‘That Light At Tunnel’s End Was Actually A Train’

“Now, [it’s] clear that light at the end of the tunnel was actually an oncoming train,” Nomura’s Charlie McElligott said Monday.

He was referring to optimistic assumptions about “peak inflation” in the US and what it might mean for Fed policy.

Last week’s disastrous CPI report dispelled the notion that inflation is on the brink of turning lower. If it’s the monthly prints that count (and it is), there’s no sign of relief (figure below).

A new record low on the headline University of Michigan sentiment gauge and a sizable uptick in five- to 10-year inflation expectations among respondents was insult to injury.

The Fed is “now forced to capitulate into an even more aggressive policy stance in a desperate race against an unanchoring of inflation expectations,” McElligott went on to say, quoting the bank’s econ team in noting that if the Fed doesn’t get ahead of the situation, they risk a scenario where an even “more forceful response” is required to “dislodge it.”

So, what do you get? A dramatic bear flattener and a ~40bps increase in two-year yields over just two sessions, for one thing. You also get all kinds of consternation in equities.

McElligott reminded investors that after seemingly ruling out 75bps hike increments at the May meeting, Jerome Powell walked it back, telling Kai Ryssdal the following on May 12:

I said we weren’t actively considering that. But I said what we were actively considering, and this is just a factual recitation of what happened at the meeting, was a 50-basis point increase, that’s a half a percentage point increase, the first one in more than 20 years. And that we thought that if the economy performs about as expected, that it would be appropriate for there to be additional 50-basis point increases at the next two meetings. But I would just say, we have a series of expectations about the economy. If things come in better than we expect, then we’re prepared to do less. If they come in worse than when we expect, then we’re prepared to do more.

Fast forward a month and “things” have indeed come in worse than expected, especially on the inflation front. So, presumably, the Fed is “prepared to do more.”

What does that mean? Well, nobody quite knows yet from a policy perspective, but for the market, it means “a whole new world of policy tightening ‘left tail’ potentials,” as McElligott put it Monday.

Risk assets, he said, are now “exposed to a fresh wave of ‘FCI tantrum’ downside,” perched as many still are miles above pre-pandemic levels. The figure (below) underscores the point.

Note that crypto was in deep trouble on Monday.

It all hangs on the Fed meeting, and as McElligott wrote, it’s “all happening into quarterly VIXperation / options expiration.”

“Equities Index / ETF Options positioning is rationally ‘Short Gamma, Extreme Negative Delta’ across the board as Puts move in-the-money,” he said, adding that the market leans “enormously” towards the put side vis-à-vis expiring gamma and delta.

Legacy downside hedges are there, but in such a dynamic environment with so much event risk in play, extrapolating anything about the potential for a squeeze is probably unwise given that, as Charlie wrote, it’s “entirely dependent on customer re-hedging or monetization dynamics this week.”

Finally, he said, “systematic flows aren’t a ton of help down here as vol picks back up and CTAs are flipped ‘short’ again.”