wknd notes: implicitly and explicitly short volatility

Dusted off an anecdote published shortly before the Feb 2018 collapse of ETFs that allowed investors to sell volatility in an explicit way (see below). Whether they want to admit it, or fully appreciate it, all investors who own equity, private equity, credit, leveraged loans, real estate, etc., are implicitly short volatility (and long stability). As bull markets extend, the ravenous sell volatility in explicit ways. Financial engineering helps disguise it. Leverage amplifies returns. Some are aware of the risks, many are not. As the cycles turn. And turn.

I take August off from writing, to do more reading, recharge. Hoping the same for you. Back again in September. All the very best, E?

Week-in-Review: Mon: US Treasury lowers Q3 borrowing estimate to $740bn largely as expected, Trump says he wants a strategic bitcoin reserve, Yellen rebuffed Trump’s views that a strong USD is walloping US mfg, UK Mortgage approvals 60.0k (60.3k e), Japan Jobless rate 2.5% (2.6%e) / Job-to-applicant ratio 1.23 (1.24e), S&P +0.1%; Tue: Israel strikes Hezbollah in Beirut in retaliation for wknd strike, BoJ to discuss a hike to 0.25% per NHK & Nikkei, Japan’s Mimura (new FX chief) says downside of yen weakness becoming more noticeable, Harris converges to Trump poll levels in swing states in new poll, China Politburo focuses more on the medium-term rather than short-term stimulus, MSFT cloud rev’s miss, Iranian President Masoud Pezeshkian said he will “spare no effort” in his push for the US to remove economic sanctions, France GDP 1.1% (0.7%e), Eurozone GDP 0.6% (0.5%e), Germany CPI 2.3% (2.2%e), Mexico GDP 2.2% (2.4%e), US Con conf 100.3 (99.7e), US JOLTS job openings 8.184m (8m exp), S&P -0.5%; Wed: BOJ hikes to 25bp / announces QT as was leaked, Fed unch as exp / Powell strikes a balanced tone, Hamas says Israel killed its political leader (Haniyeh) in an airstrike in Iran, Brazil CB unch as exp, EU CPI est 0.0% (-0.1%e) / CPI core 2.9% (2.8%e), US ADP emp change 122k (150k e), Canada GDP 1.1% (1.0%e), US Chicago PMI 45.3 (45.0e), US 2Q emp cost index 0.9% (1%e), Russia Ret sales real 6.3% (6.4%e), Russia Unemp rate 2.4% (2.6%e), S&P +1.6%; Thu: BOE cuts 25bp as exp, Czech CB cuts 25bp as exp, Hezbollah leader says fight with Israel has entered a new phase – open battle on all fronts, Opec+ signaled no changes to supply at regular meeting, Indonesia CPI 2.13% (2.37%e), Italy Unemp 7.0% (6.8%e), EU Unemp 6.5% (6.4%e), US Initial Jobless claims 249k (236k e), S&P -1.4%; Fri: NFP 114k (175k exp) / unemp 4.3% (4.1%e) / AHE 3.6% (3.7%e), Kamala Harris raised record $310m in July, safe haven assets (bonds, JPY & CHF) surge amid global growth concerns following soft payrolls print, Trump says no reason to debate Harris, Biden tells Netanyahu to agree to cease-fire, protests continue in Venezuela after last weekend’s presidential election “results”, South Korea CPI 2.6% (2.5%e), France IP -1.6% (-1.1%e), Mexico Unemp rate 2.78% (2.63%e), Brazil IP 3.2% (1.6%e), US Factory orders -3.3% (-3.2%e) / Durable goods orders -6.7% (-6.6%e), S&P -1.8%; Sat: Berkshire sells half AAPL stake (sells net $75bln of equities in Q2 - cash pile hits record $277bln).

Weekly Close: S&P 500 -2.1% and VIX +7.00 at +23.39. Nikkei -4.7%, Shanghai +0.5%, Euro Stoxx -2.9%, Bovespa -1.3%, MSCI World -2.1%, and MSCI Emerging -1.0%. USD rose +4.7% vs Bitcoin, +4.1% vs Ethereum, +3.9% vs Mexico, +1.3% vs Brazil, +0.8% vs Turkey, +0.6% vs Australia, +0.5% vs Sterling, +0.3% vs Canada, and flat vs India. USD fell -4.7% vs Yen, -2.2% vs Sweden, -1.1% vs China, -0.8% vs Russia, -0.6% vs Indonesia, -0.5% vs Euro, -0.2% vs Chile, and -0.1% vs South Africa. Gold +1.7%, Silver +1.3%, Oil -4.7%, Copper -0.5%, Iron Ore +0.6%, Corn -1.6%. 10yr Inflation Breakevens (EU -7bps at 1.84%, US -20bps at 2.06%, JP -11bps at 1.40%, and UK -7bps at 3.47%). 2yr Notes -50bps at 3.88% and 10yr Notes -40bps at 3.79%.

July Mthly Close: S&P 500 +1.1% and VIX +3.92 at +16.36. Nikkei -1.2%, Shanghai -1.0%, Euro Stoxx +1.3%, Bovespa +3.0%, MSCI World +1.7%, and MSCI Emerging -0.1%. USD rose +3.1% vs Ethereum, +2.0% vs Australia, +1.6% vs Mexico, +1.2% vs Turkey, +1.0% vs Brazil, +0.9% vs Canada, +0.9% vs Sweden, +0.4% vs India, +0.2% vs Russia, +0.2% vs Chile, and +0.1% vs South Africa. USD fell -8.1% vs Bitcoin, -6.8% vs Yen, -1.6% vs Sterling, -1.0% vs Euro, -0.7% vs Indonesia, and -0.6% vs China. Gold +3.7%, Silver -2.1%, Oil -3.4%, Copper -4.9%, Iron Ore -7.7%, Corn -5.0%. 10yr Inflation Breakevens (EU -11bps at 1.90%, US -6bps at 2.23%, JP -4bps at 1.50%, and UK -7bps at 3.52%). 2yr Notes -50bps at 4.26% and 10yr Notes -37bps at 4.03%.

?2024 Year-to-Date Equity Index Close: Venezuela +59.2% priced in US dollars (+62.6% priced in bolivar), Argentina +33.6% priced in US dollars (+54.2% priced in pesos), Turkey +24.8% priced in US dollars (+40.2% in lira), Denmark +14% in dollars (+15.8% in krone), Malaysia +13.2% (+10.8%), India +13% (+13.7%), Hungary +12.9% (+19.1%), Taiwan +12.5% (+20.7%), S&P 500 +12.1% in dollars, NASDAQ +11.8% in dollars, Netherlands +10.2% (+11.7%), Greece +9.1% (+10.7%), MSCI World +8.8% in dollars, Belgium +6.8% (+8.3%), Czech Republic +6.8% (+11%), UK +5.9% (+5.7%), Ireland +4.3% (+5.7%), Spain +4.2% (+5.7%), South Africa +4.2% (+4.2%), Switzerland +4.1% (+6.6%), Russell +4.1% in dollars, Italy +4% (+5.5%), Germany +4% (+5.4%), Poland +3.9% (+4.1%), Singapore +3.8% (+4.4%), Colombia +2.9% (+10.2%), Japan +2.9% (+7.3%), Norway +1.9% (+10.4%), Austria +1.3% (+2.7%), Euro Stoxx 50 +1.2% (+2.6%), Canada +1% (+6.1%), Saudi Arabia +0.6% (+0.7%), Australia -0.2% (+4.6%), New Zealand -0.5% (+5.8%), HK -0.5% (-0.6%), Israel -1.4% (+4.2%), Philippines -2.1% (+2.4%), Sweden -2.3% (+3%), UAE -3% (-3%), China -3.3% (-2.3%), Indonesia -4.4% (+0.5%), Korea -4.6% (+0.8%), Portugal -4.9% (-3.6%), France -5.2% (-3.9%), Chile -5.6% (+1.9%), Finland -5.7% (-4.4%), Thailand -10.2% (-7.3%), Mexico -18.9% (-9%), Brazil -20.3% (-6.2%).

Anecdote (Jan 7, 2018): To sell implied volatility at current 50yr lows, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank eager to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by structurally decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today. Also consider that investment banks and asset managers have always devised creative strategies to make money once asset valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated. Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios. As volatility has declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, this market is exposed to a historic reversal somewhere along the path to policy normalization. Which has now begun.

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

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Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, converse with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.

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