The movements of cross assets over the last week and a half almost seem reminiscent of 2008. The circumstances may have been different, but at the time commodities, specifically oil, was rallying to new heights as demand was too strong in a system that was already very leveraged showing signs of breaking down.
Back in 2008, equity markets were also disconnected from oil markets for months before the oil price hit a high of $142 per barrel, when it could not ignore the underlying collapse in the financial system, only to then collapse along with broader credit, equity, and bond markets.
Today, the narrative may differ, but the moves and disconnects look familiar. We have been living in an inflationary boom due to the aggregate demand surge, after global central bank money printing over the past two years, with supply chain problems exacerbating the tightness. A system already so stretched with inflation averaging 7.5% year-over-year now makes matters worse. Oil is making new highs, up an additional 20% with Brent trading close to $106/bbl, as Russia continues invading Ukraine, despite the whole world getting together and putting sanctions against the nation.
Last week we saw a massive collapse in the ruble, which is now trading 118 to the dollar from highs of 80 just last week. Credit markets have been in a state of stress with heightened volatility as high yield and investment grade credit falling well below where the Fed was buying all of last year. Bond volatility too has been stressed for the past three months, as the market is convinced it was on the verge of a Fed policy error, as the yield curve spreads were flattening aggressively.
With break-even inflation at highs, the bond and rates market had priced in about seven to nine rate hikes for this year alone, setting up to test the Fed's resolve, despite the Fed only now acknowledging it was wrong on inflation. After the Russian invasion of Ukraine, the massive short bond position has now but almost reversed as 10 year yields have collapsed from 2.05% down to 1.68%. These extreme moves from one end to the other in such a short time is no sign of healthy markets. Such value at risk shocks as witnessed today in bond markets is bound to cause a hedge fund blow up. The bond and rates markets are some of the most complex markets and any such large moves cause wobble in overall risk assets as risk needs to be cut fast.
Equities are the least sophisticated of all asset classes, as they have so many flows and factors that determine their path, distorting their true nature at times. Against the backdrop of such heightened volatility in other cross assets, why is the S&P 500 holding up so well? It all boils down to the derivative positioning, the famous March quadruple witching event on the 18th. The quarterly expirations of indexes, stocks, futures, and options contracts is of great importance given the dealer flows that need to be hedged every day going into it. The market has purchased so many puts over the past few weeks, that this is distorting the true direction of the market. As people are long protection and puts, the dealers are short this protection, which means they need to sell aggressively as the market falls and buy as it rallies, keeping the market "pinned" to a certain level. Today that level is around 4300 - 4400 as you can see why the market seems to want to settle in that range.
Derivatives are often not paid enough attention, but they form a vital part of flows into their expiration events, which dictate the price action of all large-cap stocks. The market is convinced that the Fed may hold off any rate rises on back of war worries, but with oil prices shooting even higher, there is no doubt that inflation, which was not a problem before, is certainly one now. The only way to get prices lower is for demand to fall. The Fed put is a lot lower than most people think and we all know the Fed is always late to the party. Its focus is now on tapering the balance sheet, combating inflation. It is a shame it comes at a time when demand is showing signs of rolling over. Derivative positioning is only delaying the inevitable, but it is important to note that the rate of change of liquidity is now moving down. This has implications for risk assets across the board, even commodities.