🐿️ Ears: Cem Karsan on Volatility and Macro

The Jam Croissant 🥐 does macro (really well!) too

March 28th, 2023. (5 minute read).

Episode Link. Run time: 65 minutes

The 🐿️ is a huge fan of Niels Kaastrup-Larsen’s podcast, Top Traders Unplugged. I am a regular listener as it helps me to keep abreast of what the CTA / trend following community are up to.

Niels has teamed up with Kai Volatility’s Cem Karsan to put together a terrific series of macro-focused discussions. We are massive fans of Cem’s work. He is a great macro thinker in addition to his deep domain expertise around flows and dealer positioning in the S&P option complex.

🐿️ key takeaways below:

• Cem sees and overall bearish trend for equities. “Don’t fight the Fed…they are selling calls”. Countertrend rallies always possible but “we are not in the same cyclical world”. We have switched from monetary to fiscal dominance when it comes to policy setting and market forces. Buckle up for more inflation and “at some stage, the Fed is going to lose control of the long end of the curve”.

• We are at the start of a regime shift from gamma and realized volatility (typified by the extreme activity short-dated “0DTE” products) back to a vega and implied volatility-led regime. Implied volatility looks set to rise (in particular longer dated volatility) as this positioning shifts.

• Recent large cap tech outperformance is partly a function of the unwind of hedging positions. Investors paid up for protection against further declines in last year’s losers (FANG) and much of that rolled off in to March’s option expiry.

• Important point. Watch out for side effects as implied vols start to rise again. When volatility increases, “correlations tend to go to 1” and assets that are under-hedged (e.g. low beta, small cap value and energy stocks where people have been hiding) could get caught “painfully” in the downdraft.

Podcast Notes

Current banking crisis.

• “Inevitable given rising rates and reduced liquidity”. 

• More fragility in the system, exacerbated by interest rate volatility. “At some point we get a Minsky moment”

• Has been “reasonably controlled so far”. “By definition banks are leveraged entities with a massive tail”.

The Fed’s Role

• Powell has to be inflation slayer (like Paul Volcker) or a crisis firefighter (like Ben Bernanke). He simply can not do both with a blunt cyclical tool (interest rates) that flies in the face of secular trends and requirements (more fiscal, inflationary populism).

• He he “does a Volcker”, we get a recession and then a pivot plus more fiscal from the populist politicians → which leads to more inflation.

Geopolitics

• Populism is not unique to the US. Cem cites his recent tour of European strike actions.

• “Inequality got too far because of monetary policy”. We now have a “generational problem” and an ongoing fightback of labor against capital.

• Globalization took place during monetary expansion. Protectionism closely linked to populism, as “labor is domestic”. The last 40 years looks set to be reversed over the next “couple of decades”.

Markets

• Narrative follows prices which follows flows. This is Cem’s key mantra.

  Liquidity dominates and it does not take much supply / demand adjustment to shift things. Fed was “selling calls” for 6 weeks but market was not ready to listen (hence a 20% rally from Oct lows)

• Now we have a tail from the bank runs and the associated chaos in short term interest rate markets. This is a setback for a Fed that wants long end of curve up (in yield). This bond rally is the opposite of what it wants. It makes it tougher to battle the secular inflationary story. Powell had to talk tough (“sell calls”) again at last weeks FOMC.

Volatility in other asset classes

• Cem is known for his expertise in equity / S&P vol complex. Interesting to hear him discuss vol in other asset classes. (Timestamp Min 21)

• Yield moves like this month are completely unprecedented for most investors active today.

• Rate and FX vol increase / spikes “is not an anomaly”. We should get used to a high MOVE. This has echoes of the early 1980s.

• Gold vol has finally begun to participate (and is “still cheap”). Cem suggests focusing on long dated gold calls.

• Recent weakness in equity volatility is “part of a broader trend which makes perfect sense”. During the 1967-1982 equity markets went nowhere in nominal terms. Not good for long dated vol!

• Oil volatility is dead and should remain subdued. Downside moves should be very controlled as resource scarcity underpins the market.

• Kai is launching a macro / multi-asset volatility fund in Q2.

Volatility vs Trend following as a portfolio diversification tool

• Rate volatility market is dominated by big institutional flows “that breaks all at once”. Rate vol should be great for secular trades over next 10 years.

• Volatility fund landscape (Timestamp: Min 32). Why did vol funds lose money last year? All about dealer positioning. Day to day, this is all that matters. Levered long equity plus long vol as a hedge was a disastrous combination. Stocks down. Skew flattened. “Easy trades (such as US$200 WTI!) never work!”

• Tails will return when everyone is no longer hedged. Watch for more vol fund closures before long equity vol starts to work again.

• “Knowledge is vol dampening”. Don’t hedge the obvious banana skin. This year’s February option expiry was a case in point. Everyone hedged so only a 5% decline instead of the 15% that people were hedging for.

• Watch for complacency. Short vol funds “are out marketing non-correlated strategies right now”. Let’s wait for the crowd to build…

• In the meantime institutions are hedging with gamma via very short dated (ie 0DTE) options. Cem discussed this at length with

  The MacroTourist
  on this weekend’s Market Huddle podcast (second hour).

• Confidence in central banks is on the wane. Therefore things can change dramatically and fast. The second leg: “Fed will at some stage lose the long end of the curve at some stage”. Watch positioning like a hawk over next year or so. A spike in rates possible more likely following or as we enter to a recession. The “clue” will be volatility and directional positioning that reflects a “welcome to a new deflationary regime” narrative.

• The rug pull could be massive. An “inflation is healed” narrative will create offside positions and “the move will feel counterintuitive”.

Election Period

• US election is top of mind for Cem as the next big narrative. Fiscal policy will be front and center.

• Biggest “inflation disaster” would be caused by a big pre-election recession “which triggers the fiscal taps again prematurely”. A “crisis excuse”.

• Millennial generation is underpinning Dem strength. Payments not markets are what matter. Expect price controls, debt relief etc. Populists on both sides. Very inflationary. The worse the economy does, the more fiscal we get.