I'm Something of a Head of Macro Myself

Reclaimed Hops 11 + Trading With Titans 6 8/22/24

This one’s going out live, because I think it’s more useful to read this before tomorrow’s Fed stuff. You can sign up for the newsletter for free here:

On: Federal Reserve, rates

On some trading days, one feels like Hachiko, the famous Japanese dog — you sit there waiting for the bid, but it never comes. All day on Thursday, I was wondering why there was such a consistent sell trend on such little volume — I tend to eyeball “real flow” and conclude where moves come from. Sometimes, you unfortunately realize what you learned in college is relevant, and you would have done well to remember it:

In the first week of class, I was asked by the professor what I was doing with my laptop open. I replied that I was taking notes on LaTeX, when, of course, I was watching my call options. At the end of the semester, when entering the final for that class, I had some equity options expiring two days out. I was extremely green on these F calls, and figured, what the hell? It’s two hours, I can take the exam and then check my position. After the test, I saw that the market had sent down 2% (this was back when VIX was rarely seen above 13), taking my options OTM, thereby making them worthless. It was then that I learned that all the volume on Fed days comes in after the call, and that the muted volatility prior is because literally nobody trades before their announcements.

Probably should have checked the calendar today, though I am fairly certain that, since the vol term structure didn’t change (as I talked about a couple of emails ago), this is a “BTFD” opportunity.

Understandably, given the ridiculous drama around rate hikes since “the VIX 60 Affair”, there’s a lot of uncertainty surrounding Powell’s speech on Friday morning. I never really pay attention to the Fed — dot plots and FFR futures are more than enough, and most people tend to freak out without really understanding what the Fed does:

So I’ll quickly summarize how I think about the Fed (from: The Inflation Persuasion 12/16/22):

Rate hikes and future prognostications are constantly push-notification’d to our phones, yet discourse around me seems to range between flummoxed to conspiratorial. And yet, it shouldn’t be that complicated. The Fed is one of the most telegraphed institutions on the planet — the equivalent of scripted wrestling where the results are mostly known ahead of time. Furthermore, the market’s expectations are also quite telegraphed, as displayed through this neat little tool from CME (who provides FFR futures) that calculates implied probabilities of future rates movement…

The Fed has 2 main mandates: full employment and price stability. The underlying policy they take to fulfill these mandates is called inflation targeting — the subject of much of Ben Bernanke's research, the essential goal is that the central bank wants to maintain inflation at around 2% as it’s the optimal level to facilitate velocity of money while not destroying savings. Too little inflation and you get hoarding — too much and you get chaos as everything gets bid up in a frenzy to outpace inflation. (A reminder that “[i]nflation is a bit of a self-fulfilling prophecy, and the only ‘inflation hedge’ is to outpace the rate of inflation through rate of return.”)

Something I repeat often is that the Fed does not care about the stock market, but rather bond market liquidity. This is why I hated the “emergency rate cut” narrative from a couple weeks ago:

Indeed, I have been heavily skeptical of the “implied odds” that the market prices cuts at. Back when a May cut was “100% probability” and banks were pricing in anywhere from 3-6 cuts in the year, I posted this take:

The argument for rate cuts is not “the economy sucks”, because the core issues with the economy are not directly borrow-cost related. There is plenty of cash sitting in yield given the extended period of 5%+ issued rates that will flood into the market. What we’re looking at is a regulatory problem first and foremost. This is why I think inflation is persisting no matter which administration takes over in November — in a Democrat administration, debt will continue to explode, while in a Republican administration, deregulation will likely lead to the biggest post-08 M&A boom as cash leaves yields and enters the “real” economy again.

The Fed, to me, seems trapped — monetary policy is not going to fix anything, QE/QT will cause too much volatility, and a perfunctory 25 bips cut won’t create any noticeable effect in the economy until after November 5, thereby raising accusations of political motives for no particular reason. But, as we clearly saw Thursday, the market is begging for some indication that cuts are coming, and the lack of bid coming in indicates that this is the expectation to start piling in again.

(Note that I think rate cuts overall are bearish in the broader purview — it means the economy is shit — but this should lead to a spike to ATH and more volatility/intraday reversals to trade.)

The argument for a rate cut revolves around deal flow — Everything in the corporate world depends on deal flow. Everything you do in sell-side is to collect fees on deals. When there’s no deals to pitch, the money that funds the people that do the deals balks, because nobody wants to pay bankers and lawyers when there’s nothing to be done. You don’t pay them for “clearing up the air”, there’s absolutely nothing a sell-side banker or a transactional lawyer can do for you.

Market froth related to “the economy” boils down to a) overregulation of deal flow and b) inability to borrow to do deals do to rates. Add on the fact that 2021 was a mass flood of cash and low rates creating a massive hiring cycle, and the blunt reality is that there is no work to do for entry level transaction-oriented employees. Then consider that everyone who did remote learning just sucks (a common complaint from my establish banker/lawyer friends), and you see the mass hiring freeze of otherwise standard white collar work. Ask your local law students who just passed the bar or the local finance students doing recruiting cycles — whether it’s New York or Spokane or Charlotte, it’s the same story everywhere. DoorDash jobs and AI engineers don’t compensate for this.

(And, as we saw a couple days ago, the biggest “jobs revision” ever came in. Shoutout to ZeroHedge, they’ve been on this for months)

This is also why Silicon Valley has either full sent for Trump or is buying out Harris to revamp the FTC and DOJ — winning court cases takes years, far more than anyone who is volatility laundering in private markets can sustain, even at this borrow cost.

Thus, a rate cut would kind of “smoothen” the rate that deal flow will pick up again. Anything to cause a spike in organic business activity will temper the forward rate of inflation that I’m worried about in a deregulatory environment. Basketball fans remember the cap spike that allowed the Golden State Warriors to sign Kevin Durant — a 25 bips rate cut, while solving nothing about the underlying issues, would be a “go ahead” signal of sorts that might prevent inflation from running as absurdly hot as it did in 2021 going forward. This seems fairly likely to me, but by no means is it 100% guaranteed. I guess I’ll just have to wait and see what happens like everyone else.

As for Powell tomorrow, here’s what I expect to happen:

From Trading in the Age of Meaninglessness (3/25/24):

What we realize is that, beyond all the waxing poetic about the “philosophy of money” and “postmodern markets”, the only thing that matters anymore is “number go up”. You can call it (3,3), Marxism, “everyone dependent on the same trade”, or whatever you want, but the core point is that nobody values bid-side liquidity the same as ask-side liquidity at the moment, so all you can do is stay long with everyone else. Unless this pattern of behavior cohesively breaks — and there’s no “one way” to do this — you will always get a rebound after, say, an NVDA selloff or a temporary dip in housing prices.

The only two catalysts I see for this changing are as follows:

A) election clarity either way — if this current regulatory state continues for another four years, you will certainly see some sort of offshoring/resignation. It’s totally unfeasible to be a nascent business and ask for an extra 3 years of time, runway, and lawyers to fight whatever happens to be the whim of the month from the top of the FTC or the SEC….

B) AI actually does create a cross-industry, revolutionary application (<3 years is my timeline) or if it doesn’t (more likely imo), the entire tech sector’s air lets out. The sector inflows have been so congregated into existing tech and purely speculative AGI plays that, without some sort of benefit across industries, this seems like incinerated capital and compute (which will spook the “sector rotation” class.) I did note that MSFT seemed very skittish when it came to OpenAI based off their investment structure (ML 79, 1/11/23):

While Microsoft’s investment is clearly an equity investment bullish on the overall ability of OpenAI to facilitate the production of a minimum viable product, it’s interesting to me that the proposed terms highlight a right to 75% of OpenAI’s profits — it’s kind of like having the ability to exercise an option to cash out rather than essentially being required to plunge any revenue into reinvestment to potentially gain a positive ROI as you’d normally expect from a venture equity position. To me, this “fail-safe” implies a certain level of skittishness that OpenAI will ever produce anything of real go-to-market value.

If NVDA doesn’t continue to blow out ER, well, look out below.

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