“The U.S. is doing pretty well,” Yardeni Research founder Ed Yardeni remarks, noting a shift from speculation about interest rates allows the market to focus on fundamentals. “Right now, the fundamentals are good for the economy. And, there’s plenty of hype around about.”
Multiple rate cuts totaling nearly 125 basis points in the next year remain expected. This seems extreme unless there’s a market crash, says Harley Bassman, inventor of the MOVE Index measuring bond market volatility. Bassman believes current pricing reflects a bimodal scenario, with an 85% chance rates remain stable and a 15% chance they drop to 1%. Combining these probabilities, the market arrives at the anticipated cuts by year-end.
Naturally, markets are cyclical, moving from one extreme to another. Despite the fundamentals being in order, a lack of broad participation is evident in the more significant number of declining stocks than advancing ones. This situation, resembling patterns seen during the late ‘90s infotech-and-telecom boom, is frequently an indicator of less resilient future returns.
Graphic: Retrieved from Bank of America Global Research.
Ryan Detrick of Carson Group notes that February typically experiences less momentum than January, often due to reinvestment and bonus inflows. Data shows that when the S&P 500 recorded a 20% gain for the year, February tended to underperform, especially in the latter half of the month, which typically marked the weakest two-week period of the year.
Graphic: Retrieved from SentimenTrader via Jason Goepfert.
While the same volatility-suppressing trades detailed in last week’s letter continue to support markets where they are ceteris paribus (where customers sell volatility, and dealers hedge by buying stock/futures during declines and selling during strength), there has been “SPX/SPY downside buying (put flys) and ongoing VIX call buying,” Nomura Americas Cross-Asset Macro Strategist Charlie McElligott writes. This steepens implied volatility skew, benefitting the underappreciated hedge opportunities shared in Physik Invest’s Market Intelligence letters.
Graphic: Retrieved from SpotGamma on February 5, 2024.
The recent repricing has allowed unbalanced, out-of-the-money options spreads to retain their value better amid ongoing market gains. The focus has shifted from worries about missed opportunities to safeguarding against potential downturns. This shift may be attributed to concerns beyond poor market breadth and the possibility of localized issues in places like China impacting global markets. These include geopolitical tensions, turbulence in specific capital market segments, lingering effects of extensive government spending, and looming debt crises.
Graphic: Retrieved from SpotGamma on February 1, 2024.
With the popularity of yield-enhancing trades like selling options, there’s concern that if significant market movements materialize, a greater share of end users will shift to buying options, indirectly exacerbating market volatility and downside.
To explain this phenomenon, we start with the options delta, which measures how much an option’s price will change for every $1 change in the underlying asset’s price. When end users sell put options, market makers buy them, assuming a negative delta stance, thus prompting them to acquire the underlying asset to hedge (which has a positive delta). Conversely, when end users buy put options, dealers sell them, taking on a positive delta. Consequently, they need to sell the underlying asset (which has a negative delta) to hedge. In sharp and volatile market declines, options sellers may opt to cover their positions by purchasing options, thereby diminishing stability as counterparties hedge in line with the market movement.
Graphic: Retrieved from Nomura.
Kris Sidial from The Ambrus Group emphasizes second-order effects are further amplified due to the large scale of options selling, adding concentration among market makers as another risk to watch. Scott Rubner, a tactical specialist at Goldman Sachs Group, concurscurrent market problems, and the unwind of stretched positioning may lead to a weak February.
In their Daily Observation, dated January 4, 2000, Bridgewater Associates argued each decade was inclined to be more dissimilar to the preceding one.
“Most people who experienced consistent reinforcement for ten years were inclined to believe that this would continue indefinitely,” the authors Ray Dalio et al. said, pointing to the situation that preceded stock investors’ disappointment in the 1970s, akin to present perceptions. Investors took untimely risks that proved costly. By the late 1970s, influenced by the trauma of inflation, they shifted towards hedge assets.
The report underscored a significant point: “Thirty years of prosperity and peace created a faith that our problems will be resolved.” Does this sound familiar? Dalio speculates we will soon test the resilience of the existing order and the containment, or lack thereof, of international conflicts.
Let’s take a step back. What has transpired?
Over many decades, policymakers orchestrated a “growth engine,” nurturing innovation and globalization, inadvertently widening the wealth gap. The urgency to fix disparities, heightened by a pandemic, suggests the next decade will unfold differently, marked by rolling crises.
Inflation & protectionism & conflict, oh my!
Graphic: Retrieved from TIME. China’s emergence as a global competitor is visualized.
This secular narrative is meticulously explored in our “Climbing A Wall Of Worry” letter. Resolving supply-chain disruptions and commodity deflation helped alleviate overall inflation concerns in the short term. Fiscal boosts, low unemployment, and wage inflation bolstered economic resilience. Pundits are now invoking terms like “soft-landing” and “Goldilocks,” capturing the current sentiment.
Graphic: Retrieved from Bank of America Global Research.
“The picture that market prices are now painting is for inflation to fall to central banks’ targets, for real growth to be moderate, and for central banks to lower interest rates fairly quickly—so the markets are now reflecting a Goldilocks economy,” Dalio says himself.
The economic outlook for 2024 seems less impressive despite lingering market support from previous stimulations. Market prices indicate five cuts, reducing the target rate range from 525-550 to 400-425 basis points. Federal Reserve Governor Christopher Waller, who generally holds hawkish views, concurs that “the FOMC will be able to lower the target range for the federal funds rate this year.” However, he cautions against anticipating as many cuts, asserting that, despite noisy data, current policy is appropriate and should persist in exerting downward pressure on demand.
Graphic: Retrieved from CME Group on January 21, 2024.
In a different scenario, where higher real interest rates persist, it would negatively affect the economy. A hard landing would be risked, Fabian Wintersberger believes, leading to a fall in GDP and escalating debt ratios. Regardless of the path, the private sector will likely reduce investment and continue deleveraging for as long as feasible.
Graphic: Retrieved from Simplify Asset Management. High Yield Index Years to Maturity suggests organizations find refinancing or reissuing debt difficult, primarily due to the high costs associated with the risk-free component. This situation is reminiscent of the Global Financial Crisis (GFC), where uncertainty in credit markets hindered entities from refinancing.
What does all this mean for the stock market? Investors across all time frames are ultra-enthusiastic, bidding products like the S&P 500 to new highs. However, breadth could be more exciting, judging by the Russell 2000 and equal-weighted indexes.
So, what’s the story? Bloomberg says, “This isn’t your father’s S&P 500. Don’t worry about valuations.”
Typically, these statements raise promote caution. However, investors seem to see no alternative at the moment. The market is fueled by enthusiastic buying of a handful of stocks “accumulating greater and greater weighting.” While the forward P/E of the equal-weight S&P 500 aligns with pre-pandemic averages, the so-called Magnificent 7, steering the well-known S&P 500 (i.e., the SPX), boasts a higher value at 28.
Accordingly, over the shorter term, there are risks, including the market pausing here to “demand some deliverables” and the passage of options expiries last week.
“The reflexive nature of the market tells us that what we are witnessing here is much more mechanical than anything and probably has nothing to do with what is happening in the real world,” Mott Capital Management’s Michael Kramer discusses.
Graphic: Retrieved from SpotGamma.
SpotGamma explains there was “rhythmic buying” of options “related to the QYLD Nasdaq BuyWrite ETF, which rolls the Thursday before monthly OPEX.”
Graphic: Retrieved from Bloomberg via Michael Kramer. Notice the amount of call open interest.
Kramer, aligning with views expressed by individuals such as Cem Karsan from Kai Volatility, anticipates a potential reversal. The premise is based on the assumption that investors owned a substantial share of call options. With a reduction in their quantity and a decrease in the risk they pose to counterparts engaged in hedging through long stocks and futures, there is expected to be diminished “mechanical” support in the subsequent weeks. SpotGamma emphasizes that Monday is the final day for any options expiration effect.
“The structural supply and demand imbalance should end on Friday,” Karsan states. “I would be careful chasing this tech up here, in particular, if we see some weakness going forward like we’ve been talking about.”
The crucial factor is the amount of “vol supply” emerging from this event, which could counteract “vol demand” (recall that investors often seek protection through options or volatility, the all-encompassing term). This counteraction may postpone weakness, setting the stage for a more significant decline later in Q1, as highlighted by Karsan.
It’s important to note that a substantial market position involves hedging equity with short-call options and long-put options. Options prices may decrease with increased volatility supply, leading to the counterpart’s re-hedging of this position by buying back underlying stock and futures hedges (i.e., if a counterpart is short futures against an SPX long-call and short-put position, they will buy futures to rebalance their delta as implied volatility falls).
Graphic: Retrieved from Nomura Securities International.
“Can that counter the lack of positive flows, the vol buying, and some of the macro liquidity issues,” Karsan asks, acknowledging the pressures linked to asset runoff, Treasury issuances, the diminishing reverse repo, and external events such as the Red Sea attacks, which are perceived as potentially more impactful on supply chains than the global pandemic. In any case, there are increasing prospects of a “February 14 Valentine’s Day Massacre.”
What’s the course of action? According to Simplify Asset Management, considering that far out-of-the-money puts are now priced at half of what they were at the onset of the global pandemic four years ago, hedging at this point is a prudent move.
Butterflies in the Nasdaq 100 and S&P 500 present an appealing opportunity. Take, for instance, the 15000/13500/12000 NDX butterfly expiring in the next month or two. It costs between $500 and $1,500 to open. If it’s the shorter-dated one that is in the money today, closing it could yield about a $90,000 credit, excluding changes in implied volatility and the passage of time. The maximum value is $150,000, and the risk is confined to the amount paid at open. Talk about the convexity!
We’ve analyzed this specific trade for you, although in the S&P 500 and without the distant protective put. Given the distinct environment, there is an elevated risk of a volatility increase warranting the acquisition of far-away protection, represented in this instance by the 12000 put.
Graphic: Retrieved from Simplify Asset Management.
Though owning volatility safeguards against a substantial decline, consider the expenses of maintaining that position and the inevitable decline in its value during calm or rising periods. It is “the investment equivalent of death by a thousand cuts.”
“Vol is cheap enough when you go out two or three months, particularly on the call side,” Karsan ends. “Into a rally particularly that should continue to be relatively bid. That doesn’t mean go own one-month vol because that is more uncertain here, right? You will experience a lot of decay if the decline doesn’t happen till February. Right? There is still theta to be had.”
Graphic: Retrieved from Bank of America Global Research.
Photo: By Glenn Halog. Taken on September 17, 2012.
Hey, all! I hope you had a great weekend. We’re sticking to our promise, as shared on Substack. Today, we dive into what’s driving markets and what the near future may look like. Generally speaking, on Monday, we will do deeper dives like this. Friday, we will do recaps. Trade ideas are coming soon via monthly research, which will look similar to this linked document.
That’s a take hot enough to grab your attention, isn’t it? We digress. It’s been a couple of years since central banks began tightening. With it being this late in the economic cycle, the effects of contractionary monetary policy should be felt, right? Well, not as you imagined heading into last year. The economy is strong, and inflation was better managed than anticipated.
Is it that the economy is less sensitive to monetary policy? Citadel’s Kenneth Griffin states that monetary tightening struggles to offset fiscal stimulus. Jerome Powell, Chair of the Federal Reserve, has had his mission to engineer a soft landing complicated. “Whether it is the Inflation Reduction Act or other programs that have increased spending, we keep stimulating the economy out of DC.”
Graphic: Retrieved from Global Financial Data via Meb Faber Research.
That’s the outlook envisioned by some, including Cem Karsan of Kai Volatility. In his analysis, this policy divergence traces back to the era of easy money spanning decades—instances like the Federal Reserve buying long-term bonds, reducing their yields, and steering investors towards riskier assets. A “growth engine” resulted, as Karsan describes it, driving innovation and globalization, accompanied by low inflation and occasional deflation.
The bulk of the stimulus predominantly benefiting the top echelons—corporations focused on profit generation through cost-cutting and expanding market share—contributed to a widening gap between the privileged and the less privileged (i.e., the wealth effect and labor competing globally with other labor and technology). If the current emphasis is on populist fiscal measures (such as increasing the velocity of money by directly injecting funds into the hands of the public and, consequently, into the economy) to address inequality and enhance the average person’s spending capacity, this could be the catalyst for sparking inflation and the potential for elevated yields for years to come.
Photo: By Glenn Halog. Taken on September 17, 2012. View on Flickr here.
It’s a new era, and as Karsan points out, the tail is getting thicker, indicating a shift towards one-sided and risky positioning. Why is that so? Individuals are hedging the above realities, turning to Treasuries (used as collateral) and short equity options or volatility (the all-encompassing term) to enhance returns.
Graphic: Retrieved from TradingView. Pictured is the short VIX Futures ETF.
“If you remember 2017, right before we got into Volmageddon in February 2018, the volatility environment smelled similar to right now,” Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets, shared with Bloomberg. “It works until it doesn’t.”
Graphic: Retrieved from Bloomberg via Simplify Asset Management’s Michael Green. Implied correlation for a 90 Delta call or 10 Delta put. Given the current volatility level, the implied correlation is lower than expected, indicating potential market vulnerability or “deeply unhealthy” conditions.
Kris Sidial from The Ambrus Group explains highly responsive spot-vol beta results. For example, we see quick fluctuations in volatility measures like the Cboe’s Volatility Index or VIX. He adds it’s a crowding of the dispersion trade, where participants shift from underperforming longer-dated options to shorter-dated ones for purposes like hedging, directional trading, and yield enhancement. This activity supports and stabilizes the indexes while the individual components underneath occasionally fluctuate pretty drastically. The only way to reconcile these fluctuations is through a decrease in correlation.
This environment is reminiscent of the 1999 to 2000 period, mentioned by Michael Green from Simplify Asset Management during a pre-event call for a Benzinga appearance. Despite the costliness of growth stocks in the late nineties, they still managed to double and triple.
In this scenario, the go-to trade of stocks and bonds (e.g., 60/40) may be less effective. Instead, at least over the short term, one could own long-term call options while selling stocks. Why? Karsan says that volatility “pinning leads to a momentum factor” that sustains itself. As yields rise, more liquidity flows into alternatives like structured products. With index volatility subdued and at a lower limit, positive flows persist until more significant market trends take over.
Graphic: Retrieved from Danny Kirsch of Piper Sandler. On December 18, the S&P 500’s price and SPX’s $4,800 strike option volatility were up.
Looking ahead to 2024, Fabian Wintersberger predicts a higher stock market, dismissing concerns of a second wave of inflation in 2024. The changes in the money supply typically impact the broader economy with an 18-month lag, implying projected rate cuts in 2024 may not affect inflation until 2025 or 2026.
“It seems that the Fed’s and the ECB’s projections are too high, and inflation might turn into deflation in the second half of 2024.” Otherwise, we’re likely in the seventh or eighth inning because higher real yields are starting to come through the economy, Griffin states, noting the Federal Reserve will likely make it clear they will get near a 2% rate in time, stabilizing as best they can employment and prices.
Graphic: Retrieved from Bloomberg. A recent quarterly refunding announcement spurred a rally in bonds and equities. Generally, a weak dollar and lower rates ease financial conditions. That’s good for stocks.
“[Jerome Powell] had a horrible hand to play. We’ve had the pandemic supply chain shocks and massive fiscal stimulus. And he’s supposed to try to achieve price stability. That’s a no-win scenario.”
Graphic: Retrieved from BCA Research.
As interest rates decline, the discussed structured product trades and dispersion flows might slow or reverse. The question arises: will the diminishing volatility supply compound challenges arising from weakened macro liquidity, potentially outweighing the anticipated benefits of interest rate cuts and stimulative fiscal measures? We’re working on unraveling this.
While euphoria seems scarce and fragility is not prominently signaled, as Sidial points out, the telltale signs will come as an “explosion” of convexity in the 3-, 5-, and 7-day terms of the volatility structure, as noted by Karsan. Until these signs emerge, former open markets desk trader Joseph Wang suggests cautious optimism, advocating for bullishness amid digestion in terms of time or price.
Graphic: “The market averages three 5% corrections a year,” explains Jay Woods of Freedom Capital Markets, who foresees a touch of ~$4,600 in the S&P 500 ($460 SPY) as a likely scenario. “It isn’t abnormal.”
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%.
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.
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.”
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.
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.
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.
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.
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.
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.
US consumer prices rose by 4.9% in the 12 months to April, down from the previous month’s 5%. Wednesday’s figures suggest inflation is moderating and emboldens the case for a pause to interest rate increases.
Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
“The Fed will want to see declines in these statistical measures for a few more months before it could feel comfortable about cutting rates,” John Authers writes.
Notwithstanding “sticky price inflation” falling (only “if shelter prices are excluded,” the most challenging “front in the battle on inflation”), applications to purchase and refinance homes rose with yields falling, and that’s exactly what the Fed doesn’t want.
Many maintain the Fed is looking to walk-up long-end yields, and that’s problematic for assets; higher interest rates portend lesser allocations toward risky assets.
Pimco’s Erin Browne and Emmanuel Sharef add that “12-month returns following the final rate hike could be flat for 10-year U.S. Treasuries, while the S&P 500 could sell off sharply.”
Accordingly, bonds look attractive “for their diversification, capital preservation, and upside opportunities,” while “earnings expectations appear too high, and valuations too rich,” warranting “underweight” equities positioning.
Compounding the risks are flows “that eventually will constrain lending and nominal growth on a 6- to 12-month horizon,” writes Goldman Sachs Group Inc (NYSE: GS).
Graphic: Retrieved from Bloomberg via The Market Ear. “The bull in money market funds refuses to cool down.”
In other news was worry over a US debt default.
The US government has been using accounting measures to provide cash after reaching a borrowing limit. Treasury Secretary Janet Yellen informed Congress that these measures might be exhausted by June, resulting in payment disruptions; a default would cause an economic disaster and “global downturn,” threatening “US global economic leadership” and “national security,” Yellen says. A solution (e.g., to raise the debt ceiling) could manifest issuance of “a substantial amount of bills in 2H23 … that would drain liquidity,” Morgan Stanley (NYSE: MS) writes.
Despite the worry, markets are contained in part due to positioning contexts. Decline in realized volatility (RVOL), coupled with implied volatility (IVOL) premium, makes it difficult for the market to resolve directionally.
In fact, Nomura Holdings Inc (NYSE: NMR) said it sees “significant further potential for additional equities re-allocation buying from the vol control space over the next month if this ongoing rVol smash / tight daily ranges phenomenon holds—i.e., +$37.8B of US Equities to buy on theoretical 50bps daily SPX change).”
Options are sold systematically as traders aim to extract the premium; the Ambrus Group’s Kris Sidial says there is a puking off options exposures and short-bias activity (i.e., selling options) used as yield enhancement as traders call bluff on authorities not being there to prevent crises.
Graphic: Retrieved from Sergei Perfiliev. “This is a 1-month vol – it’s 30 calendar days for implied and I’m using 20 trading days for realized – both of which represent a month.” Note that “juicy VRP = big difference between options’ implied vol (what you pay) and realized vol (what you got). Options are cheap historically, but expensive relative to realized vol.”
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 volatility, not higher.
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.
Our levels have been working. For instance, as shown below, yesterday’s Daily Brief levels were key response areas for the Micro E-mini S&P 500 Index (FUTURE: /MES).
Graphic: Retrieved from TradingView.
Some of the levels overlap centers of options activity; falling volatility coincides with increased sensitivity among those options, lending to reversion and responsiveness.
“This continues to suggest that our theoretical framework of ‘options dominance’ is indeed the driver. In 2017 when the XIV (inverted VIX ETF) was king of the hill, that 44bps high-low range would have been the 47%ile,” reports Tier1Alpha. “If you think these markets are boring, try 2017. Our suspicion is that similar forces are at work, just concentrated in 0dte options. The 2017 bear market in vol came to an end with Volmaggedon. The cycle will end this time as well, but the catalyst remains to be seen.”
Graphic: Retrieved from Michael Green of Simplify Asset Management.
Consequently, per SpotGamma, “there is little room for error.”
From an options positioning perspective, for volatility to reprice lower and boost the market, “we need a change in [the] volatility regime,” SpotGamma previously added. The likelihood of that happening is low since many expect the Federal Reserve (Fed) to stick to its message of higher rates for longer, notwithstanding the consumer price index rising by a below-forecast 4.9%, the first sub-5% reading in two years. Overall prices remain hot, and the job market remains robust. Policymakers need more than one month of data to be confident that prices are on a sustained downward path, Bloomberg reports.
“Inflation is higher than the Fed’s mandate and not on a path to get to that mandate soon. The CPI report is one data point, and most measures show elevated inflation. Areas that had been disinflationary are reverting. And the stickiest parts of inflation remain elevated.”
Graphic: Retrieved from Bob Elliott of Unlimited Funds.
So, support for a pause or hold is the more likely scenario.
“When pauses have occurred against the backdrop of tight labor markets, the Fed has rarely eased in the subsequent six months — the most common outcome has been an on-hold Fed,” explained Praveen Korapaty of Goldman Sachs Group Inc (NYSE: GS). “In contrast, periods with material deterioration in the labor market have more reliably resulted in easing. At least during this period, the inflation backdrop at the time of the pause does not appear to have had a material influence on policy actions.”
Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via Bloomberg. “As this chart from Goldman shows, when the employment is tight (which it plainly is at present), pauses tend to become extended. It’s only when employment is seriously deteriorating (on the right side of the chart) that the Fed pivots swiftly.”
Moreover, heading into price updates this morning, the expectation was for a smaller move in the S&P 500. However, with volatility very low, we’ve maintained that selling options blindly is dangerous. When you least expect significant movement, it often happens; just before the opening, the market has moved over 1.0%.
Graphic: Retrieved from Pat Hennessy of IPS Strategic Captial Management. “Welp, it was fun while it lasted. SPX straddle only pricing 83bps for tomorrow ahead of CPI, lowest on record since dailies were listed in May 2022.”
Check out our detailed trade structuring report for more on how to better manage a portfolio in this enviornment.
Graphic: Retrieved from Bloomberg. “The case for concerted easing rests fundamentally on the yield curve. Long-dated bonds have been paying a lower rate than shorter securities for the best part of a year, and this is a well-known recession indicator,” John Authers says. “It’s also a serious headache for banks, who traditionally borrow at low short rates (via deposits), lend at a higher rate, and make their profit from the difference. Banks, we know, are in trouble. If claims of a ‘crisis’ are a tad overblown, the deposit flight created for them by the inverted curve will contribute to the recessionary environment.” A way for the curve to return to its usual shape is for the Fed to cut rates, but the consensus among pros is that won’t happen for some more time.
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.
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.”
“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) strategists say 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.”
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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.
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.
Keeping it brief today, as well. PS: Almost ready to go live with that detailed report!
Half of the S&P 500 (INDEX: SPX) is scheduled to report earnings in the next weeks, and this will help investors further validate the index’s recent strength and tameness driven in part by “liquidity turning higher,” early solid earnings reports, the resolution of the bank turmoil, and expectations of “swift cuts by the Fed” later this year.
Aside from the debt ceiling issue, if new data confirm a growing consensus that the economy could slow and stay slow for a while, markets may endure some upset.
Graphic: Retrieved from Bloomberg via Tier1Alpha. Default probabilities are low. With a CDS of 130 and assuming a 40% recovery, the implied probability of default is 2.17% or so (130/0.6).
Anyways, the most objective thing to do is to hedge upset and the lagging effects of policy as covered in the previous two letters more deeply. Lock in protection against inflation while allocating remaining buying power to plays on equity strength that you may monetize and roll into bets on weakness later on should it be realized.
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.
Last week, we discussed the recent response to the bank issues cutting risks for the S&P 500 (INDEX: SPX). Volatility and correlations fell as time passed, and this helped contain the market. Though last week’s options expiration (OpEx) may free markets up, we maintain that the SPX may stay contained longer before it weakens.
Graphic: Retrieved from SqueezeMetrics. “Monthly OpEx just shaved off nearly $300mm per point in SPX dealer gamma exposure. That means index liquidity has lost quite a bit of depth going into next week.”
Catalysts for weakness include falling earnings growth and a debt-ceiling crisis that’s driven T-bill yields lower from surging demand; a failure by Congress to raise the limit on how much the government can borrow may disrupt funding markets, WSJ reports.
Let’s limit our expectations and focus on low- or zero-cost call structures (e.g., bull call ratio) monetized to finance longer-dated put structures (e.g., bear put vertical) while allocating a chunk of our portfolio to near-risk-free yield-harvesting structures (e.g., box spread), mainly if you are a portfolio margin trader.
As I explained to a subscriber over the weekend, for boxes, the greatest possible loss across a range of prices is negligible. Hence, buying power is unaffected in trading a box. Consequently, using portfolio margin and trading boxes, you have more buying power to allocate to other trades that are margin (and not debit) intensive, such as synthetic long stock (i.e., purchase ATM call and sell ATM put). Using options, among other derivatives, enables us to stack returns on each other.
Here’s one example.
We can trade box spreads expiring at the end of June. We buy the $4,000/$5,000 call spread for $22,365.00 and simultaneously buy the $5,000/$4,000 put spread for $76,620. This trade costs $98,985.00, and by lending this amount (on April 21, 2023), you will receive $1,015.00 upon maturity. Yes, you will have $99,000.00 cash tied up, but you should be able to use $99,000.00 in buying power in other trades if you have that portfolio margin component which is so important.
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See you later!
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.
