A Week of Idiosyncratic Volatility


A Week of Idiosyncratic Volatility

Monday, February 15, 2023 By Vincent David-Robin

Last week was a week in which markets moved for reasons that were really idiosyncratic. There was no external news impacting the direction of travel. A lot of it was down to perception of inflation again; and what the Fed would do as a reaction to that inflation.

“Higher For Longer Scenario”

What was interesting to me is that it shows how fickle participants are in thinking that the Fed would stay dovish, and that the pricing of the futures as it was at the start of the week was correct and cast in stone. But by the end of the week, all of a sudden the mood had changed and pricing evolved to be a reflection of a more hawkish Fed, or the Fed more likely to stay the course, and not lower rates as fast as possible.

Therefore it is a ‘higher for longer’ type of scenario. I'm very surprised. Tomorrow, we have the CPI. We have to be a bit careful because every little bit of information – even though it is just a small part of the puzzle, or just a cog in the chain – is really taken at face value. At least, it has been till now until now.

If inflation is perceived to be a bit better, Fed funds rally very hard in 24 and 25, and then equity markets rally really hard. If any piece of data is perceived to be less favorable to inflation, then Fed fund futures remove that ease and then set off again; and all of us in equity markets follow suit.

Strong Rally in Equity Markets

What happened last week was not so much about golly rocks and soft landing because we were very low on that time in terms of production, real estate and employment. It is more about perception of the reaction function of the Central Bank. I think that is why we had that really volatile week with very strong rally in all equity markets and fixed income markets Monday to Wednesday, and a sudden reversal through Thursday and Friday for fixed income inequities.

We are again at levels that are a bit key, or not too far away, from being at relevant technical levels. I think 12 two-and-a-half on Nasdaq is interesting. The 4060 on S&P is also interesting, in the less defined territory in Europe. But those are levels that are not so far away for both the S&P and the Nasdaq.

We saw very large swings on Russell last week: up 3%, down 3%, and finishing the week at down 3% as well. In my opinion, this choppy pattern is likely to continue as employment data gets rolled out and inflation data gets rolled out; be it CPI or PCE.

Choppy Markets Ahead

I suspect though that what we saw in the month of January – that strong rally and then the now subsequent sell-off in February – is a one-off. I think the January effect was the traditional January with animal spirits and enthusiasm by investors. From here, we could have a choppy markets up and down every month for the next few months, till we have a better read on where inflation is going. My hunch is that, as a matter of fact, it is going to decrease. But it's going to be relatively slow, and not as fast as most participants would like it to go.

As a result, bonds will remain under some pressure, and equities are likely to be under the cosh as well; because what we also know is that earnings are coming down. It is likely to be a bit of a tough one for earnings this year because there's a slowdown in the economies. That is clear.

Even when you look at retail sales in the US, we have seen that they are slowing down; that there has been a really big slowdown in staples as well. You just have a few categories are resilient; like healthcare, for instance. But overall it is a slowdown. So you could expect earnings to slow down, no matter what.

Overly Optimistic About China

The reopening of China is a big question mark. Now everybody expects China to go back to 7% growth from 3% growth last year. Frankly, it is highly debatable how they could have 3% growth with the economy being shut down for six months of the year. But the data is probably a bit manipulated. But now most expect China to come back with a vengeance.

It is not quite clear whether it can so fast, because the main issues of indebtedness of the regional governments and the real estate and massive in-effect bankruptcies are likely to be a very large drag on the performance of the economy in China, because of the wealth effect that people felt in China with the real estate crisis going up. If anything, now it's the opposite.

We know that the global growth for the exports of China is not as strong at the moment. The domestic market would really like to support since there is that large issue linked to the real estate market. Anecdotally, two months ago, I recall the central government issued an edict whereby estate developers couldn't lower the prices of new offerings by more than 25%. So they tried to put an artificial floor into the market to maintain prices, but it's not really working.

The markets are still expecting a lot coming from China. I doubt we'll see as much.

Stable Metals and Solid Oil

When it comes to commodities, with slightly higher yield and the short dollar position being slowly unwound, the dollar index has rebounded a bit. I do not think we are going to see a screamer on that. I think maybe there is another 2% to gain, but not much more than that.

That said, it is not a support for commodities in general. If the reopening of China is not as strong as current expectations have it to be, then industrial metals are likely to stop as well. So copper, which has recovered nicely, may pause. Nickel as well; and iron ore as well. Those could be a bit of a stop on the commodities market.

The one commodity market that I am still fairly optimistic about is oil. We know that Russia is in trouble now with the cap. But the overall demand still exceeds the overall capacity to to produce. The situation of Iran is not completely clear. Venezuela – even if the US now are a bit more open-minded about Venezuela – the reality of putting production capacity back online will take a year.

I think the demand for oil is going to remain very solid. It will not spark. We are happy about that. I wish we had a little more. But that is the one commodity I like. I am not so sure about gas. Gas is a fragmented market anyway, because you have gas in the US and gas in Europe; and they are so different in the way they behave.

I still like commodities as a risk off trade. I think the demand is there. But is it going go very far? I am not sure. It is a risk of trade, especially in the case of wheat; linked Russia and Ukraine.

Wide IV Crossover Amidst Tight Credit

Credit is still very tight. Too tight, in my opinion. But it could underperform by about 20 basis points. We could see a wider IV crossover in Europe – widened by 20 to 30 basis points potentially, but I do not see it go much further than that. So it is tight. Not a very good place to invest. Still, a lot of corporations in America have been snapped up because it is higher. You need bad news on the economy front – on the corporate front – for spreads to widen.

Otherwise, if you don't have a lot of defaults and bankruptcies, credit is tight and could remain so for a while. So I do not think there is much to do for us there. We are not really in the business of shorting credit spread. We cannot even buy CDS in use its form anyway.

We have CPI tomorrow. We are going to be tactical again. I see markets going up or down by a few percent. So it's likely to be a similar story, where we need to be smart about the ranges. If we have conviction and trade range, I don't see any real change in the underlying factors that would move the markets at this stage.

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