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Now, let’s get into the market dynamics!
There has been an extremely tight correlation between oil and ES through the last month, where we’d get huge bids in ES and oil sells off. However, this is beginning to change today and is a red flag I’m monitoring. My views haven’t chnaged but I am aware that if oil continues to sell off and ES fails to bid, then there is NOT enough of a mitigating factor in crude prices to outweigh the movement in rates.
Today it’s pretty evident that rates are in the driving seat.
It was previously only the Russell that had such high beta to movement in rates, and what we were seeing was the Russell fail to bid when crude prices dropped, but would sell off and bid hard in direct positive correlation with bonds. Now on the day we’re seeing oil down over 3%, but rates are up and ES is trading in direct correlation with that movement LOWER in bonds.
Now the reason this is a red flag is because if lower crude prices can’t reprice rates lower, then that means bonds are pricing in the fact that inflation is a bigger problem than simply crude trading lower and inflation scares disappearing. For as long as oil is trading at these prices, there is an increased chance that we see inflation flow into core CPI (which didn’t really happen ealrier in the year). I noted in the Substack chat that oil doesnt even need to rally to cause probelms here, it just needs to hold these levels to be a tail-risk to equities.
It’s CRUCIAL to note that this repricing of the long-end is being driven DIRECTLY by the Fed (in the orange bars below). That means all tension inside of bonds is directly driven by a component that can flip extremly fast. What I mean by that is, when the long-end is ONLY driven by growth and inflation then there’s more stability because those dynamics take a longer period to shift. But the fed themsleves can shift their stance and policy goal within a single meeting if they decide to.
We’re seeing bond vol rally aggresively while equity vol remains contained, but this has a time limit on it because bond vol can be a HUGE catalyst for higher equity vol if it persists.
One positive I will note is that in previous cases where bond vol has blown out like this, equities have sold off in equal proportion, yet we’re seeing ES hold these levels without any real drawdown, even after this huge rally in bond vol. That means that a collapse back in bond vol is now likely to be just as big of a catalyst as a drop in crude prices, if not bigger.
What I need to see to remain long ES is, 1) a tighter correlation between ES & crude through til the end of the week, 2) a bid in bonds, or at LEAST a range created because there is a specific yield in the 10y that even a drop in crude prices WILL NOT mitigate. There was around 10bp of hikes added yesterday and we’re appraoching a fully priced path of 4 hikes.
Breakevens have found a range and steadied from its the rally previously, and even though credit spreads are rising, they still remain massively conatined and are NOT at levels that are causing tail-risks to being long equities. However, if credit spreads begin to rise further across next weeks trading sessions, as crude prices drop then this is ANOTHER huge red flag. If that happened alongside bonds selling off further, I would atcually flip short rather than neutral, but we’re not there yet and is simply just a scenario I’m laying out.
We’re in an extremly difficult macro enviromement where things flip and chnage so fast. I have no issue with flipping from long to short if the signals are there. This isn’t a common action, I would usually be neutral in between but with the aggression in changes in the market, I have no issue with doing this particulalry given taht I’m onsides on ALL open trades right now (all were sent to the Substack chat) and the short ZT trade has actually been most fruitful.
You can also note how I flipped from being short equities (trade hit 1:2.4 on ES), into being long equities and am now onside there. Also, bear in mind that if bonds bid with bond vol collapsing perisistently, as crude prices drop, we could see ES hit an all time high within a week because repricing can be that aggressive in these conditions.
I also want to note that on the FX side, if the signals to be short equities begin to come into fruition, the dollar will continue bidding aggressively in my view. But as I have laid out multiple times in previous reports, I do not want to be long the dollar and I’m looking for oppurtunities to get long equities and short the dollar, both aggressively (but the dollar trade is really not there yet).
Rates are the driving force here, and if ANY of these signals above occur, I would want to open trade with aggressive management (rolling stops fast). For anyone trading equities or FX, the signals are laid out above, but right now my eyes are on whether ES will begin to bid through this crude selloff and whether bonds can find a bottom, the correlation between ES-crude-bonds is number 1 on my list right now in terms of what to watch.
Thanks
Alfie
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