I have been to many stakings- you have to know where to stand! You know, everything in life is positioning, positioning, positioning…
The market has seen quite the bloodbath this Monday before the opening; stories of carry trade unwinds, panda bears, Sahm’s rule, recessions, FED policy mistakes, and trying to buy insurance on your burning house and not having the time to digest brewing tensions in the middle east.
Now that we have seen the fires of Mount Doom in the shape of unemployment numbers ticking above expectations; the only rational thing to do is to ignore all other economic data, and cyclical mechanisms and press the panic sell button. Well… fine not quite what happened… The rates markets have been experts at overshooting to the upside and downside with every piece of economic data and this time may not be so different. On the back of the unemployment print last week (act 4.3% vs exp 4.1% vs prior 4.1%) preceded by manufacturing PMI (act 46.8 vs exp 48.5 vs prior 48.5) the market was prompt to price in a 50bps cut to the policy rate in September in addition to a 40% chance of an emergency rate cut; fearing the Fed had made a mistake of not cutting on the FOMC meeting before the economic numbers. Just that same week, everyone talked about Goldilocks on a rocket ship to the moon with steady 25bps cuts on the back of softer but positive economic data (well I was at least). This volte-face made the yield curve bull-steepen to the point of uninverting intraday. Not too long after; another volte-face to the volte-face: the ISM services PMI data materialized out of the rubble and turned out better than expected (act: 51.5, exp:51.0, prior:48.8) calming fears about a recession.
Clearly retail was a fan of this economic data given they bought the dip in droves on Monday averaging 1.8bn…
I’ll make one point around the market’s tactical positioning with the now common knowledge Yen carry trade (we also had the Russel funding short trade unwind not long ago) and avoid plagiarizing every newspaper on this earth. These positioning unwinds are expressions of leverage in the financial system and the start of a negative response to an economic print can provide a spiral that flushes out leverage from a trade and should not be confused with cyclical behaviors which investors can benefit from using a longer time horizon than market participants. This tactical unwind provided however a great opportunity to sell short-term vol for those who have the tapdancing shoes to do so. The materialization in a few trading days of a few months’ worth of yield rallies should provide for the expectation of a mean reversion and take profit on rates-driven trades with the expectation of a narrow rates selloff (relative to these daily black swan moves).
Although vol has considerably abated to the 25 handle from its highs, the bid on vol of vol is at the level seen at the start of Covid in addition to one-month equities implied correlation being at record levels. This implies a few things about how equities can reprice in the coming days.
1) The VIX has a high likelihood of being bid, we have seen the start of that this Wednesday.
2) If the VIX is bid, the speed at which the VIX would go back to highs can be equivalent to the price action we saw on Monday. This implies we need to be looking at wider ranges for equities to move within.
3) Rapid price actions are skewed to the downside given the implied correlation between equities is at highs and the diversification by industry and sectors in portfolios will be muted in the coming days. This also implies that hedges using broad equity indices will be more effective.
4) I would be long vol right now and focus on buying vol to hedge the downside in equities. Given the vol of vol, further out of the money puts on ES, NQ, and RTY provide the best risk-reward in the coming days (but hope they end up being sacrificed to the macro Gods)
I also expect a continued inverse correlation between equities and bonds to persist through the next few economic prints while we obtain clarity on the direction of growth and consider maintaining long bonds across durations (focus on ZT – 2y and ZN – 10y) currently as a hedge for the lazy equity longs.
I want to quickly mention an uncomfortable situation the central banks find themselves in due to this positional unwind which could change the current general trajectory of the cycle. The cheap Yen funding short was used by both Japanese and foreigners buying Mag 7 and Japanese equities respectively which caused the three assets to become highly correlated. All that was needed was for the expectation carry between USD and JPY to narrow at a faster pace than had been priced before the start of growth scare talks. For now I don’t have an answer to how much has been flushed out, JPM claims 75% for now but we shall see.
Given the central banks do implicitly look at market volatility to guide their behavior, the FED would in part be incentivized to cut at a reduced pace than what the market is currently pricing in to stop the bleed on the USDJPY and calm the equity selloff. Now if the economic data continues skewing on the weaker side, the reduced speed of cuts to calm the USDJPY would be perceived as a policy error on the economy and accelerate recessionary concerns. In either of the two scenarios, equity valuations collapse either due to USDJPY funding short becoming more expensive and the leveraged players having to unwind or due to growth scares forcing the unwind of US equities and due to the linkage between the three asset classes the other two fall in tandem. Basically having to choose between being staked in the heart or burning at the stake. However, there is a path threading the needle between the two where economic data comes in supporting the continued growth thesis between now and FOMC where Goldilocks could be hiding after eating the bear’s porridge. But maybe she was already eaten…
One last guiding principle to help navigate the weeks ahead: “One Central Bank to rule them all, one Central Bank to find them, one Central Bank to bring them all, and in the uncertainty bind them”
In the next section, I want to focus on what this cycle has in store for those who can accommodate a longer time horizon than that expressed currently in the market and go into the probability-weighted paths for the US economy and liquidity. We will then go over portfolio composition with a focus on real assets (very long-dated futures or call options on metals and energy, namely oil) with uncorrelated returns to equities and bonds and equities that should outperform during a recession or be supported by fiscal stimulus (good thing both presidential candidates are experts in fiscal stimulus).
The initial macro thesis that was posed a few weeks ago was that we would see a gradual bull-steepening of US rates over the next few quarters while rate cuts start materializing into sustained but slower growth. This was clearly very wrong on timing but the mechanics driving that conclusion still apply today and can be worth revisiting.
July 11:
July 24:
Cheers!
