Liquidity flows, volatility shocks

0:09Welcome, everyone. Daniel Snyder here from Seeking Alpha. Thank you so much for tuning into this today. We're going to dive into conversation with Michael Kramer from Mott Capital Management. He has been writing on Seeking Alpha for quite a while, talking about volatility and liquidity and some of these higher level topics that not everybody might be super knowledgeable on. So I'm going to have Michael break those down today as we get into all the charts and the entire presentation that he has brought to talk about today. And with that being said, Michael, thank you for joining us. Thanks for taking the time today.

0:38It's great to be back. It feels like just yesterday we did one of these. Yeah, just a few months ago. We just talked about all of this. I will not specifically realize vol and what's coming potentially. But the conversation that after you reached out was talking about, let's talk about Trade War 1.0 versus Trade War 2.0. are we going to see a similar vol kind of market period mimicking that trade 1.0? And you got a lot of correlation and things you want to mention across the board here with that. So I would love if you could go ahead and share that presentation you put together and let's dive on into Trump 1.0 versus Trump 2.0 and all the uncertainty in the market out there.

1:17Sure. So I have a little disclaimer. Basically, this is not financial advice and you should always consult with someone. Essentially, again, just kind of going back to where we were the last time, Trade War 1.0 versus Trade Point 2.0. And I think the key takeaway that we should really always remember is that Trade War 1.0 created a lot of volatility. And it created not only a lot of volatility, but it created basically no return. We saw a market peak in January of 2018 and not go anywhere until October of 2000. And I think I said January of 2018 and not go anywhere until October of 2019. So there was almost a really long period of time there, almost two full years of stagnation, but just lots of volatility in the market.

2:05And so far, it's starting to look like maybe that's shaping up in a similar way. And things that really stood out to me are the volatility and the causes and the effects, both very similar. And I think this is an important concept that we're just going to want to take a moment to review. So right now, what we've seen is a big, sharp sell-off in the equity market in 2025. And we saw a really big spike in both realized and implied volatility. And it's really important to remember. I write a lot of articles, and sometimes I'm talking about volatility. And sometimes what I'm referring to is not necessarily people tend to associate volatility with the market going down.

2:46And unfortunately, that's not really the right way to think about volatility. When we talk about volatility and volatility returning, it means the market can go up or down. It's just the rate of change that's associated with that volatility. And so basically, we went through a period of time following the announcement of the tariffs and really leading up into the tariffs where realized volatility expanded quite dramatically. And that was because we were getting these one, two, three percent type moves in the market on a daily basis. And that also helped to boost implied volatility. Then Trump comes out with his trade war liberation day, market tanks, implied volatility, realized volatility, you know, rip higher.

3:27We get that big, you know, snapback rally that kind of paused right in the middle of May and June. I think when we were doing our last presentation, I know I was my bias was bearish on the market. My bias has been bearish on the market for about a year and a half, two years now, really going back almost. Well, yeah, I guess two years, 2023 is because the market's valuations today are just really stretched. And that really sort of forms the bias. And then really everything around it kind of gets, you know, the market generally in terms of what I'm seeing gets built around that bias. And it was certainly right to have that bearish bias in this period of time at the end of last year.

4:06But it hasn't really worked at this point for me since May. But generally speaking, what we're looking at here is this giant rise in implied volatility and then the reset in volatility coming back down. And when the market starts going up like this and the moves start getting smaller, that pushes 10 and 21 day realized volatility lower. I use 21 day realized volatility because it basically is a measure of one month volatility. And I use 10 day volatility because it gives me a little bit of a snapshot of where 21 day month volatility is likely to go. And so when we start seeing realized volatility, you know, and I mean, basically, I'm not the only one that that knows that realized volatility is going to start compressing.

4:52Once you start seeing the market moves get smaller, there are a lot smarter people than I am. And there are a lot of people that run very sophisticated strategies that are built around trading this. And so what they do is they go out and short implied volatility in anticipation of realized volatility coming down. And essentially what you got coming out of the COVID, the liberation day crash was that implied volatility melt, which kind of puts that bid back into the marketplace almost automatically, almost systematically. And that's why we saw that big sort of rally that followed right out of into May into June.

5:34Hey, Michael, real quick, for the people that are watching right now that may not know the difference between implied and realized vol and how they're kind of court, like for implied vol obviously is what the market is pricing, correct, but it may not necessarily come true. Do I have that right for everybody? Yeah. So implied vol is basically just, it's just basically a bet on where realized volatility will be in the future. And, you know, the market could have been completely wrong in its view of pushing down implied volatility so sharply and quickly. In fact, implied volatility, the VIX, peaked before 10-day realized volatility even peaked.

6:11And so you could see the market almost immediately once we got past that that that April 9th, 10th, 11th period of time where we had the pause, the market almost immediately began to expect volatility to fall because the worst they had felt obviously must have been beyond us. and realized volatility is basically taking the daily moves in the market on a look back. And it's basically so if you get to get into a period of time where realized volatility is 1%, you know, markets going up 1%, markets going up 1%, markets going up 1%, your realized volatility is going to start going up towards 16, right?

6:49Because you basically annualize it by taking the volatility metrics and multiplying it by 16. And so if you start getting those 1 % moves, realized volatility is going to start gyrating and moving towards that 16 handle on the realized vol. And that's going to push implied vol up along with it. And just like if you start getting 25 basis point moves in the marketplace, that realized vol is going to start coming down to resemble something of 25 basis points divided by 16. And that pushes implied volatility down. So basically the market was saying, hey, everything is the worst of the scenario is over.

7:30We're going to start pushing implied volatility down by shorting implied volatility. You could do that many different ways. And essentially that's going to then and that was a bet that the market's volatility levels were going to return to normal. And essentially that's exactly what happened. You got you got that big reset and realize vol was crushed. implied vol was crushed and then you saw the market just continue to move higher and that reset in volatility has basically now played out the question is is whether or not we're going to get a second wave of volatility going into the second half of the year and this is where the similarities to 2018 start to come in i hope that that i hope that i explained that clearly enough yeah i think that a couple of things that we might want to touch on real fast just to bring anybody that may not know about the vol space up to speed is the vix is trying to measure where the s &p 500 index will be 30 days in the future right so that's where the kind of implied vol kind of shows you well uh the expansion or contraction and as vix comes down right never short a dull market or low vix and and not expect spikes um the one question i have for you i would say is when did we last see like a a vol up spot up scenario because i think you mentioned earlier most people kind of have that correlation of VIX rising, meaning that the market pulls back, but that's not always the case, right?

8:55So do you have anything that you might be able to reference there? Well, we had, I can't really zoom in on this chart, but if you kind of look like right in here going into the end of July into August, you could see the VIX actually started going up right into this period in time. And so we did get that little bit of a scenario where the VIX started to rise and you had the stock market rising in what they call a vol up, spot up type scenario. And that's basically when the betting on the call, basically the implied volatility in the market is rising, not because people are taking out hedges and puts, it's rising because the call activity is picking up and it's so strong, people are actually anticipating the market to go even higher.

9:38Right. Yeah. Thanks for clarifying that. Now, hopefully that helps everybody. But the correlation to 2018, because I've got to ask you, back in 2018, I think a lot of us remember the trade war was really with China. And it was very focused on China. And nowadays, we're talking about tariffs across every country across the board. And we haven't even gotten into the semiconductors and the pharmaceutical tariffs coming down the line, which may line up with your thesis. I don't know. But what's the 2018 correlation to today that you're seeing? So, I mean, in 2018, we saw something similar in that we had that really big shock in the first half of the year.

10:16Remember Volmageddon? Volatility spiked. Volatility basically melted all throughout the summer months. We actually rallied to a new high. Sound familiar? Basically, it's almost an exact sort of situation as what we saw more recently. Then volatility really started to ramp up into the year end. And one of the reasons why we started to see volatility ramp up was because the actual hard data or the data that the market was kind of waiting to find out whether or not these tariffs were going to have an impact started to show up in the fall of 2018. It was also the time where the Fed was still reluctant to stop the rate hiking cycle.

10:59And so the market sort of freaked out because it was like, oh, the Fed's not going to keep raising rates. And now we got these tariffs coming in. We have this trade war with China. And I wanted to show everyone here, the tariff rate in 2018 was about two and three quarter percent. And the market was freaking out that the trade war in China was going to upset the apple cart. Now, if we fast forward to where we are today, 2018 is all the way down here. And this is where the tariff rate is pre-August 7th. After August 7th, I think the number is going to be more like 17.5%, which is what I've read.

11:36But the market was freaking out because the ISM data, services and manufacturing data points were deteriorating. And we had these high tariff rates. And that led to that big that led to that big, you know, sell off that we had in the fourth quarter of 2000. I'm getting myself confused in the fourth quarter of 2018. And currently, we haven't really seen yet the data at least deteriorate in a way where the market's getting a sense that we're really seeing a major impact from tariffs. But if you read today's S &P Global PMI, which came out, it seems like the immediate effect is inflation. You are reading about output prices going up, input prices going up.

12:22We've been seeing in all the survey data. The one place that really hasn't shown up yet is in the actual CPI report. And unfortunately, we're not going to be talking a lot about CPI swaps today, which I know is one of everyone's favorite topics. but they are anticipating that inflation does rise to about three and a quarter to three and a half percent between now and May of 2026. So the soft data is kind of already telling us that there is some impact, but it's not showing up in things like the ISM services and ISM manufacturing in a way that the market is getting overly concerned about. And at least in the unemployment rate, we haven't really seen that yet.

13:01Not to mention the Fed minutes that just came out yesterday. I remember before the Fed minutes came out, everybody said we're was saying, oh, the Fed's going to focus on employment, unemployment. And then those minutes came out and it says they're actually watching inflation over the employment numbers. It would be interesting to see what happens. Yeah, I mean, Powell has consistently said for some time that it depends on where they are and and which of their mandates is more out of sync. And so, I mean, it's hard to argue that with a 4.2 % unemployment rate that the labor market is really more out of sync than inflation at this point, especially given the PPI and the import export prices we had last week.

13:43And if you look through some of the CPI data, even goods prices are starting to go up. And honestly, if you take out energy, you know, the oil and gasoline component, we're talking about a higher inflation rate. I mean, gasoline and oil have largely been the biggest drag and part of the disinflation process that we've seen now in some time. And I wrote a story last week for readers talking about you forget about the rate cut in September. And I didn't read all the comments, but I'm assuming that there was a little bit of pushback on that. And I think when you read through the Fed minutes, it kind of illustrates the fact that the Fed's probably not going to be in a rush to cut rates.

14:24And I don't really think Powell is going to feel the pressure to do it. So, I mean, when we think about 2018, lots of volatility at the beginning of the year, we get that volatility crush. You get that grinding higher motion in the equity market to new highs. And then the hard data begins to hit. Hard data begins to show tariffs having an impact. That's when volatility expands again. And again, I don't know the timing of how this is going to play out. Is it going to be September, October, November? I'm not really sure. But I think what what matters is, is we're looking at a period of time from September on into December, January, where you could begin to see those impacts really start showing.

15:06And I think the impacts are going to really start showing mostly in inflation data. And that I'm really thinking that you could start to see in August or September. But there's other comparisons today versus 2018, not just from a tariff and sort of a volatility standpoint, but really the liquidity standpoint. And really the liquidity standpoint is what the lifeblood of the market is. You give the market lots of liquidity, the market's going to go up. You take away that liquidity, the market's going to go down. We're looking at the reserve balances held at the Fed and the S &P 500. And I think the key takeaway that I want to give everyone is that reserve balances, when they're falling, it doesn't necessarily mean that the market is going to go down.

15:54But what I think it means is you get a market that stalls. And I think you get a market that basically becomes more volatile. 2015 and 16 reserves were clearly declining. that led to basically a market from the end of 2014 to basically the Trump election, which was the end of 2016, that did practically nothing. That reminds us of what happened in 2018 when reserve balances were declining rather rapidly because we had the first time of quantitative easing going on. And you had a market that basically, again, was doing nothing for a really long period of time. and it almost was like the market went up as volatility was coming down in 2018, but the market was sort of like sitting out there on a ledge.

16:44In other words, the liquidity wasn't really supportive of the market. The market was just going up on its own. And eventually that liquidity drain caught up to it. And that resulted in that big decline. And then that period of lots of volatility in between. If you notice, it wasn't until the fall of 2019 that we started to see the equity market rise again as the Fed began to do QE, not QE. Remember that program they called? This is QE, but it's not QE. That was when they started to expand the balance sheet again. If we kind of keep going forward, you can see in 2021-22, we saw balance sheet really decline sharply.

17:24S &P 500 came down. Balance sheet begins to expand again in 2023 and 2024 as a reverse repo facility drain, adding lots of liquidity into the market. S &P 500 rallies now going into 2024, 2025. We're sort of in a similar situation where the balance sheet is shrinking. It's been flat to shrinking. And essentially, the market has seen lots of volatility again, although it's been still trending higher. I mean, the August 24 was a very big period of volatility. Obviously, March and April, very big levels of volatility. And again, if you think about realized volatility, market rising the way it has, we've had some periods of realized volatility increasing over the last couple of weeks because we've seen some big spikes in the marketplace.

18:14And so we're now at a point, again, where we need to understand where is the balance sheet, where is liquidity going in the future? And based on a number of indicators, liquidity is actually likely to start declining again. This is just another way that we can think about liquidity. We often wonder how does liquidity from the Fed get transmitted. And my theory is that the liquidity from the Fed gets transmitted through things like margin balances. And so you can see margin balances and the reserve balances tend to trade really closely with one another. There is a key similarity here between 2018 and today.

18:54The key similarity here is that margin balance kept rising into 2018 as reserve balances started to drop. Again, that kind of left the market vulnerable. Can see clearly margin balances rising while we have reserve balances coming down as well. Kind of in one of those moments where there's just not a lot of liquidity beneath the surface to support everything, specifically if it continues to decline. the relationship between the S &P 500 and margin balances. Margin balances pull back, S &P 500 pulls back. Yeah. The correlation looks like it's definitely there. Right. It's not hard to see. So for somebody that's watching right now, doesn't understand what maybe the reverse repo facility is.

19:34Could you summarize that real quick and why it was so much in focus over the last four or five years? Yeah. So, I mean, the reverse repo facility, think of it more as a symbol, a symbol of excess cash. Essentially, what happened in parts of 22 and beginning of 23 was the Treasury started to cut back on bill issuance. And with all that cutback and bill issuance, it came at the same time that the Fed was pumping some ridiculous amount of money into the system. And essentially, there was so much excess liquidity being generated, it had nowhere to go. So the way the reverse repo facility works is that you're an institution, you have all this cash, you don't know what to do with it.

20:23So you give it to the Fed. In exchange, the Fed basically pays you a rate of interest. The next day comes, the Fed gives you your money back and you got paid overnight to lend your money to the Fed. Next day comes again, you do the same thing over and over again. The reverse repo facility from around zero to around$2.5 trillion between April and January of 2022. Now, what's important to understand is that the reverse repo facility is held on the Fed's balance sheet. And so the reverse repo facility is a liability. And so if we go back to how this works, we have the Fed's overall balance sheet,$9 trillion.

21:11Then you have all these little liabilities that are on the other side, currency in circulation,$2 trillion, reverse repo facility,$2.5 trillion. So as a reverse repo facility was rising from zero until to$2.5 trillion, you saw reserve balances really, really declining. in 2021 and 2022, that had a negative feedback loop into the S &P 500 as liquidity ultimately drained. And then, of course, as the reverse repo facility began to drain, that was freeing up all of the reserves that were held at the Fed. So everyone talks about how the Fed is quantitative tightening, the Fed is quantitative tightening, but reserve balances have really stayed unchanged because what happened was all the money that was getting locked up in the reverse repo facility and was acting to drain liquidity out of the market in 2022 was basically being fed back into the market in 2023, 2024, and up until last week.

22:14This is why you haven't really seen reserve balances come down despite the size of the Fed balance sheet going from around$9 trillion to$6.5 trillion today, if that helps. Yeah, definitely. I wanted to make sure people understood the excess liquidity going, the interest being paid there, and how it's kind of gone back down to zero. Right. So we talked about the reverse repo facility. That's only one piece of what happens with liabilities at the Fed. The other piece is called the Treasury General Account. The Treasury General Account is basically an account that's held at the Fed that's used as a liquidity source for the treasury to make payments.

22:54It receives money from taxes. The TGA rises. They have to go in out and pay out social security benefits. The TGA falls. It's like a checking account. And so when the TGA falls, that adds to liquidity. It pushes reserve balances higher. When the TGA rises, it drains liquidity. It pushes reserve balances down. So what similarities do we have in 2018 to today? Number one, notice in 2018, there's no reverse repo facility activity at all. You have QT going on in the background. And you get this period of time and call it 2008 in the winter, early winter, spring months of 2018, where the TGA is rising and refilling.

23:44So you're getting a double whammy basically at the same time where you have liquidity being drained because of quantitative tightening and you have liquidity being drained because the TGA is rising. You have no more offset from the reverse repo facility. And essentially that, again, led to this period of time where you had the rise in the TGA, lots of volatility in the market. TGA kind of balances out, QT normalizes, you get a run up in the stock market. And then with the draining continuing, you basically get this big period of volatility to follow in the equity market. Big run up in reverse repo facility, lots of cash, nowhere to park it.

24:24You just give it to the Fed. The Fed pays you four and a quarter percent at an annualized rate. When this begins to come down, all this liquidity that was locked up at these levels and basically gets released. We also go through these periods where you get the TGA drawdowns. You get the TGA rises. Now, what just happened? We had a debt ceiling. So the Fed, the Treasury couldn't raise debt. They couldn't increase the size of the debt limit. So they had to fund the government somehow. So what do they do? They drained the TGA and they brought that basically down to zero now. And that basically allowed reserve balances to stay unchanged.

25:04It sort of added another liquidity source into the market. So you had two things going on that were very favorable to stocks. And basically over the last couple of months, TGA drawdown adds liquidity, reverse repo facility going to zero adds liquidity. But now, just like in 2018, reverse repo facility is basically finished. There's$25 billion left in it, for all intents and purposes, has no more importance from that standpoint. But you have a TGA that still needs to rise by another$350 billion between now and the end of September. So essentially, if you're at$3.3 trillion in reserves as of today, by the time we reach September, and I've written about this too, We should see reserve balances go down to around$2.9 to$3 trillion, depending upon what happens at the Fed with quarter-end balancing and stuff like that.

26:01The good news is there's lots of ways to monitor this stuff. And these are things that we do almost every day in my reading the market service. All we've been doing lately is been preparing for this liquidity drain because it was so obvious to me. I think I wrote the first story about it right after the debt ceiling was signed. The big the big bill, big, beautiful bill, because it was obvious that the TGA needed to go back up. One way we can monitor this is by watching the standing repo facility. This is the exact opposite of the repo facility. So when liquidity gets strained and there's not enough cash out there, you can go to the Fed and you can borrow money and pay the Fed a rate of interest, give them collateral.

26:46If this number starts going up, this is an indication that liquidity is getting more scarce and the Fed needs to be there to backstop it. We already had one instance in the end of June where it spiked to about$11 billion. I mean,$11 billion in the grand scheme of things is really like nothing, but it was the biggest spike we had seen in years. And so what that was was basically sort of a test shot or a warning shot for me to pay attention more to more to this number, because if this number starts becoming more active on a daily basis, it's telling you that there's just not enough liquidity in the system to meet all the demands that are out there on an overnight funding basis.

27:30Another thing we can watch is SOFRA. SOFRA is published every day at 8 a.m. SOFRA has been fairly stable at around 4.3%. SOFRA stands for the secured overnight funding rate. And effectively, once this number starts to rise, that's an indication of liquidity being strained too, because as the number rises, it means people have to pay more to get cash. cash. And because the standing repo facility really begins to pay out at 4.5%, no one's going to access the standing repo facility until SOFR starts approaching the 4.5 % number. So if for some reason you start seeing SOFR inching up towards 4.5%, that's telling us that liquidity is getting really scarce and the market is having a tough time finding the liquidity it needs to fund itself.

28:23Again, we're still at 4.3%. This number tends to rise going in the month or quarter end. But again, what we're kind of looking at here is that the trend has been a little bit higher. And so what we're watching right now as we go into month end in August is if this number starts trending up to 440, 445, and how high it really gets. Again, the higher it gets, the more risk there is for liquidity in the system. And then finally, the one other thing that we're watching very closely because once the TGA is filled and reaches$850 billion and reserve balance has come down to that$3 trillion number, there's still a lot of debt the Treasury is going to be issuing.

29:06And that means that debt needs to be paid for. And that means that this money is going to have to come from private markets. So I think today is a Treasury settlement date. I think there's a$44 billion settling today. Next week, we have more settlement dates, usually Tuesdays and Thursdays. The big settlement date comes from what I saw on the calendar today was that on September 2nd, you get a$90 billion settlement. So what that means is that there is, that's a net number. So what that means is that that's$90 billion that has to come from somewhere to settle that treasury issuance. And if it's not going to come from the reverse repo facility anymore, and if it's not going to come from the reserves at the Fed because the TGA is basically filled, it's going to have to come from places like primary dealer balance sheets.