October 2022 Update
Top of the book liquidity
The bastion of liquidity, the place where the world comes to hedge, the 10,000lbs gorilla maintaining world peace, is seeing the thinnest liquidity ever recorded. This is a long term warning sign as other places are incredibly volatile. The depth of the market is also now below the 5th percentile.
Long vol’s dramatic underperformance
Artemis Capital, who puts out exceptional white papers, came out publicly last week about closing down some of their long vol funds. As we’ve discussed throughout most of this year, Artemis’ and most long vol strategies did not work because the street was overly hedged for Russia and for Fed rate hikes. This positioning, in turn, created the perfect environment for vol selling, which paired with the events never realizing their worst case scenarios, ‘artificially’ compressed volatility since late April. As long vol funds capitulate, the pendulum swings to complacency on hedging the tail. This is when a second leg down move can unpin the market to the downside and what we’ve been waiting for all summer.
The Oil Put
One might wonder why the price of oil is at $82 a bbl, down from a high of $130, despite the Nordstream sabotage, OPEC production cut, and crisis in Iran. This is because the WH’s been depleting the Strategic Petroleum Reserve (SPR), flooding the market with supply of oil. The SPR is now estimated to have <30% left, down from ~90% in February. It is worth noting that this extra supply has been completely absorbed and no inventories in the world have replenished. To replenish the SPR, just last week, the WH became a buyer of US oil between $67-72 (now $82). This will basically act like a put on commodities. Next year, we expect commodities cost to increase, driving additional inflationary pressure across the market.
The Fed is in the process of losing control of the long end of the curve
Ironically, higher interest rates in the long end of the curve continues to march higher. There is a divergence given that the Fed spoke about talking about talking about pausing rate hikes (yes, you read that right). Yet we saw 10Y yield making new highs. The more they do that, the more inflation becomes structural (instead of cyclical) because higher rates pull demand forward and cause inventories to buildup. Simply put, it’s better to buy today than next year when it’s 5-10% more expensive, depending on the rate of inflation. Also if the expected real rate is still negative, one can borrow money and put it in anything that is going to appreciate more than it and leverage it. These things drive structural inflation and will bring in more volatility and less demand to stocks (which are purely vehicles for speculation)
Real grey rhinos, no longer black swans
Russia has begun to lay the ground work for blaming the US for the explosion of a tactical nuke that might happen.
China saw the passage of the chips act, a blatant form of aggression against China, as provocative and will unequivocally retaliate (limited rare earth exports?). The retaliatory actions are likely to come after the midterm elections as China doesn’t want to affect the outcome or create more bipartisan outrage here in the US.
In the last week, we had two warnings. The first one is from Secretary of State Blinken, and the second from Admiral Gilday, Head of the Navy. Both warned about an invasion of Taiwan is increasingly likely in a much sooner timeframe than expected. Palantir execs and others that have a good view of what’s happening in government all seem to agree with these warnings.
Outlook for November:
Given positioning around the midterm elections, we’re expecting a countertrend rally in the first week an a half of November that’ll last into EOY. Despite the likely incoming bullish flows, there are tail risks as we’ve discussed above. The macro overhang from inflation alone is very serious and will likely weigh on the market.
Until we find a solution to inflationary problems which only seem to get worse, the trade remains the same:
- Look for asymmetrical ways to bet on the downside
- It doesn’t just mean to find ways to get short into rallies, but also increasingly take advantage of convexity (long gamma) to the downside given the underhedging that’s happening in the market. We suspect it’ll take about another 2-3months for the market to completely give up on hedging.
But in the short term,
- the trade is to be long in long dated calls for what is likely a major countertrend move coming out of the midterm elections and to opportunistically, as we get to the end of the year, to start looking at that long tail.