Zaps: January 18, 2022

Welcome to Zaps, Friktion’s DAO Contributor driven Market Notes covering the latest market developments, implications, and opportunities.

Thanks to JP, Leonardo, Thiccy, and GVol for contributing to this Week’s Zap. Interested in contributing to Zaps? Drop us a message on Discord or Twitter!

This week’s coverage: Macro, US Federal Reserve, Crypto Vol, DeFi structured products

Macro:

Real interest rates — the rate of change, not the level, is what matters for markets

  • In times of increasing real interest rates, as we have seen since their November low, equity markets experience varying degrees of pressure and volatility depending upon how quickly interest rate markets are repricing.
  • Using real interest rate and equity market data since 2006, an increase of 40 bps (0.40%) of more in the 10-year U.S. real yield in a month’s time tends to lead to a 4% drop in equity markets, on average.
  • At the time of writing, 10-year real yields have increased 38bps over the past two-and-a-half weeks and the S&P 500 stands roughly 3.5% off its all-time high.
  • The recent market volatility, which has stemmed mostly from Fed communications on interest rate hikes and balance sheet reduction within their December meeting minutes (and the variance around investors’ interpretation of the communications), is sure to pass once markets reach a clearing level — i.e. where investors broadly agree — for interest rate expectations.

Value Factor shows signs of life as a result of real interest rate moves

  • As noted in last week’s ZAP, “unprofitable tech” tends to take a hit when real interest rates increase (i.e. liquidity tightens). For evidence, see Cathie Wood’s ARKK fund, for instance, which is down > 50% over the past year.
  • The Value factor (long stocks with low valuations vs. short stocks with high valuations) shows an 87% correlation to 10-year real yield levels over the past five years.
  • As real interest rates fell precipitously with the Fed purchasing TIPS, among other fixed income instruments, to loosen financial conditions during COVID, Growth stocks got a valuation boost.
  • Now, that is working in reverse as real yields climb and sky-high valuations fall (consider Software, for example).
Morgan Stanley Value Factor, 5y History: Bloomberg
Source: Goldman Sachs

December’s Inflation Data Show Persistence and Momentum Underneath the Surface

  • While the headline numbers only beat expectations by small margins, the underlying trends over the past three months show an increase in momentum.
  • The three‐month headline inflation rate (annualized) stands at 9.1% versus a 7.0% 12‐month rate, and a core (ex-food and energy) inflation rate of 6.9% over three months versus 5.5% year‐over‐year.
  • The Fed has abandoned the transitory language to describe inflation but still looks for the largest deceleration in inflation since 1975 in their 2022 forecast.
  • However, the Fed’s recent track record in forecasting inflation has been awful with the December 2020 median SEP PCE price inflation forecast for 2021 a mere 1.8% (on both headline and core).
  • As such, there is potential for more than the currently priced-in four interest rate hikes in 2022, or even a 50bp rate hike at the beginning of the hiking cycle.

Source: RDQ Economics

Source: RDQ Economics

Crypto Markets

This weeks narrative has concentrated around the low levels of IV and RV across crypto assets. Notably, the dampening effect on Implied Volatility (read this for a primer on IV) that structural DeFi options selling programs have. The BTC and ETH ATM IV charts show some evidence of the impact on-chain options selling has on off-chain screen markets like Deribit. When this on-chain options selling first started, the strike and expiry selection targeted 10delta 7dte European style call options on Ethereum. Today, deposited assets across protocols like Friktion, Ribbon, Dopex, and Lyra are approaching $1bn!

Key characteristics of this selling:

  • Asset dominance (today): ETH > BTC > SOL > AltCoins
  • Predominantly fully collateralized overwriting (both calls and puts)
  • Strike selection ~10 delta fades closer to ATM. In search of “yield”, many protocols are adding risk by creeping closer to ATM strikes.
  • Expiry selection: 1 week from expiry

What are the key impacts of this risk selling?

  • Similar to equity options markets (S&P) short-term crypto options writing causes volatility term structure to steepen. It’s important to note this isn’t unique to crypto markets — the last 10+ years of TradFi have optimized for max time decay (theta) over a short period of time (1–3 week expiries) in these options writing strategies.
  • Traditional counterparties to these flows include dealer desks (market makers looking to neutralize their net risk) and volatility arbitrage desks — hedging their weekly long gamma positions with either further-dated expiries or via relative value (mispricing vs another underlying).
  • An interesting analog: For the first time ever in 2021, medium/long duration US TradFi structured products volume (largely retail+pension yeild/income strategies) surpassed South Korean flow. Similar strategies have been deployed in TradFi using 20+ year backtests, across pension funds and retail end user products — branded as equity like returns with lower risk (defensive equity) contributing to short-term IV compression.
GVol.io: BTC ATM IV
GVol.io: BTC term structure
GVol.io ETH ATM IV
GVol.io ETH term structure

25delta Skew (Put IV — Call IV) quickly dropped

Crypto basis arbitrage

  • The BTC and ETH March basis continues to be subdued, hovering around 5.5% as the majors remain rangebound. As basis looks to be finding a floor here, the demand for cash has taken a back seat while the demand for alts has been driving the growth of the book. (Genesis Trading)
GVol
GVol

Some notable highlights this week:

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Friktion brings high quality portfolio construction and dynamic risk management to DeFi.

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