Busy Times Ahead

Busy Times Ahead

We’re certainly going to start of the second half of the year with quite a lot going on.

Earnings season starts this week. In general, we’ve seen a combination of persistent inflation and a stronger-than-expected economy make corporate earnings stay fairly strong, so far. At the same time, we’ve also seen an increase in earnings warnings and corporate problems, as tighter financing takes effect and parts of the economy potentially leads investors into trouble.

Earnings season primarily starts with banks, though not until Friday, where it seems a bit tougher to be constructive. Mark-to-market (MTM) losses have been an issue, and that seems unlikely to change. Should we care? Admittedly, it’s probably not an existential situation, but it’s not a sign of bank health, and the problem has likely only become worse since the quarter ended.

Credit losses also seem likely to become a problem for banks. Corporate bankruptcies have swiftly climbed to levels last seen in 2020 and 2009. We also have roughly $1T in credit card debt, $2.7T in C&I loans, and $2.9T in CRE loans that are likely more stressed. Regulators don’t want to get caught out like they were in the banking crisis earlier this year, so higher provisions for losses seems extremely likely. We also should wonder what the status is of deposit flight.

We also have the CPI report on July 12th. While there still seems to be hope that we’ll see a lower trend on inflation, that doesn’t seem as likely with Core CPI. The Cleveland Fed expects headline CPI to be 3.2% Y/Y, but Core CPI to be at 5.1%. They also currently expect that inflation will start to move back up, next month. That’s way off where the Fed can fly the “Mission Accomplished’ flag.

Ultimately, we’ve seen yields move up, of late, and the current odds of a rate hike this month is 93%. Like it or not the Fed has been pretty loud in talking up more rate hikes, and while some people will talk up the lower headline, that’s not enough for the Fed. They’ve said they want inflation down to 2%, and that move from here to 2% is likely to be much more painful than the move from the peak to here. People seem very positive inflation will gracefully swoon downwards. What if that doesn’t happen, or the Fed doesn’t care about your narrative?

The last thing I’d look at is what I consider to be the big, uncovered story of the year, which is the impressive downswing in VIX. What’s going on? I think Cem Karsan of Kai Volatility is about the only person that’s been on top of this. This is not at all simple, but what he says is the rise of short-term interest rates has led to a lot of structured product creation.

Structured products don’t particularly care about valuations or much of anything outside of delivering a return. Let’s say a structured product promises a return as long as the index doesn’t go beyond a certain boundary. To do that, you have a layered options strategy that effectively sells vol.

The hedging activity from this in turn tends to pin the market. That gets harder as life happens in the market, companies get in trouble, and so on. To maintain that pin to keep structured products fed, you get this incredible dispersion, where a few big ‘vol center’ stocks do well and the rest act relatively normally.

I view this as the single best explanation of what’s happened so far this year. The same basic thing happened in 2017, which led to the 2018 ‘Volmegeddon’ event (pictured below.) Nothing has to happen immediately, but I’d point out that in June, VIX hit the same levels it hit the month before Volmegeddon.

A lot of people, quite logically, look at the monthly options expiration and VIX expiration for when we could see this vol suppression end. What I wonder is if the less-followed quarterly options expiration could be a trigger. These things tend to happen when nobody is looking, after all, and volatility has been moving up some since then.

At any rate, the near-term has quite a bit worth watching. I’m not willing to predict fire and brimstone, or anything, but there’s plenty to pay attention to this week and month.