility.

“The VRP is so wide across all of the tenors I track,” John elaborates. “It’s going to be hard for gamma buyers to cover daily theta bills.”

Clouds are appearing on the horizon, however, and the trend higher (lower) in stocks (volatility) may not last. Bloomberg forecasts the largest fall in SPX earnings since the start of 2020. Notwithstanding, strength can continue for longer …

Graphic: Retrieved from Citigroup Inc Research (NYSE: C) via @tr8derz. “YTD rally stems from $1tn in CB liquidity. High-frequency indicators suggest this is already stalling, and coming weeks seem increasingly likely to bring a sharp reversal. Higher TGA and RRP, ECB QT and reduced China easing could easily see a net drain of some $6-800bn.”

… even with the SPX breadth reading poor. The SPX has rallied with multiples rising; strength came with positive earnings surprises, bond demand, and other things.

Graphic: Retrieved from Morgan Stanley (NYSE: MS) via Bloomberg.

Hence, at the risk of sounding like a broken record, the low-cost call structures we’ve talked about in the past remain attractive.

If markets move higher, you can monetize and roll profits into put spreads (i.e., buy put and sell another at a lower strike). This may work well if JPMorgan Chase & Co’s (NYSE: JPM) call that “even a mild recession would warrant retesting the previous lows” is realized.

Such structures work well as “a big pop in the market can result in a decent drop in the VIX…and vice versa, a market sell-off will result in a greater increase in the VIX now than it did in 2022,” says Alpha Exchange.

Alternatively, lean neutral and buy into cash or bonds yielding 4-5%. Some long box spreads yield 5.4% as of yesterday’s close.

In other news, Physik Invest’s first in-depth note is nearing completion and will be available for public viewing in short order. Take care and watch your risk!


About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

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Commentary

Daily Brief For April 11, 2023

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The narrative yesterday was bearish

A big deal was made surrounding some data that shows investors increasing their bets on US equities falling; net short positions in the E-mini S&P 500 (FUTURE: /ES) are the highest since 2011, Bloomberg reports. JPMorgan Chase & Co (NYSE: JPM) and Goldman Sachs Group Inc (NYSE: GS) concur as their data shows clients betting on stocks falling or reducing stock exposure quickly.

This is happening in the context of some mixed, albeit still robust-leaning, data; payrolls upped bets that the Federal Reserve or Fed would move its target rate to 5.00-5.25%. GS’ Bobby Molavi adds, “the prevalent view seems to be that more things will break on the back of rapid rise in cost of capital.”

Graphic: Retrieved from Bloomberg

In light of the rate expectations, the Nasdaq 100 (INDEX: NDX) appears to be handing over the leadership baton to the S&P 500 (INDEX: SPX), though both indexes remain primarily intact and coiling; the fundamental-type pressures are balanced by follow-on support from those actors that base their decisions on such things as the amount a market moves (i.e., realized volatility or RVOL), says Tier1Alpha and SpotGamma.

Graphic: Retrieved from Tier1Alpha.

The two providers of market insights see falling implied (IVOL) and RVOL as catalysts for buying stocks. This, coupled with the hedging of soon-to-expire large options open interest, particularly on the put side, in a lower liquidity environment, supports the indexes while underlying breadth and correlations are underwhelming.

A large concentration of put open interest near current prices is pictured just below. The eventual removal of this put-heavy positioning will reduce some directional risks to options counterparts; as puts disappear or decline in value, their delta or exposure to direction does too. If a counterparty is short a put and has less positive delta to hedge, they may buy back some of their short-delta exposure in the underlying index, a catalyst for higher S&P 500 prices.

Graphic: Retrieved from SpotGamma.

A large open interest concentration set to roll off this April is pictured just below.

Retrieved from SpotGamma.

This has happened before. Newfound Research explains it best in their paper titled “Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants.”

In keeping the indexes and their underlying idiosyncratic baskets in line via arbitrage constraints, while there is a build-up of suppressive and supportive dealer hedging at the index level, “then the only reconciliation is a decline in correlation.”

In this context, Tier1Alpha explains, “lower correlations tend to lead to lower volatility … giv[ing] volatility control funds the go-ahead to augment their risk exposure, with an estimated $14 billion in equities purchases … to be spread out in blocks.”

Consequently, in line with our thesis that positioning and technical contexts support near-term strength, it still makes sense to take the profits of very wide, albeit low- or zero-cost, call ratio spread structures discussed in past letters to cut the cost of our bets on the equity market downside and lower rates with more time to expiry. Should the indexes trade higher, SpotGamma agrees with Kai Volatility’s Cem Karsan that volatility could be sticky.

Hence, call structures could keep their value better and enable us to lower the cost of our bets on the market downside. If the fundamental context supporting the rotation of call option profits into puts is no longer valid, then the losses on such trades are limited; the money is made in not losing it.

Graphic: Retrieved from SpotGamma’s Weekend Note.

Not doing as outlined and blindly buying put options to protect long equity exposure is generally a poor-performing strategy, despite the performance claims of some funds specializing in that practice.

Graphic: Retrieved from QVR Advisors via Bloomberg. “Buying puts is a money-losing proposition when considered in isolation. Chart shows the performance of hedges rolled every quarter with delta hedging, as a percentage of notional amount protected.”

About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

Categories
Commentary

Daily Brief For April 10, 2023

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US payroll data has increased the possibility of a rate hike by the Federal Reserve or Fed in early May, leading to higher rates and affecting those who expected a pause or pivot through poorly performing yield curve steepener trades. The market expects the Fed to raise its target rate to 5.00-5.25% and keep it there through mid-year.

Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.

There is more to the pressure than just yields. Surveys indicate a drop in profits for sensitive areas of the equity market, such as technology and banks; as soon as the labor market starts softening, a credit crunch is expected to accelerate by some.

Graphic: Retrieved from the St. Louis Fed via Cubic Analytics.

Despite the turbulence from earnings, data suggests the S&P 500 (INDEX: SPX) may perform well through year-end. Historically, the full-year return was always positive when the S&P 500 had a positive first quarter. However, there have been exceptions, says Callum Thomas, quoting data gathered by Ryan Detrick.

Graphic: Retrieved from Ryan Detrick via Callum Thomas’ Weekly S&P 500 ChartStorm.

Peeking beneath the hood, only a few (primarily rate-sensitive) stocks have bolstered recent index strength; many components are not participating in the rally, which could be a harbinger of potential post-earnings weaknesses. 

Graphic: Retrieved from McClellan Financial Publications.

Notwithstanding, if rates continue to fall, so do borrowing costs; falling inflation cuts pressures on input cost; rising unemployment helps keep labor costs under control, Bloomberg reports. The forecasts (not surveys) actually show earnings holding up better than the narrative suggests.

Graphic: Retrieved from Bloomberg.

So what, then? In an annual report, JPMorgan Chase & Co (NYSE: JPM) concludes that if “we have higher inflation for longer, the Fed may be forced to increase rates higher than people expect despite the recent bank crisis.” Compounding the rate hikes is quantitative tightening or QT, the process of a central bank reducing the amount of money it has injected into an economy by selling bonds or other financial assets, which “may have ongoing impacts that might, over time, be another force, pushing longer-term rates higher than currently envisioned.” The net effect, though insights gleaned from the curve may be muddied due to the scale of recent interventions, is an “inverted yield curve [implying] we are going into a recession” and lower credit creation because, as Sergei Perfiliev well puts it, “if capital ends with the Fed, it is dead – it has left the economy and the banking system.”

Graphic: Retrieved from Bank of America Corporation (NYSE: BAC) via TheMarketEar.

How do we position ourselves, given all these narratives? Equity volatility implied (IVOL) and realized (RVOL) decreased. This may continue to be a booster. In fact, “if markets remain within a +/-1.5% range, a drop in volatility could trigger significant buying activity from the vol-control space, with up to $14 billion in notional flows hitting the tape, creating a favorable environment for equities,” says Tier1Alpha.

Graphic: Retrieved from Tier1Alpha.

So, positioning-wise, stocks could trade up into a “more combustible” state where “volatility is sticky into a rally,” as Kai Volatility’s Cem Karsan said would happen.

SpotGamma confirms that, based on current positioning, SPX IVOL is projected to move up as the underlying index moves up; there are likely many people chasing the rally with long calls, “creating a swelling of call skew.”

In this environment, very wide call ratio spread structures discussed in past letters may continue to do well. We can use the profits from those call structures to cut the cost of our bets on the equity market downside and lower interest rates.

Graphic: Retrieved from SpotGamma’s Weekend Note.

About

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

Categories
Commentary

Daily Brief For April 6, 2023

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Administrative Bulletin

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

Tomorrow’s Good Friday, and some markets, including the US’s equity market, will be closed. The Treasury market will remain open, albeit for less time, and may enable traders to price the impacts of coming releases, including non-farm payrolls (NFP). The consensus is that the US added 235,000 jobs in March, with the unemployment rate expected to remain steady at 3.50%. Higher for longer, then? We shall see.

Moreover, the big news is that the trend in mortgage rates, followed closely in the US, continues to be down. US 30-year fixed mortgage rates fell for a fourth-straight week, though applications to buy and refinance a home declined for the first time in a month. However, borrowing costs remain generally high and housing inventory low, keeping a cap on homebuying activity. 

Notwithstanding, as explained by Akash Kanojia, for the housing market to “clear” on today’s affordability, home prices need to fall by about 20.00%. 

READ: HOW MUCH HOME PRICES MAY FALL

To explain, typically, banks use a debt-to-income ratio to determine how much they will lend to a borrower to buy a house. Adding, they could enforce a limit of 80% on the purchase price of the house, and the remaining 20.00% is paid in cash by the borrower as a down payment.

Mortgage rates comprise the short-term risk-free rate, term premium, the Treasury-MBS spread, the primary-secondary spread, and a credit spread based on the borrower’s creditworthiness. Any of these numbers changing can influence a borrower’s final payment to the lender. 

Graphic: Retrieved from Negative Convexity.

An analysis starting with a home price in 2021 of $575,000.00 and a borrower whose income was $92,000.00, and adjusting all for inflation and movements in rates, the decrease in home values to boost affordability is 21.00%.

Graphic: Retrieved from Negative Convexity. “To do this analysis, I started with a home price in April 2021[1]($575,000) and figured out how much annual income a borrower would have needed at that time to buy the house (~$92,000). I then adjusted the annual income up by 8% for 2023, extrapolating from this, resulting in a person that would have earned ~$92,000 earning $99,205 today. Then I calculated how much house a person earning $99,205 can afford today at a mortgage rate of 6.70% ($452,000). Divide the two, and you get a decrease of 21%.”

A worst-case scenario is that the fed funds rate rises further to quell inflation. If the fed funds rate were to rise to 6.00-6.25%, matching the latest annualized CPI print, and “the market realizes the Fed is not going to cut, and the curve (e.g., 3m-7y UST) steepens to historical norms (~150 basis points long-term average), barring changes in the MBS spread, primary-secondary spread, and credit charges, this produces a ~40.00% decline in home prices.

Graphic: Retrieved from Negative Convexity.

Consequently, as the economy slows and layoffs increase, as we’re starting to see, it will negatively affect housing demand and affordability due to income stability and growth. On the bright side, inflation destroys the nominal value of debt, Kanojia says. Assuming wages keep up, buyers in hot markets may be spared if they can withhold from selling at market-clearing prices, Kanojia ends.

On a note about the doom and gloom (i.e., economy slowing and layoffs increasing, as well as yield curve steepening), JPMorgan Chase & Co’s (NYSE: JPM) Jamie Dimon says the following: 

Today’s inverted yield curve implies that we are going into a recession. As someone once said, an inverted yield curve like this is ‘eight for eight’ in predicting a recession in the next 12 months. However, it may not be true this time because of the enormous effect of QT. As previously stated, longer-term rates are not necessarily controlled by central banks, and it is possible that the inversion we see today is still driven by prior QE and not the dramatic change in supply and demand that is going to take place in the future.

Dimon, the CEO of JPM, says that a graph showing the yields on bonds of different maturities is inverted, meaning that the yields on shorter-term bonds are higher than the yields on longer-term bonds. An inverted yield curve has often been a reliable indicator of an upcoming recession; it reflects investor demands for higher returns on short-term investments and expectations that short-term rates will fall in the future, which happens when the central bank cuts rates in response to a weak economy.

In other words, the conditions around the yield curve inversion are different this time.

Graphic: Retrieved from the Federal Reserve Bank of St. Louis. A normal yield curve is upward-sloping, meaning long-term interest rates are higher than short-term rates; investors demand a higher return for tying up their money for a longer period; the spread between the 10-year and 3-month treasury yield is positive. 

Further, a peek at the bond market shows cuts priced within six months.

Graphic: Retrieved from Bloomberg via @TheBondFreak.

Same thing with the Secured Overnight Financing Rate (SOFR) market, developed by the Federal Reserve to replace LIBOR, which was phased out due to manipulation concerns, among other things, as a benchmark interest rate. 

READ: WHAT IS SOFR?

Unlike LIBOR, which is based on unsecured lending transactions between banks, SOFR is based on actual transactions in the overnight repurchase agreement (repo) market, which makes it a more reliable benchmark. Consequently, the shift from the Eurodollar (FUTURE: /GE), used to intervene in support of the dollar and other currencies and allow lenders to lock in rates, to SOFR has accelerated, too.

As stated yesterday, options activity in the SOFR market was centered around the 95.00 strikes. To calculate the implied interest rate using the value of the 3-month SOFR future, we can use the following formula:

Implied interest rate = 100 – future price; the implied interest rate calculated using the 3-month SOFR future is an annualized rate.

For example, if the current value of the 3-month SOFR future is 95.00, the implied interest rate would be 100.00 – 95.00 = 5.00%.

Graphic: Via Charles Schwab Corporation’s (NYSE: SCHW) thinkorswim platform. The three-month SOFR (FUTURE: /SR3) curve implies a 4.86% terminal rate today, followed by easing into year-end.

The S&P 500 (INDEX: SPX) has not bottomed based on these conditions. 3Fourteen Research concludes that the SPX has never bottomed during a Fed hike cycle, which one is still ongoing; typically, forward earnings stabilize and turn higher 3-6 months after a market bottom, which hasn’t happened; the 2-10 yield curve has never remained inverted six months after a major bear market bottom.

Graphic: Retrieved from Bloomberg via @MichaelMOTTCM.

Notwithstanding all the doom and gloom, we explained in past letters that markets would likely remain strong through month-end March. 

Graphic: Retrieved from Damped Spring Advisors’ Andy Constan. “6 of the last 6 quarters, the quarter end flow has resulted in a spike or dip and a subsequent 8%+ reversal.”

Accordingly, it made a lot of sense to own low- or no-cost call options structures in products like the Nasdaq 100 (INDEX: NDX), where many participants were caught offsides and bidding call volatility in response to the dramatic reversal; the reach for the right tail reduced the cost of ratio call spreads, making them the go-to structures.

It may make sense to re-load in similar call structures on pullbacks while using any proceeds or profits from those structures to reduce the cost of owning fixed-risk and less costly put structures (e.g., vertical) that may enable us to participate in equity market downside, as well as bet on lower rates in the future using call options structures on the /SR3 to express that opinion.

Graphic: Retrieved from TradingView via Physik Invest.

Disclaimer

Don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

Categories
Commentary

Daily Brief For April 4, 2023

LOAD LEVELS ON TRADINGVIEW BY CLICKING HERE.

Administrative Bulletin

Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.

JPMorgan Chase & Co’s (NYSE: JPM) Marko Kolanovic believes the equities rally will falter, with headwinds from bank turbulence, an oil shock, and slowing growth poised to send stocks back toward their 2022 lows over the coming months. Kolanovic says this is “the calm before the storm,” adding that the equity rally is masking weaknesses from recent bank collapses and a decline in corporate profits and growth.

Read: Black Knight Mortgage Monitor Report.

As a validation, we can look to ISM’s inventories exceeding that of new orders, and a dip in cost-push prices, Bloomberg’s John Authers explains. The overall ISM measure is recessionary; the upcoming earnings season may be unforgiving, and companies with weaker EPS are likely to be penalized more due to the prospects of a recession.

Graphic: Retrieved from Sergei Perfiliev. “Based on this relationship, today’s PMI reading of 46.3 implies an earnings contraction of about 8% over the next 12 months or an SPX EPS of 204. Using the current forward PE ratio of 18.7, this leads to an index level of about 3,815. A ‘recessionary’ PE ratio of 15 will see the index at ~3,060, assuming earnings don’t fall further.”

Tech’s outperformance, driven partly by a supply of previously demanded downside put protection, has become even more magnified recently as traders ramped up bets that banking system stresses prompt the Federal Reserve to hit the brakes.

Read: SOFR Futures And Options 1st Edition

Graphic: Retrieved from @countdraghula. “We aren’t seeing the same thing for out-of-the-money calls on front-end futures. BUYING A CALL on front-end futures is taking a bet on Fed rates collapsing, especially if it is considerably out of the money, as below. Pricing for these is still sky high, despite some calm.”

Over the past weeks, we anticipated the markets trading “spiritedly for far longer,” quoting the likes of Kai Volatility’s Cem Karsan, who said the signs of a combustible situation would emerge when options implied volatility is sticky in a market rally.

Typically, as the market trades higher, volatility levels for fixed-strike options should decrease. If broad implied volatility measures are bid and fixed-strike volatility increases, this may lead to a more combustible situation as options counterparties begin to thin out on volatility, resulting in less support.

We maintain that you can monetize the example call structures we provided and roll some profits into bear put spreads (i.e., buy put and sell another at a lower strike), though you may limit your expectations. Some think there is a greater likelihood of a “crash-less selloff, a grinding de-leveraging.”

Read: China’s Yuan Replaces Dollar As Most Traded Currency In Russia.

Disclaimer

Don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.

Categories
Commentary

Daily Brief For March 30, 2023

Intrigued about what moves markets and economies and how that can impact your financial wellness? Subscribe to this free newsletter below!

Graphic updated 6:30 AM ET. Sentiment Risk-On if expected /MES open is above the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MNDClick here for the economic calendar.

Administrative

Thanks for the feedback on the newsletter design! The technical section has returned for your viewing of crucial levels. We may update this section or merge it with another in the future. If you have any feedback, please comment or reply!

By the way, check out fx:macro’s neat market dashboard how-to-build guide! They have a fabulous newsletter, and this dashboard is an excellent component.

Take care, everybody.

Fundamental

In the coming sessions, there will be a dive into the geopolitical developments of late, far higher in quality than what we started this week with. For a sneak peek at what we will be talking about, look at this article, this podcast, and the Daily Brief for 1/4/23.

Positioning

In yesterday’s letter on positioning contexts, we concluded it was likely for markets to remain contained through month-end.

We said, “there is potential for markets to move into a far ‘more combustible’ position, … [and], with call skews far up meaningfully steep, still-present low- and zero-cost call structures” in previously depressed products like the Nasdaq 100 (INDEX: NDX), buoyed by financial tensions easing, were attractive to express the bullish view.

Graphic: Retrieved from JPMorgan Chase & Co (NYSE: JPM) via The Market Ear.

Though we weren’t too right about the potential for volatility to be sticky, which may be detrimental to some of the more expensive structures, such trades’ exposure to direction and movement appears to be offsetting time decay and volatility, sped up by the resolution of the liquidity crisis (i.e., the asset-liability mismatch at some banks that thought their depositors were far more loyal, hence less of a need to hedge risk) which prompted traders a few weeks back to demand protection and reprice options higher; the Merrill Lynch Option Volatility Estimate (INDEX: MOVE) and Cboe Volatility Index (INDEX: VIX) have come in dramatically. Please take a look at the full letter here.

Graphic: Retrieved from NATIXIS via Bloomberg.

As stated on 3/29, the fundamental view hasn’t changed. Therefore, we may consider monetizing our structures now and in the near future and using those credits to offset debit risk in plays such as far-dated bear put spreads (i.e., buy put and sell another at a lower strike); options data and insight platform SpotGamma says the juice has been squeezed now with S&P 500 (INDEX: SPX) 1-month at-the-money implied volatility or IVOL pricing at 17%. “For a decline to continue, we need a change in volatility regime (i.e., soft landing, bank crisis resolved, etc.) because, with 1-month realized at 15%, you can argue there isn’t much juice left to squeeze.” Caution on the upside plays.

Graphic: Retrieved from Bloomberg via SpotGamma.

Technical

As of 6:30 AM ET, Thursday’s regular session (9:30 AM – 4:00 PM ET) in the S&P 500 will likely open in the upper part of a positively skewed overnight inventory, outside of the prior day’s range, suggesting a potential for immediate directional opportunity.

The S&P 500 pivot for today is $4,077.75

Key levels to the upside include $4,087.75$4,097.25, and $4,108.75.

Key levels to the downside include $4,062.25$4,049.75, and $4,038.75.

Click here to load the updated key levels via the web-based TradingView platform.

New links are produced daily.

Quoted levels likely hold, barring an exogenous development.

Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.

About

The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market. 

Separately, Capelj is an accredited journalist with past works, including interviews with investor Kevin O’Leary, ARK Invest’s Catherine Wood, FTX’s Sam Bankman-Fried, North Dakota Governor Doug Burgum, Lithuania’s Minister of Economy and Innovation Aušrinė Armonaitė, former Cisco chairman and CEO John Chambers, and persons at the Clinton Global Initiative.

Connect

Direct queries to renato@physikinvest.com. Find Physik Invest on TwitterLinkedInFacebook, and Instagram. Find Capelj on TwitterLinkedIn, and Instagram. Only follow the verified profiles.

Calendar

You may view this letter’s content calendar at this link.

Disclaimer

Do not construe this newsletter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements for their work.