A further widening of inflation break-evens complicates things for the Fed even if it remains committed to its wait and see strategy that only decides to act when the evidence of higher inflation is clear.
Risk premiums become prices in plain sight and they become a statement on expectations of the mean and variance of inflation. The prices also help satisfy the market’s (almost insatiable) need for narrative.
One such narrative might read “inflation break-evens are a Fed credibility metric”. These narratives serve to reinforce the broad market consensus. In circular fashion, what we think helps determine prices, which in turn tell us what to think and what to believe.
Staring at quickly rising market determined B/E levels will not be comfortable for the Fed. In such a circumstance, the already prominent chorus of professionals asking the Fed to keep its options open during a period of uncertainty would increase in number.
If demand for inflation protection far outstrips the supply of it, the price for protection can gap higher. Investor views could be quickly shaped and updated to include a wide array of outcomes.
All of this is to say that market prices matter. The longer the Fed ignores the price discovery of inflation risk premium, should it reach a further elevated level, the more out of step it could conceivably be if it turns out the Fed’s hopes for transitory are not fulfilled.
It is not a leap to have market prices force the Fed’s hand. Imagine the scenario in which expectations feed into price so strongly that the absence of tightening action from the Fed becomes a de facto ease. Market prices matter.

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More from @Alpha_Ex_LLC

14 Nov
Effective risk management is compromised by a failure of imagination. We generally believe what we see. Market prices are especially powerful in this way. They live alongside us, in motion always, inviting us to look.
We spend considerably less time contemplating things that do not change so frequently. Change makes for easy daily study. But market prices are altogether different in another way. They impact our wealth.
And when this cycle is "virtuous", it is impossible to push back on. Risk taking is excessive? Who is to say? If you are in the business of managing money, your payout is a call option, not just on performance but on your asset base.
Read 9 tweets
10 Nov
In some ways, 10-year note is just another risk asset. Over-owned by those with no alternative. Valuation profile is absurd. All other assets are priced off of and seem “less bad” by ridiculous proxy. Can’t argue any more that duration is a +carry hedge, at least on real basis.
I am sympathetic to idea that neg real yield on UST and correlation regime change has something to do with higher VRP in equities. The “easy” hedge is no longer.
Apollo Co-President Scott Kleinman said record-low interest rates are causing a “collective delusion” on deal valuations. Near-zero interest rates are having “a whole variety of unintended consequences” and are causing valuation multiples to rise “incredibly dramatically,”
Read 4 tweets
8 Nov
In the old days (ie, 2 years ago), being short an upside call was pretty harmless. "I'll buy some stock, maybe lean long with client," said the guru sell-side derivs book-runner who made the price.
"Plus, when the stock rises, it will do so gently. Stocks are escalator up / elevator down assets!", she thought to herself. "Plus, if I'm using market implied vol to calc my delta, I'm probably already long more than I need to be should the stock pop."
Then came 2020. "It's complicated," she said, adding "I'm getting two things very wrong now." The up-crash in stock prices, a defining characteristic of the Meme era was one.
Read 8 tweets
4 Nov
Some thoughts on realized vol…If inflation is the "anti-earnings" to nominal bonds, then falling realized vol is the same to options. Of the factors that drive option prices, motion in the underlying is of most importance. Without the daily swings, "the rent is too damn high".
News Alert: The RVOL index...a handy Bberg command that saves us from typing SPX <INDEX> HVG <GO> all the time, has dipped below 10...again. 10 vol is around 60bps a day.
Realized vol is mostly a concurrent indicator. Nothing bad in markets happens when RVOL is below 12. Here's a table that maps RVOL versus returns. RVOL below 15 is generally safe.
Read 12 tweets
3 Nov
post FOMC, the 2nd $VIX future is set to test post-pandemic low. vol pops are fast becoming difficult to remember. I see 3 characteristics of vol that are worth keeping close at hand-->
1. Vol Mean-Reverts: Market disruption events don’t last forever as a combination of cheap asset prices and regulatory fire-fighting response ultimately provides runway for capital to be re-deployed and vol to decline from very high levels.
2. Vol Has Memory: The best predictor of vol tomorrow is vol today. Periods of low vol tend to lead to a self-reinforcing psychology of stability. Conversely, de-risking episodes cause forced selling and more volatility.
Read 5 tweets
2 Nov
Roughly, we can think of equity vol as derived from 1 of 4 places: 1) distance to default (Merton) 2) vol of earnings 3) vol of rates 4) vol of the P/E multiple. There's overlap..vol in rates, for example, may be related to inflation which may lead to vol in the multiple.
In 2008, it was #1, distance to default in financials that sponsored vol. In 2020, it was #2, vol of earnings. In 2013, it was #3, vol of rates that hurt equities (briefly). In 2000, it was #4, vol of the P/E ratio (those stocks never had earnings to begin with).
AMZN has 5 year CDS at 34bps but 2y IV at 28. MSFT has 27 IV and CDS of 24. GOOG has 27 IV and 28 CDS. These stocks move quite a bit. Default isn't a risk that comes to mind. Sure, they have vol in earnings. But it's also that their P/E's are quite volatile.
Read 12 tweets

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