July 2022 Update

Equities index is the last bastion of liquidity in the market. There is no liquidity in the interest rate and bond space anymore. FX has lost all its liquidity and we’re seeing that in the movement in vol. Tech, crypto, credit spreads are also widening dramatically. So watch equity vol in this month and coming quarter. It is the one place where if it breaks, we’ll see greater and greater problems.

If we continue to see a rally, IV is likely to increase (as we’re seeing right now). If that happens, it will continue to untether index vol which has been one of the most supportive flows in this market into a decline.

Places to hide are starting to break down

Beginning to see higher correlation. Energy has seen massive liquidation this month. Banks and other defensives are also starting to see a lot of liquidation. In the mid term, QT has only started for a month, and a lot of MBS effects take about a month or so to pass through the system. We’re seeing decreasing liquidity right around September 1st (1.5 months from now) is going to see a doubling of QT from 47.5B runoff to 95B.

The 8th or 9th Inning

There are a couple of things that are leading to a bit of complacency. In the next month, we’ll see a bit more pain in the equity vol trade and a bit more vol compression, but that’s ultimately the 8th or 9th inning. HF sentiment is at 15th percentile. Retail sentiment is at 80th percentile (still quite high) but dramatically reducing. We will likely see continued pinning in the market and vol underperformance. As we come into the fall, we expect much greater opportunity.

Entering earnings season

We just had awful bank earnings (JPM and MS). We expect that trend to continue. Margin compression and inflation is really beginning to hurt earnings. Early in the cycle, entities could raise their prices because demand was that strong but as demand begins to slow a bit due to fed activity and markets coming down, the inflation will have to go to the bottom line. About 40% of US corporations earnings come from the dollar. That dollar strength which is historic will take a significant bite out of earnings for many multinational companies. Target has mentioned that entities are seeing an inventory whipsaw. In order to hedge inventory cost as well as get out in front of inflation, entities have built inventory dramatically. And now this reduction in demand is seeing massive inventory gluts. This is going to cause a significant write off in retail and corporate entities.

This all happens during a period of buyback blackouts

As we go into earnings, many corporations cannot drive the demand for stocks that they have been for the last 2 months. We’ve seen major buybacks this year and that’s been a major source of demand. So now we’re losing buyback flows right as there’s earnings risk.

The Fed’s credibility is at stake

At the end of these 2 weeks, on the 27th, we expect the fed coming, right after a really hot CPI and lots of uncertainty, right as the MOVE index is increasing. November midterm elections are also coming. The fed does not want to be incredibly active come November, so there’s a shortening window where the fed needs to be aggressive. There’s a good chance for 100pts increase in rates despite the comments that we heard last week. Even though the market is saying 50/50, we believe that we’ll continue to see an aggressive fed.

The contrary argument

Positioning particularly in HF is expecting poor outcomes. P/C ratio is normalizing in the short term. Vol is oversupplied. We believe that these effects will dampen downside despite what is otherwise a very bearish macro outlook. Any real risk that comes to the market from other parts of the market could really break equity vol and that’s what’s important to look at. That could come from China, private equity news, commercial RE, JGBs, credit spreads could all create that tail. If they can push equity vol well enough, there is very liquidity outside S&P and equity index vol.

Outlook for August

We’re seeing S&P upside vol at 17.5-18. If we continue to slide to the upside, the VIX isn’t going below a 20 in this environment given the macro risk. So given how cheap upside vol has gotten, the most basic thing right now is if you’re long stock, it’s almost insane to not buy calls and do stock replacement. Calls are not only following their deltas to the upside, they’re actually outperforming to the upside. Obviously they also give you protection (cap losses) into a market decline.