Markets had their first brush with a losing week in the last month. Israeli promises to strike Iran back after the nation’s failed ballistic missile attack response to the assassination of Hassan Nasrallah, Hezbollah’s leader, have put the Middle East and the world on edge. Markets weren’t heartened when President Biden seemed to confirm reports that Israel is considering a strike on Iranian oil facilities. Such a development, given the concentration of Iran’s oil industry could cause price spikes in oil to be sure. Nonetheless, I think this is still a low probability event and that Israel can find plenty of military targets. It is always hard to determine what is a bluff and what is genuine in an escalatory cycle.
War is the foulest and most destructive of all human activities, and there has always been a dramatic psychological component involved. Of course, given the stakes and the emotionality of the dreadful human outcomes that occur in war it provokes an emotional response in human beings. In other words, when our judgement is needed to be most acute, war can often compromise it. This is part of what leads to unintended escalatory cycles that pepper the beginning of large conflicts throughout history. While Israel is talking tough after the ballistic missile strike, we should expect the multiple fronts the country is now fighting on to begin to limit its aggressive potential. Still, the implied volatility of Oil is surging.
But, as I’ve covered extensively there are limiting factors in the Middle East Conflict, including geography. Hezbollah was the crown jewel in Iran’s axis of resistance and was one of its major deterrents against Israeli aggression. Now that it is weak, Israel may choose to get overly aggressive and run the table with a comprehensive attack that focuses on or includes oil facilities. Markets are fretting about re-emerging inflation particularly when paired up with an ongoing Longshoremen strike at US ports.
The twin inflationary catalysts of war and port strikes could temper the recently victorious Doves on the FOMC a bit. Still, these catalysts will most likely prove short-lived in my estimation. If the economy significantly deteriorates on an exogenous catalyst, the Fed will still cut. They will just cut even faster. So, the Fed put is in place and we have an incredibly strong economic backdrop in place as well, with GDP growth around 3%.
The ultimate path of interest rates is most likely down. It would take quite a lot for inflation to re-emerge in a way that is strong enough to reverse the Fed’s course on rates. It is simply a very low probability scenario. Two of our recent Trades of the Week have been somewhat tied to the highly probable scenario that rates go down over the coming quarters, our long on $TLT and our long on $HD.
The economy has been strong. Jobless claims came in better than expected today and all eyes are on Nonfarm Payrolls tomorrow. These have become the new report that markets focus on since the employment side of the mandate is now factoring more predominately into FOMC decision making. Chairman Powell said the following: “From a base case standpoint, we’re looking at it as a process that will play out over some time, not something that we need to go fast on.”
So, after an aggressive start to the cutting cycle last week the Chairman indicated, the committee would return to its more customary 25 bps cuts. This is a positive if it occurs in a way, because it is based on robust economic data. Furthermore, the FOMC appears to be preventing a future taper tantrum from a market that might like and expect the 50 bps cuts a little too much. I think the hysteria about Iran attacking oil facilities is also overdone. I agree with foreign policy expert Ian Bremmer that Israel will attack, but that a direct attack on oil facilities likely is beyond the tempo of this current exchange.
Ultimately, we are pretty on track for a normal end of the year. The typical seasonal pattern is for a drop in October followed by a recovery in November and the Santa Clause spirit in December. The fundamental underpinnings of a very strong market lead me to believe that we will follow this pattern. If you categorize exogenous geopolitical risks as their own category distinct from endogenous market risks, it is very hard to find any that adversely affect markets as much as people fear in the fog of the present.
We have several trades that will benefit from this typical seasonality. We took long-term shorts on the VIX expiring in November and December over the past few months. Those are at $23 and $18 in November and $15 for December. We expect a post-election volatility crush along with positive seasonals to really make these contracts sing around the time of their expiration.
We don’t just short the VIX though. We also got you into some long VIX positions to benefit from the seasonal volatility and election uncertainty. These positions did very well. We trade in some remote corners of the options markets on the VIX that often have very little liquidity. So, ideally, we like our VIX positions to expire in the money. It’s always nice that like SPX options, they settle in cash directly to your account. We are good at shorting the VIX our dear Punk Rock Traders.
October 10th, 2023: We urged our readers to short the VIX, even during the heightened uncertainty caused by the Hamas attacks. Our recommended December 20 $17 put options saw a 230% gain, while the $16 put options delivered 327% returns, all within three months.
June 18th: We recommended shorting the VIX again amidst geopolitical tensions, resulting in a 210% gain with June $14 put options.
We are not whistling past the graveyard. We’d also remind you that we have a demonstrated track record, as shown above, of successfully understanding and giving positions that benefit from the overreaction to the Israeli/Iranian conflict. We think this will be another case where markets overreacted, and that within two weeks the VIX will be back to the mid-teens.
