Should Investors Still Be Afraid of the Fed?

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1:48Should the market be more afraid of the Fed? Hi, everyone. Welcome to the Real Vision Daily Briefing. with me today is Jem Carson, founder of Kai Volatility. Hi, Jem. How are you? Great to have you on with us. Good to be here. Always a pleasure. And we were talking right before we went on air with your heading into the weekend shirt. You're getting us there. I said, come on, weekend. Let's go. It's appropriate. Exactly. We love when everyone comes with their fantastic shirts. I'm sure we're going to get some comments. You're challenging Darius Dale in a shirt off, I think. That's Miami territory.

2:23I can't keep it up. This is Chicago. I love it. Well, Chicago's best you rolled out in. So really curious to get your thoughts on the markets. We had stocks down, U.S. stocks down, bond yields also down, U.S. bond yields. VIX up a bit after hitting its lowest level in a year yesterday. I don't know, what's top of mind for you as you look across these markets? Yeah, so markets have been in a tug of war between fundamental kind of bigger flows, which have a distinct lag to them, right? An overhang that's kind of impending doom, call it, with structural short positioning, you know, reflexively pushing back the other way, right?

3:10And this is a common story in recent history, right, in the last, call it six months or plus, really. And it's continuing. The difference here is that lag is starting to work itself through the economy. And I think that's the big part, right? There's$450 trillion of long assets in the world. There's about$50 trillion of domestic equities. most of that other 400 trillion operates on or 350 trillion operates on a massive log lag you know struck real estate private equity venture capital even equity market demand operates on the lag because buybacks themselves which have been at records in the first quarter almost equivalent to last year's records right are starting to fall off a cliff so i think that lag is coming that five percent is working through it through the market at the same time you know the short interest and all of the short positioning is getting, you know, going through a pain trade.

4:10And that is ultimately driving lower volatility, that push bull, you know, pair that with the Fed selling puts, giving deposit insurance back there at the bottom, and then coming up and trying to sell calls and talking, you know, the market down with, you know, all about a driving vol compression, but still march higher until this narrative changes and people get back on board. Usually these things die, take a long, slow death, or they have a dramatic squeeze before they roll over. That's what 99 was about. That's what 07 was about. That's even what Jan Feb of 2020 before, you know, we knew about COVID, you know, month and a half before the market rolled over.

4:52That's why markets do what they do at the end. So that's kind of what's top of mind, where we are, and how things are moving through. I think that's a really great, thank you for that because it's a really great explanation of what seems to be things at odds with one another, you know, and it just feeling like, you know, something's got to give here. It's a great explanation for where we are. By the way, we're taking questions, everyone. So go ahead and I know you've got them. So go ahead and put them in the chat. We'll get to as many as we can. So how do you think that it'll end this time? Because if it's either a slow, painful death that works its way out or a more kind of spectacular dramatic and yeah i mean the reality feel like the reality is positioning um you know ultimately turns in one of two ways and you need positioning not to be you know if everybody thinks something's going to happen it's not going to happen that's just the way markets work people are positioned for it that means there's there's a demand underneath the market counter that right um as we saw last year um so you really need positioning to turn to match the secular, you know, you need the narrative to turn against the secular realities.

5:59And that's generally what happens to at least to an extent before the end. And so that happens in two ways. One, it happens, again, with some type of blow off top, a squeeze in price, right? That changes narrative. That also changes positioning, you know, structurally because people have to buy back. It also tends to unpin vol. So it can happen that way, which is my probably top guess of how this ends, or it can happen with time. Why does time matter? At some point, people give up. A certain amount of time just leads people to throw in the towel. And particularly as it relates to vol, people will not hold vol or convexity because there's a cost to it over time.

6:41And crowding happens the more nothing happens for some time. Crowding happens into short convexity because it's very profitable as that happens. So historically, those are the two ways this resolves itself. Positioning versus secular structural flows can unpin from countertrend moves that are dramatic in fashion or time. And that's why things tend to take longer than you think or happen very counterintuitively with some type of dramatic blow off time. Yeah. And when it takes longer than you think, then people start to think it's not happening. I mean, we've had people asking, in fact, a viewer just asked yesterday, what happened to the Fed rate hikes?

7:20Like, where is the impact on the economy? Why haven't we seen that yet? Yeah. So, you know, that part is a lag. That's another reason that things take longer. People see the headlines and they think, oh, it's already started. And again, buybacks would be that perfect example, right? We started a year ago going from 0 % to 5 % in rates, and yet buybacks are still at a record. Real estate, last housing starts, showed a 22 % increase in single-family home housing or multifamily homes to housing starts. That doesn't make sense given that interest rates have gone from 0 % to 5%. Why? Because all the projects were started a year ago.

8:01And so this lag takes time to work itself through markets. People assume it's instantaneous. QE and QT are fairly instantaneous. That's different, but we haven't really had any QT, right? But the interest rate piece working through the economy is very much a huge lag that people underappreciate. So when we're looking at, so we had economic data and you are starting to see some weakness, but it feels like every time we get a sort of steady drumbeat, we had Philly Fed survey was weaker than expected, weekly jobless games were up. But every time you get that, you also see signs of strength someplace.

8:35So it still looks like it is working its way through the system. We've got a lot of Fed speakers right before we go into blackout. In fact, someone asking why so many Fed speakers. But Loretta Mester, our Cleveland Fed president, speaking today, once again, signaling she supports higher rates, although putting a caveat on there that there should be prudence around it. What are you expecting from this May meeting from the Fed? So before we get into the exact what to expect from the Fed, let's talk about the why. You know, you can't look at this 5 % increase in a vacuum. Why are they increasing by 5 %?

9:12You know, let's not forget we did$9 trillion of fiscal stimulus in a year and a half. That's more by an order of magnitude than anything we've ever done in real terms. That is still in the economy. that is still flowing through the economy. On top of that, we have lockdowns. China just exited lockdowns like a quarter ago. They're just now re-stimulating. You have, throughout that period, a strong dollar, which is very disinflationary as well. So we've had actually massive disinflationary forces in the context of a very inflationary push in fiscal stimulus that is now those other items, like we've had dollar weakness, right?

9:59Now we have China coming back online, all under the context of that fiscal stimulus still working through the economy. So there is a demand push here that people are underestimating. There is a underlying strength to demand that is underappreciated. So yes, we've taken zero to five and that is lagging through the economy. That is a lot, by the way, 5 % change in a year is a ton. And that's still working its way through and counteracting this. So why haven't we seen it? Because there are countervailing forces And that is what's going to force the Fed's hand to continue, in my opinion, to continue to increase and talk down this market.

10:35They need a lower market as well. They need a negative wealth effect. They need a stronger dollar. They need several things that are kind of fighting against them. Never mind OPEC stepping back into the fray and underpinning oil prices, which for a while there were still relatively calm for the last year after that initial push. So I think it's very important to note that if you look back a month and a half ago, the Fed was trying to take interest rates higher. Before this little banking crisis, they were trying to talk down the market. They were trying to strengthen the dollar. They're trying to do all these things.

11:11And then what happened, interest rates went lower. Oil went higher. The dollar got weaker. I think if you think the Fed's going to come in here and pivot, you're talking yourself into a trade that doesn't exist. The Fed has been pretty clear the last several weeks and honestly the last several months about where they stand on this. So I think the Fed will continue to sell calls. And I think just like last time, the markets aren't listening because positioning is already, again, reflexively betting on that and people, the pain trade is higher. But that doesn't change the secular realities of what the Fed is doing.

11:49Just a reminder, the Real Vision Daily Briefing is in partnership with the Gold Investment Letter, helping sophisticated investors successfully navigate capital markets and maximize profits in gold, silver, and mining stocks. GIL discovers the most undervalued companies and isolates special situations in the mining sector for their members, breaking down unique topics such as investor psychology, portfolio management, and macroeconomic trends with a goal of drastically improving investment returns. Sign up for this free e-letter for immediate action. Goldinvestmentletter.com.

12:31That's so interesting. By the way, when you're talking about the amount of stimulus that went into the economy, I've got to dig it up. I don't have it at my fingertips, but I know that we put it up in my interview with Nancy Davis. I'll try to find it and tweet it out. If you look at a chart of what was happening, even with QE, what happened during the pandemic was just off the charts. I mean, it's a huge injection into the economy. So your point about having to work that through is an excellent one. And it's not over. We keep getting more, by the way. It's not over. And my prediction is the worst thing that can happen in this market is actually that we get a recession, which I don't think – a deep recession, which I don't think we're going to get.

13:15That would be the worst case for this market because guess what? Next year is the beginning of an election cycle. And you better believe if the economy is not great, expect another$2 to$4 trillion. dollars. And again, people can't believe it. People have been like, oh, they're not going to do more. They said that at six trillion. They said that at seven trillion, nine trillion. The reality is it's popular. And no matter what you think about the economics, it is what the increasing, you know, the millennial generation on down wants. And those are the votes that people are battling for as they become a bigger and bigger part of the election story.

13:51Yeah. Ignore the nonsense around the debt ceiling, they're all going to spend it. That's what they've done on both sides. Give me incentives. I'll tell you the outcome. It's pretty simple. Exactly. A couple of good comments that I want to bring up based off of what you just said. But since we're talking about the difficulty of the Fed and inflation, I just want to run a clip from my colleague Andreas just released his latest steno signals where he's kind of focusing globally as well on what's happening with China and the China reopening as it relates to inflation. Let's listen to a clip of that and then we'll talk on the other side.

14:30So I'll show you a chart on why I think there will be a huge building boom in China relative to the last couple of years. The dark blue chart is the yearly change in the price of credit in China. So when the dark blue goes up, it means that credit is more easily available, both from a price perspective, but also from an availability perspective from banks. And we've seen a sharp rebound in the dark blue line, meaning that credit is now available to an extent not seen in a few years. And the light blue is the index of newly started housing construction in China. So it's been completely under the weather for a couple of years due to this credit contraction, due to this Lehman-like event in the Chinese economy.

15:20But now, looking into the second half of the year, I am starting to convince myself that the rebound in the construction activity will resemble the rebound seen after, for example, 2008, 2009, and after the 2011-2012 debt crisis in Europe. So it will be, from a sequential perspective, a very severe move from a contraction to an expansion, which is typically something that spills over to asset prices of relevance to this story. And industrial metals are obviously linked to the construction activity in China, China being the biggest consumer of copper, nickel, tin, stuff like that on earth, meaning that the Chinese cycle is the most relevant cycle to these industrial metals.

16:08It also means that inflation could resurface in Europe and in the U.S. with the time lag to this construction boom in China, if I'm right.

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17:20You can see that full interview on the platform. It was just released today. Andres coming to us live from Singapore. I love it. So no wonder he's thinking about what's happening in Asia. If you're not already a member, you can hit the QR code or the link in the chat. Jim, presumably, if we've got that working, in addition to everything else we just talked about, I mean, this is a more serious inflation problem for the Fed. Yeah, I mean, look, we kind of mentioned this before, but there were a lot of things going for us when inflation was hot and the Fed started fighting it. Again, China lockdowns, a strong dollar, oil prices being kind of held down by the reserve kind of releases during the last election.

18:05And again, all those things now are going the other way. All of them, the dollar is weakened. You're seeing a strength for demand out of China coming out of lockdowns. And oil prices are now being held up by OPEC and they're cutting supply. So I would add this to the pile of things that are going to make structural inflation, you know, are going to make it sticky. It has been sticky for some time. It's going to continue to be the case. I really think people are underestimating. I think the biggest thing here to realize is everybody is still trying to play some cyclical inflation game. That if we go into some recession, that inflation is suddenly going to be vanquished and we are going to move out of this.

18:51play the direction of bonds based on the cyclical turn in demand in the short term. I think it's so important to look at the structural realities of populism, of deglobalization, of resource scarcity and conflict that we're seeing globally. That is what will underpin inflation in the 60s and 70s. We are seeing exactly the same dynamics play out, And that is not a coincidence. That is what happens when you reach a point in a cycle where a generational belief that things are unfair, that they need to be created to be more equal happens. That's where we are politically. This is somewhat of an inevitability.

19:35People want this that are younger. They believe things are unfair. They can't afford housing. They can't afford things. And so we're going to give them money to do it, which is ultimately inflationary. That populism aspect is such an interesting one. And it's something I think we're going to be talking about a lot more over the course of the summer. What about so even if you believe all that, though, what about the issue of financial stability? I mean, can the Fed, even if they want to fight inflation without destabilizing the financial system? They can. To be clear, they can they can raise rates while still underpinning the tail.

20:12That's what they just did. Right. They just want to secure deposits across banks. and then they are going to keep raising interest rates. Everybody plays a very linear model where they're just adding all liquidity together and saying, well, what's net liquidity and what does that mean? That's not how the world works. So we try and talk about this with options all the time. It's not just a matter of up or down. There's a difference between buying deltas or buying the market by selling out of the money puts or buying stock. They're not the same thing. Liquidity is the same way. If you underpin the market by securing depositors, that is not the same thing as going and buying stocks or buying bonds.

20:48It is not just simple QE. Those are different things. So the Fed has underpinned the left tail, the deep left tail, but they are still here to bring down demand in the market. And those things have very different structural effects and operate in different dimensions of the distribution. I think that's so critical to understand. They can do both and they are attempting to do both. That is part of why the fall is dampened like it has. They are both buying, selling calls and selling puts on this market. I love it. This is why it's so important to catch up with folks like you, because I think someone described it as if you can sort of understand what's going on in options, it gives you more of a 3D view of what's happening as opposed to looking at it in a linear fashion.

21:34And I think that you're right. That's so important. We've got some questions that I want to get to from some of our viewers and some observations. I love this comment from Francisco. If markets need to squeeze shorts out and make people lose conviction by painfully trading higher, wouldn't the same logic inversely apply to the buy-the-dip mentality cemented over the last decade? This is the question. What will it take for participants to lose conviction in passive investing? I think that's actually a great question. I think time, as I mentioned, right, will play a huge role in that. Ultimately, you know, there was no passive investing in 1982, not because it was a technology that didn't exist.

22:19It was a technology that it was a thing that didn't work for 20, 30 years prior. Right. 68 to 82 markets went nowhere in nominal terms and lost, you know, 70 percent of their value in real terms. So nobody passively traded, you know, been passively by the market. I think with time, people will begin to realize, you know, my wealth advisor is not making me money. I'm paying them money for just buying me beta and beta is not working. So much like there are very little or if you active managers left, right, because everything went into passive, I think there will be a decade plus move back to people who create value.

22:55It's more expensive. It's more fee heavy. But that's what you have to do in order to create real value as opposed to just buy assets. So I think it'll take time. I think that's the biggest component. The other one is pain to the downside, right? So at some point, people will not lose conviction until they start feeling that pain. It's almost always a function of price and time. Yeah, when you were talking about the Fed taking demand out, does that mean that they also need to see the stock market lower? Is that part of the plan? Yeah, a wealth effect is definitely part of the solution in their minds.

23:31I don't think it's their primary goal or way of affecting this, but they definitely don't want speculation. speculation tends to also come from the populace. And you don't want people making a gazillion dollars on Bitcoin and YOLOing tech names. You want institutions to do okay. That's fine. But ultimately, you don't want that inflationary wealth effect. And that's true for real estate as well. So there's a broad need to take some of the air out of what's going through the market. Kevin asking, please ask, Jim, has he noticed an impactful increase in participants selling calls, buying puts to hedge against long positions?

24:18Also, has there been demand for margin puts? What's the impact of these flows? Yeah, so have not seen much put demand. For a second there, in the banking, kind of the throes of that one-week banking crisis, there was a bit of a spike in skew relative to where it had been. It is still elevated relative to where it was maybe a month ago, but still historically very, very low. Demand is quite low for hedging. Two structural dynamics have happened in the last six months that I think are very important positioning-wise. One, the move has been from vega, so month-plus out options, right, used for hedging, to more very short-dated zero DTE.

25:06You've heard about this phenomenon quite a bit. Short-dated gamma-intensive options for hedging because vega has not performed and has been a source of losses within portfolios in a dramatic way. So people have moved to zero DT. They are very gamma intensive positions. But what that generally leads to, people assume that they can catch the realized move if they keep buying them. But, you know, and they won't need the Vega. The problem is what happens sometimes is the market won't move for some time, yet Vega will start to work its way higher. So the insurance costs can start to work their way higher on the long end of the curve and short dated options won't hedge in that environment.

25:44That usually happens before the end, before a decline. We saw that in 07 in dramatic fashion. Again, we saw that in 99 in dramatic fashion. And my bet is here now that people are no longer hedging with Vega and looking for gamma, that you likely get Vega implied volatility going higher, despite not being in the throes of a decline before a decline comes. So I think based on positioning, that seems what's likely. Separately, we've seen a dramatic amount of hedging on duration for some time. The NASDAQ in particular and tech names that has now, as of last OPEX, right, as we went to that OPEX, we saw a dramatic reversal in activity in the market as a function of that.

26:25That positioning was over hedged tech, under hedged kind of value in other broad sectors. My guess is as vol goes higher, usually correlation goes to one. And so we'll likely see an outperformance, sort of underperformance in value in small cap and areas of the market which have not been as well hedged and likely see correlation broadly go to one. Even S &P will begin to perform for the first time in years. So if anyone out there is feeling a little bit lost because that was a little bit technical, the question was, as was the answers. I'm just going to remind you that we have an entire section on options on the Academy on our website.