How Low Can Yields Go?

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0:53How low can yields go? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Jem Carcon, founder of Kai Volatility. Hey there, how are you? Always good to be here. Doing well. Well, happy to have you. So what a crazy week we're in. Another bullish day for U.S. stocks and bonds. The 10-year fell below 4%. The Dow hit another record. Small caps storming higher. The Russell up 2.6%. But we had the S &P and the Nasdaq both kind of gaining into the close. And I got to tell you, all of this comes, as we know, after the massive moves yesterday. And under the category of you cannot make this up, I don't know if you saw this, Jim, But commuters in New York City had to do a double take this morning when a bull appeared on the railroad tracks, darling traffic in and out of Penn Station.

1:39A real life bull. Now, for those of you who are listening audio only, maybe you're not sitting in the States and didn't see this. It was like a giant longhorned bull, like straight out of Yellowstone. And so, of course, everyone taking a double take only in New York. But you know that everybody was on Wall Street coming in was like, it's a sign. It's a sign. Does this happen in Chicago, John? Yeah, I mean, we got bulls everywhere in this town, right? No. Yeah, no, this is, that is a sign, I think. To your point, things are getting weird. Things are getting really weird. Yeah, sign of the apocalypse, maybe.

2:16I don't know. But listen, very seriously, I would love to hear your take on the action, because we know the headlines are saying Fed pivot. Clearly, the Fed meeting and the presser and what we heard was a catalyst. but what do you see happening in the markets? What do you make of this reaction? I mean, you know what I'm going to say, right? It's, yeah, the macro narrative and everything falls in line and that helps, right? But the bigger issue here was flows. Tomorrow is Dece OPEX. This is the biggest options expiration of the year by far. It is the primary driver for why we were able to point to a calendar at November 1st and point out the coming rally that has now been 15%, right?

3:05In a month and a half, we rallied 15 % on the S &P, like need to not lose sight of that. These are not coincidences, right? There's a massive amount of positive flows in this market and it is squeezing the shorts, but Powell is just piling on. We're at three standard deviations over the 20-day right now. You see that so rarely. RSIs are stretched more than they've been in the last two years. But again, that's what happens when you get everything aligning together. The flows themselves are already super positive, and then you got this little Powell bit on top of that. But these things have a funny thing.

3:47When everybody gets bullish and everything just seems like coast is clear is exactly when you need to start looking the other way. And that's what we're starting to do. Obviously, we don't think because of these flows that it really resolves to the downside until mid-January or so. And it could even stretch a bit more. But this is the point of the story where you start getting that market vol up, you start getting high realized moves to the upside, and all the pieces that eventually lead to the blow off top are in place. So the next part of this chapter is really that end move, which we think will come probably in the next, you know, by January 17th and if not by February.

4:26But this is this is exactly what we've thought is coming. Yeah, it is. And we've been talking about it. You've been spot on. You can all go back and watch this daily briefings. Jensen, kind enough to bring us along on this, pointing out what's going on on the sort of operational side of the market. And it has been powerful. So we're going to talk macro and we're going to talk into next year in just a moment. But, you know, from a from a sort of, you know, trading perspective, if that's a good we've got a good month when we're going to be in this situation. And we've already got questions coming in about where this could take us.

5:01So based on what you're seeing from flows and from some of this, how powerful does it look from here? Because, you know, you have people say, my God, we look at what happened from from November. And this has been an enormous move already. Maybe this is it. and other people who are like, when I see these kind of signals and you're getting this kind of action, no matter how you feel about it, you have to pay attention and you have to kind of ride this. So where could we go on yields? Where do you see stocks going? How much momentum is behind this? Yeah. Again, it's only a month and a half. But based on what we know about flows and what's coming by the end of the year.

5:43And then again, behind that for that kind of last bit of demand into the January expiration, we're not done yet. That said, if you look at the last six, seven weeks, and you kind of map it out, it didn't all, today, you know, last couple of days feel huge, right? We had a couple other massive, you know, 5%, 7 % rallies. But we've had a lot of slow time in between. And that digestion is what we're going to get next. Why do we know that? Why do we think that? Because after options expiration goes, all the open interest disappears. It's higher. There's a lot more open interest and you can sell that to buy behind it.

6:29And so there's implied vol is incredibly cheap behind the December expiration and entities are long it versus what they're short in December. So everybody, the whole street is decaying longer, implied volatility, and right in time for the holidays. So I would expect a digestion from here for the next couple of weeks or week and a half, I guess I should say, past Christmas. I would expect after that into the end of the year, we get a Santa Claus rally again, and that will be the next move higher. So expect, again, pullback, digestion, vol in the front of the curve coming down. The back of the curve is too low.

7:04So that'll still experience decay. But I would just expect decay, nothing more. It is time to start buying that. And the next move again up will be market up, vol up. And we'll continue to see that, in my opinion, until we get that January 17th date. So it is time to buy vol and the call wing and the back end of the curve at this point. That started really two weeks ago or so. And that is the play right now. Usually the last part of the rally is a buy vol move. And if you can make money on vol on the upside, you better believe you can make money on vol on the downside. So this is a very good time to start preparing for what's coming next.

7:41And ironically, the vol up in the back of the curve when it does come is one of the actual drivers of a reversal in the market because it unpins vol. When the vol just gets too low in the back, entities are willing to step in and buy it and take away the supply from dealers. And that's what we're starting to see. Amazing. I love when we get options humor in the chat, which we have now, because Frank Anthony said, can Vanna and Charm close the effing door? Your crowd rolled up for you today, Gem. So I just want to point out something on this powerful rally and flag some other program we had on the platform.

8:18Beth Kindig was on today as part of our Crypto Academy Live. And she also made a great point as you're thinking about this. So Jem's saying, pay attention, start to prepare, know what's coming, but start to prepare for the next leg. Beth talking about this from a perspective of managing your portfolio. If some of your holdings start to accelerate to the upside, let's have a listen to that. So when I talk about things, just keep in mind that it can change. So if NVIDIA is up 100 % or 200%, that allocation grew, even though I didn't add any money. And I just like to clarify that because sometimes I'll say an allocation and in a week or two later, it's different.

8:56And that's why gains or losses change your allocation without you adding or taking away. But I will say that from the very beginning of the IO fund, which was in 2019, 10 % was our max. And Bitcoin immediately had a 10 % allocation and has this whole time for the most part, except for when we went to the sidelines that one time or one or two times. and then we were 100 % ready to go put that right back in. Ethereum has had the 10 % and an altcoin has had 6%. This is very high conviction and that is exactly what we put into our stocks. So NVIDIA would have been 10 % and then it grew to 16 % or 18 % and we're trying to take gains to get that risk management under control.

9:42So that was from day one of the Academy Live. We have another lineup tomorrow. If you are not a member, go to the website and create a free account to access it. You can find all the information there. Absolutely fantastic interview with Beth, who is phenomenal on all things tech, including crypto. And interesting because she looks at it through that lens. So really interesting conversation. I encourage you all to go take a look at it. Of course, you all know Beth from that amazing NVIDIA call that she had. But she's very in the weeds. It's always really interesting to hear from her. And we've got Denise Schultz tomorrow, too.

10:13I just had a prep call with her. So that's going to be an amazing conversation with two of our community members. So, Jim, to bring it back to our conversation, how do you think about managing risk as we're in this kind of rally? Because, I mean, sometimes people just, you know, this is the fear that people buy in, jump in. How do we need to think about risk in this period? Yeah, so implied volatility is so low. you'd be foolish not to try and still play this in two dimensions. It is much easier to play with calls, out-of-the-money calls, which are on a, we're talking about in January, they're on an eight and a half ball or so just out of the money.

10:59So incredibly easier time to manage risk, not the time given that we're three standard deviations above the 20-day, that the moves are happening as a function of flows and not a function of fundamentals, it is a really important time to try and take those upside bets with a defined risk, and options are the way to do that. So, an easy way to do that, stock replacement, sell your stock, buy calls. Even better is to kind of overbuy calls and be short some stock because the more volatile the rally is, the calls will give you gamma and give you extra mileage to the upside, but you'll be hedged the downside.

11:40So I know that's maybe complicated for some, but the reality is this is not a market that is going to continue to move in two dimensions. It's really moving with faster speed to the upside with implied volatility going up. And it's an important time to manage risk accordingly. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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13:09So this is an interesting conversation from AJ. And AJ, thank you for asking it, because I feel like this is exactly where people are mentally with this. So he said, should we see a slight crash in the market around the 17th? So there's this sort of feeling, but you can understand, because the moves have been like this all year, even when people are getting crushed. We're seeing cruiseries move in a way that they didn't move previously. These are huge moves. And the same thing with stocks. When they run, they seem to go so fast. So now that you put that date out there, January 16th, 17th, could extend beyond, if you were paying attention, he did say that.

13:48Then it's going to go down significantly. Are we in that kind of period, Jim, where the market's going to move like that, these big moves up and then reactions down? So we need a couple of things to be there for the recipe to kind of come together. This is a conditional probability. That is the window where things can happen, right? And why is that? Because these flows that have been so supportive for the market go away after that period for some time. And the momentum that comes with that slows, which generally can then lead to a reversal and it's a mean reversion. Now, all that said, does that mean we're going to crash?

14:29Not necessarily, right? A lot of things need to happen for that to become a very risky kind of scenario. One, you need implied vol to really unpin, and you need to continue to have market vol up into this move. So you need this to be an increasingly kind of almost eye-opopping move, and we're starting to see that, right? But I think it would make a lot of sense to go revisit highs or somewhere close. a minor new high or just missing a double top, right? Something along those lines, there's supply there. And if it lines up with a positive narrative, all the shorts would be squeezed by that point, I think it's fair to say.

15:14And so there'd be less demand to buy equities on the way down. And so the recipe is a supply and demand imbalance. And we're starting to get there, but we're not there yet. And also, I've all been pinning and then the flows at that same time disappearing. And all these things are kind of lining up to happen in that window. Now, the more people are expecting it, the more I'm on every format like talking about it, there is dampening and it never quite happens that easily. Well, not never. We call the last couple moves perfectly, but I think we've been talking about this for three months. So there's a decent chance if we get there that it's kind of front run and managed.

15:51And if that's the case, than the odds of a fast move decline. And it could just be a mean reversion with vol decline. But we'll see when we get there. We know what to look for. We know what's happening. And at the very least, it is not yet the time to be bearish. And that said, there will be a time, if we keep going like this, to be bearish. And it is going to be in that Jan 17th to Feb 14th window and likely on the front end if it's a bigger move. Right. I'm glad you clarified that because whenever we're talking about this, I mean, we just kind of all do that. It's human nature, I think. But these are always probabilities when we're talking about them.

16:29And then they're always sort of, you know, target windows. But this is not sort of, you know, Nostradamus predictions here. This is just sort of what I'm seeing. Yeah, I do want to say something about that real quick. You know, people think in two dimensions. They want you to give them the whole path. And we're able to actually, you know, give high probabilities to certain paths being more likely. And when we hit it just right, we get the exact path. And that's really hard to do. But what's easier to do is to understand the forces at play and how they affect the distribution. And that is something that we can do with great conviction.

17:03And that means if you bet again and again on a correct probability relative to what the market is doing, you can make a lot of money over the long run. And so we know those forces. And those are the forces that I'm trying to describe to everybody here and make sure they understand. But that does not mean you circle January 17th and just blindly get bearish. If these things continue to transpire and continue on this path and we're giving you the recipe, then that would be a time to be, you know, the probabilities then increase for a short there. Yeah. Super, super helpful. So on that, on that note and helping us sort of see the world that you see, talk to me a little bit about structured products.

17:42I know we're going to get a question about them because you've been talking about the fact that there could be sort of growth in this, you know, sort of a longer term about just new things that are coming up. But you just said to me earlier that you're watching that because of the relationship with interest rates. So what do we need to be aware of when it comes to that? And why is that important for people to have on their radar? Yeah, Maggie, I haven't talked about this anywhere. So this is actually a big, important point for people to kind of think about. One of the biggest drivers of structural markets, market structure lately, meaning the last couple of years, has been the absolute enormous growth of structured product issuance.

18:26Because markets have broadly the last two years gone nowhere and in real terms lost money, because more importantly, interest rates are higher at five and a half percent, you can stack yield with derivatives on top of that 5.5 % and get people 8 % non-correlated in a pretty straightforward, easy format. And this is something that's very popular as opposed to being in equities right now. That demand is driving vol compression. How is that driving compression? When the banks issue these structured products, these products are vol selling, and so the banks take on long volatility. And then they need to go sell that volatility, those options to the street.

19:08And there's a massive supply of this. And it is pinning the S &P 500 in terms of implied volatility. Dealers are massively involved on the index. However, in the other parts of the market, the bond market, FX, precious metals, everywhere else, this supply does not exist. And then with interest rates going higher, volatility is actually increasing everywhere else. So what that leads to is this dispersion tree. It's kind of like a donut. All of these supplies pinning the middle of the S &P 500 while everything else is flying around. This is part of why we've had breadth issues. This is part of why we see massive rotations from one side to the other.

19:44This is a structural phenomenon that has been very, very important to how markets are working in the last two years and more so than ever in the last year. So much of that is tied to interest rates. If and when interest rates start to decline like they have, and we've seen a significant reversal, that will naturally slow the issuance of structured products and the demand for it. That is something that is very important to watch because it has been so critical to the growth and success of this dispersion trade, which has grown massively. It is so important to the ball broadly in the market being pinned.

20:19I've equated the structured product issuance to like the Dutch boy sitting with his thumb in the dike. The liquidity is, you know, the problems are sitting on the other side of the dam. And it's kind of holding things together. If that little Dutch boy has to go home for the night because he's not well fed, you start to have a problem. And I think that is a very important thing that nobody else is talking about that is a very important thing to think about. Now, to be clear, that issuance takes time. There's a little bit of a lag, right? It's not like all of a sudden it just stops and then it affects everything.

20:54Some of these things have to expire. There's less issuance, et cetera. And then after that, you can have some issues. But it's something that we're definitely watching closely. There's a lot of short vol out there in the street and it's been counterbalanced by this issuance. If that issuance disappears, now you get into a situation where there's a lot more kindling and a lot more risk in the market. And now some of those structural macro issues that have been kind of we haven't had to worry about because the market just seems to kind of shrug them off again, all of a sudden they'll matter again.

21:22And so I think that's something that's very important to pay attention to as interest rates go lower. Wow, that's amazing. Okay, and I'm just going to put a pin in that because we are going to go back and continue to talk to you about it, but also take your warning on that and stay on that. Are you saying, am I right in understanding that we've been asking the whole time as the Fed has aggressively raised interest rates, that something's going to break? There's a potential for something to break. The scenario you described sounds like if they lower interest rates, something could break. So historically, implied volatility and realized volatility of the market increases when interest rates go up.

22:06Why? Because liquidity is being pulled out of the system. There's less liquidity, which creates more volatility. But the last time we saw this was in the 1970s. And guess what? There were no derivatives back then. There were no structured products. They actually were created in the 70s. So this is a kind of a reflexive opposite effect. And so it's very counterintuitive. But instead of people just going into the bond market, which is happening, a lot of people are also going into the bond market plus. They're going to the bond market and then using that collateral of the T-bills to then get some other yield.

22:41And the majority of that is vol selling. And so reflexively, you are getting volatility increasing on the edges of the market everywhere but the S &P, but then you're getting the supply right into the middle in the S &P 500. And so ironically, now as interest rates would go lower, you're actually going to remove that pin. Now, the question is, are you also dampening the volatility? Otherwise, I would argue if it's a secular kind of an increase in interest rates, that is still risky, right? All the things that are also coming, all the risks that are also coming with broadly increasing interest rates like populism and protectionism and global war and all these other things are already happening and volatility broadly is going higher anyway.

23:26So I think removing this pin is more important than the marginal benefit we're going to see from lower interest rates in the short term otherwise. So it is counterintuitive, but the best trades are the ones that are counterintuitive. And this is happening against the backdrop of, I mean, this is not we're in peaceful times. You're saying that it's happening against a macro environment that is in and of itself more volatile, that creates that sort of toxic brew where this can be problematic. What does that look like if it breaks? What would happen in that kind of situation? Or what are the types of things that you would be concerned about is a better question since you don't have a crystal law.

24:12Yeah, look, what it does is it fattens the tail. It's kindling. And any issue that comes up becomes magnified. And instead of a Silicon Valley bank blowing up and then it not really mattering because of all is well supplied and you see a quick reversal, now these things can start to feed on themselves and become bigger issues. We see this again and again throughout history, whether it's Asian flu and then long-term capital management's implosion and what came after that, whether it's the volpocalypse and the decline that we saw there, even during the COVID crash. We knew about that in December, early January.

24:58It didn't happen until mid-February when all the open interest in March came in, and that was the kindling that allowed for a 30 % one-month decline, expiration to expiration. You need the right environment to get the volatile moves, and you need people to be off sides. What I'm saying is basically people have been leaning and depending on this one trade that's massive and that's stable. But if that begins to disappear, then there is very little supply of vol, and liquidity broadly is weak otherwise, and that can be a real issue. We're going to take another quick break to hear a word from our partners.

25:35We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Join over 5 ,000 attendees for the largest AI event in Asia, Super AI in Singapore, June 5th and 6th, 2024. Edward Snowden, Benedict Evans, Balaji Srinivasan, and over 150 others will hit the stage, joining the industry's most influential to explore and unveil the next wave of transformative AI technologies. Singapore will become a vibrant AI hub for a full week from June 3rd to the 9th, with over 150 side events that will make for unparalleled networking opportunities. Visit superai.com for 20 % off tickets with the code REALVISION.