Volmageddon

and the Art of War

We live in interesting times. Being a 40 year plus veteran in this industry we call investment management I have not seen such utter confusion and such wide division between those that must be obeyed, central banks, regulators, CEOs of very large banks and the relatively small handful of us who actually remember what a real bear market looks like.

We may well be on the cusp of another bear market rally. So far, we are tracing out very similar patterns to 1973/74. Sharp declines followed by “impressive” rallies with investors speculators buying the stocks that lead the bull market up predominantly anything with a growth bias notably tech and ESG, accompanied by the braying financial media calling that the bottom is now in.

The release of CPI data on Thursday resulted in an immediate mark down at the opening bell on Wall Street followed by a heroic rally with the market closing higher than the previous day. This was all because the CPI number was 8.2% compared to the expected number of 8.1%. On such small margins are errors made on market positioning.

In the long run fundamentals, earnings and balance sheet strength matter, but in the short-term market volatility is driven by derivative positions that can have a significant effect on market moves. Last Thursday ahead of the announcement market participants had taken out a significant number of put contracts and on the opening plunge many of them would have taken profits; abiding by the short book mantra “buy puts on green and sell them on red.” Green being a rising market price, red being a falling one.

The second derivative effect of put buying is that the market makers in those options (who are only in it for the margin they make on the pricing spread) have to hedge their positions by selling the underlying stocks. If the price of stock or market does fall, they are liable to pay out on the put option, but they will have gained a similar amount by closing out their own short sales on the underlying stocks. This they will do every day depending on the flows of the options contracts they are writing.

Last Thursday the volume of put contracts being sold by investors would mean that the market makers would have had to buy back their short hedges, which created the very sharp rebound in the first hour and then the FOMO crowd (fear of missing out bottom pickers brigade) joined in pushing the market up into the close.

So, this really had very little to do with the news of the day. Controversial, but news doesn’t drive markets, it’s a combination of positioning and second derivative effects. We are told that the markets did this because XYZ happened; we are addicted to find a logical reason when one doesn’t exist. One of many reasons I do not read the Racing Pink or the Ecomicist. Or watch the BBC for that matter. Not having a television is bliss! Your mileage may differ…rant over.

Volatility in equity markets is pretty much a given, but far less so in bond markets. But when that volatility does occur as it did in October 2008 and March 2020 it was signalling a significant change in bond world. We are reaching those levels again, but let’s not blame the Bank of England and Kami Kwasi as the only culprits. Bond volatility as indicated by the MOVE index (this is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options) was already well on its way before the LDI debacle.

There is however a big difference between bond vol in the two earlier periods and now. In both 2008 and 2020 the high volatility represented a low in bond yields. Today volatility is rising along with higher yields. Are we about to see a reversal of bond yields to the downside. This is the index to watch as the bond market is the barometer of “truth”.

The PM was not the only U-turner this week (what would Mrs T have said?) On Tuesday the US Treasury Secretary, Janet Yellen, was quoted as saying that she had not seen signs of financial instability in the US. The very next day she became “worried about the lack of adequate liquidity in the US Treasury market.” Why the sudden reversal?

The following observation on that point is from the ever-resourceful Luke Gromen

We do not want to play 5-minute macro, but we also do not want to ignore the curious coincidences that Yellen reversed herself…as the IMF Annual Meetings were taking place when she reversed herself… meetings where “the strong dollar has been dominating conversations.” And then on Thursday, despite the USD initially rising sharply and stocks falling sharply lower on a higher-than-expected CPI print, the USD rolled over and the stock market ripped meaningfully higher. Were these all truly coincidences, or was something important decided at these meetings? Is it possible that “Yellen’s ears left resonating with the strongly-stated global recommendations for stern action to stem severe dollar strength on exchange markets?”

And where does this all leave the Fed? There are two narratives running here. The Treasury want to guarantee a liquid bond market, which they could do by retiring a series of bonds using their reserve fund, which is nowhere big enough to support the whole Treasury market; so, it could work for a while, but only as a band aid.

The Fed on the other hand want to deal with inflation by increasing interest rates and reducing their Treasury holdings, quantitative tightening. So, we could have lower bond yields at the long end of the curve, courtesy of la Yellen, which would be good for the US mortgage rate which is priced off the 30-year bond and has doubled so far this year to almost 7%. And higher yields at the short end as the Fed keep up the pressure on rates and sell back short-dated securities where much of their quantitative easing was directed. The yield curve (10s and 2s) hit minus 50bps last week which is as wide as it has been since July 2000 after which the yield curve returned to positive territory and the equity markets entered a pronounced bear market. Central banks usually cut rates as the recession unfolds (they can never predict one coming…) but often is the case as in the 2000-03 period and the post GFC recession the markets kept on going down. In 2008 and earlier examples the minus 50bps level has been an early warning indicator of much lower stock prices, which to me, suggests that this bear market is not yet over.

The secondary, or is it primary, effect of higher rates, which will mean a higher dollar, is that the economies of China and Russia are going to suffer more pain. The Biden administration seem intent on re-opening the cold war (did it ever really end?) by crushing their economies. Last week new regulations were announced forbidding any support to Chinese technology companies, particularly in the semi-conductor field, on pain of huge fines and the loss of American citizenship for individuals working in China. Those individuals often at senior research and CEO levels have already started to pack up for the journey home. Whilst aimed at military applications the collateral damage will be felt across the Chinese economy. The effect on the semi industry is best summed up by this quote.

“To put it mildly, Chinese companies are basically going back to the Stone Age,” Szeho Ng, managing director at China Renaissance, told the Financial Times.

So far, the Chinese media have not commented on this story, perhaps because the Chinese Communist party’s Congress has just opened, and nothing must take away the focus on “Chairman” Xi. It is however comparable with the US decision to halt oil shipments to Japan during WWII. Six months later we had Pearl Harbour.

On that note I’ll leave you with a quote from another WWII combatant, George S. Patton,

“If everyone is thinking alike, then somebody isn’t thinking.”

PS

Recommended reading -  Sun Tzu – The Art of War almost certainly read by Xi Jinping and almost certainly not by Joe Biden.