Why do vol markets blow up?

The 5th Aug carnage was attributed to the "yen carry trade", but I think this is just macro trying to be smart.

While we can trace it back to the Nikkei, the conclusion is that the event itself is random, necessary and impossible to avoid.

1/ 2/ Some background.

The NKY was off by over 11% in the weeks preceding the 5th, with USDJPY off about 5% over the same period.

This was after a considerable period of quiet, with both the SPX and NKY grinding up with no vol over Jun & Jul.

BoJ & Fed and USD and then worry.

Today's PBOC actions give more panic feeling than a Fed 50bp.

Slow motion slowdown, deflation & de-leveraging becomes more worrisome when you introduce shock & awe...how bad is it?

View in charts (long one sorry)

1/ 2/ In a nutshell:

1. Post-pandemic slow in consumption & property partially offset with aggressive exporting of excess manufacturing capacity

2. Property related shortfalls in LGFV revenue is being managed, partially with a large fiscal deficit which hasn't helped the consumer

Tools being used to extend the business cycle now were once implemented only in economic crisis.

By breaking the limits, it seems like the goals of these institutions is to keep the US in constant expansion.

Equity markets love it too, as economic volatility has plummeted.

1/ 2/ Changes in underlying volatility of the economy (as measured by hard data), push up asset prices and encourage more leverage (which pushes up asset prices).

Measuring eco vol can be done as simply as measuring the range of nominal GDP.

The "25 or 50" discussion is painful.

Why?

1. There is logic for a direction to rates, but hardly ever one for individual moves.

2. Market pricing has a feedback loop with the Fed.

3. Hindsight doesn't make the move obvious.

1/ 2/ Every cycle this century has started with a 50bp (ex 2019).

Proof the Fed is always behind the 8-ball? Maybe.

Enough to start this one with a 50? Depends on how they view the current employment trend.

If you think they are worried, 50 is a great bet based on the past.

Keep an eye on this trouble maker - Nikkei futures traded weak in the overnight session despite stability elsewhere in equities

USDJPY looking just as precarious...

1/ 2/ It's managed to avoid the headlines so far without a sure break lower but expect it to make some news this session I'd say

Z4 SOFR has reversed the "game changing" NFP. I think pre-NFP levels act as support here, but the markets schizo approach to perceived recession risks are making both long & short vol strategies underperform.

Short-end sell off => curve flattens => equities rip higher

1/ 2/ 2 yr future back to pre-NFP levels...

The Japanese horror show today (down 12.6%), shows that it isn't about the direction of rates, but the vol a turning point produces.

All started with US CPI which shifted the market on rate cuts. Rates bid, USD off hard, shoulders tapped, risk unwind.

1/ 2/ Short vol/gamma positioning must be way bigger than everyone thought.

Right now we are tracking about the same as 2018 volmaggedon, with gamma trading measurably worse (esp. NKY)

As a buy & hold portfolio allocation, bonds really suck right now.

If the economics deteriorates quickly, bonds:

* Won't protect your portfolio;
* Won't profit more than leveraged short-end

All of this relates to how & why the curve is inverted.

1/ 2/ The 2/10y curve was inverted because the market always expected short rates to come down due to inflation subsiding + being long for portfolio protection.

In reality, the market could never price a normal yield curve because it was never going to believe inflation would stay.

US real GDP prints another solid qtr at +2.74% ex-inv/exports.

3 q's of near identical growth that have different composition - this month residential investment slowed and was made up for by accelerating non-res fixed inv and government...of course.

Don't bet on recession.

1/ 2/ After a slump in govt contribution last month, it's picked right back up to its +0.5% previous level.

Huge deficits will do this.

IT'S OVER.

That print likely ends the monster 3 year bear/flattener trade. I've been wrong the last 2 mths, but its been great before that.

Remained bearish through SVB, Q4'24 pivot.

We've rallied without crisis, and the easy roll up the curve is dead.

What's next?

1/ 2/ Moving back to flat rates in the US and Europe we have to consider our next move.

Being long here isn't clear, there's a lot priced for a Fed that has time to take it easy.

10s are rubbish and you have little reason to own them long-term (next newsletter on this topic)

Bonds have backed up around 20bp to LEVELS NOT SEEN since 2 weeks ago.

This is primarily a Euro story, as Bunds broke upward trend on French politics and have reversed the move just as violently.

Fed path unch, leading to steepening.

I remain very short.

1/ 2/ Year-end Fed funds have done nothing, pricing a cut in the 4th quarter.

Prime reason for continuing to stay short is that I don't think they cut, and even if they do its overpriced and they are likely to be very cautious about further messaging.

Lots of excitement to be long rates here. Weak CPI, jobs worsening (?), political Fed.

My argument against that that there isn't much upside. Remember, you have to exceed current expectations to win.

Futures still in downtrend and yet to breakout. How many cuts to break?

1/ 2/ First to explain the chart above.

This is a series calculated from chaining together returns of the US 2y futures contract and rolling at the first notice date.

Crucially it includes the roll up an inverted curve...a cost in being long.

2s10s isn't a measure of the relative performance of an actual trade in a 2y and a 10y bond (or future) when the curve isn't flat.

It doesn't suit the supply argument, but curves have been flattening aggressively all year, MOSTLY in the last 3 months.

1/

https://twitter.com/dampedspring/status/1797617274213322963

2/ The generic yield used in Bloomberg or tradingview is based off the interpolation of the curve at that point.

This gets recalc'ed every day which is the equivalent of rolling forward to a NEW 2y bond every day.

The Yen has devalued against everything, but none more convincing than against the Yuan.

Is China winning and Japan losing?

No - they are just doubling down on the same economic goals in different ways and are becoming more alike.

The battle between the Yen and the Yuan.

1/ 2/ The straight-line depreciation of the JPY against the offshore Chinese Yuan has been a better bet than the S&P from a risk-to-return standpoint.

A key narrative has been that China has been encroaching on Japan's high-value exports, and this is true.

Only 6 bullet train routes in China are profitable, and the push to raise prices to cover the maintenance, operation and debt load of these sprawling systems illustrates the issue with building infra that isn't economically additive.

NY times article linked in thread.

1/ 2/ These lines are subsidised at multiple levels - not just ticket prices but the electricity that runs them and interest cost of the debt that built them.

Electricity costs have also recently been pushed up for factories.

nytimes.com/2024/05/13/bus…

Mute "stagflation" on your feed, this was another incredible US GDP result.

Growth ex net trade and inventory = 2.8% (2.77% last Q)

Govt contribution down, but residential investment picking up the slack! Non-res still printing positive.

Cyclical parts of GDP crushing it.

1/ 2/ Why do we leave out net exports and inventory?

Because they average to zero over the long-term, so if we want to find the underlying growth, we stick to the other components.

Both net exports and inventory average -0.05% per quarter over the last 20 years.

USDJPY pretty much out on its own here.

Post-CPI breakout is definitely confirmed now - when Dec-24 SOFR busted through the point of no return.

The BoJ's meagre tightening measures not working here as it's even underperforming CHF who have already cut rates.

Mega FX thread

1/ 2/ CHF has softened relative to the USD more than the EUR...but this has only reversed more recent outperformance, and DM currencies in general are nowhere near their weakest levels, with that happening in the blow off top in bond vol in late 22.

Chinese supply-side growth is the engine for Chinese growth and to this end there is only one thing you need to follow:

STEEL.

If you want to know when to care about the effect of China on US equities & credit, read on.

1/ 2/ If you had asked a China analyst 10 years ago whether a 50% decline in property activity would cause a crisis, the answer surely would have been "absolutely".

This has basically happened, and Chinese growth (and western markets) are just fine.

An everything JGB and JPY thread.

Rumours are for the BoJ to end NIRP & YCC at the Mar 18-19 meeting.

2y new high, 10y heading to 1% fast.

USDJPY only off ~2%. USDJPY vol the surprise...shouldn't it be more? Reality is JPY vol has been in decline.

1/ 2/ First up, economics. Core CPI has been cooling while growth has been good.

Last 3 mom core CPI prints are around the 2% mark. I wrote a long thread about how well Japan navigated the pandemic vs western states below.

https://x.com/countdraghula/status/1689092931947487233?s=20

Despite more certainty on the range in rates compared to the same time last year, daily ranges in 2s and 10s remain quite high compared to pre-pandemic, at about 10bp per day.

But this isn't the right way to look at it.

1/ 2/ Considering that range as a % of the base yield, we are back to the good old days of bond markets!

Only a little more vol than in the pre-pandemic days when accounting for higher Fed Funds.

Macro is the toughest asset class to generate alpha. It requires constant stops and incredible discipline. Why?

1) Long-term trends are very rare, happening 1 in 10 years
2) As such, they "range trade" over decades
3) There is no "earnings growth" to fall back on.

1/ 2/ Here is a systematic trend following strategy I run for myself as base alpha.

Trading rates futures, the avg trade frequency is 3 per day, with 75% of days having 1 or more trades.