Frameworks To Trade The Hormuz Crisis

[MUSIC PLAYING] The macro trading floor. With me, Alfonso Piccatello, founder of the Macro Compass, and former head of investments at the large European bank. And I am Brent Donnelly, president of Spectre Markets. I've been a portfolio manager, day trader, and market maker at the biggest commercial and investment banks in the United States. I'm also the author of Alpha Trader and the Art of Currency Trading. If you want to know what's going on in markets and where they're going, you found the right podcast. Hi, everybody. Welcome back to the macro trading floor. Alfonso Piccatello, brand Donnelly, as always, with you. Alfonso Piccatello, if I sound like not, please stay with me. It's going to be Italian with a bit of nose, French accent today. Brent, how are you doing, my friend? I'm doing OK. It's been a pretty weird market of late. Overall, I've been doing all right. And yeah, nothing to complain about, I guess. OK. Well, that's quite something already. This month, I think, was one of the worst for many years back for barriers, hedge fund strategies, for example. So in my world, there is a lot of pain in March. So Mr. Donnelly is completely detached from pain, which is good. It means you can think more clearly. You're not afraid, not hiding under your desk. So-- Well, the thing is, too, is these environments tend to be good for me because I don't really have a core view and I trade like good things. So the difficulty comes when you're in less liquid stuff, I suppose, or you have a strong core view, which I never have. But anyways, if you need something, we should talk about, I think, Brent is-- I mean, what are the approaches that a trader can have to an environment like this one? I can tell you then what I am trying to do from a long-term, oriented discretionary macro investor. But from a short-dated, oriented trader, like you are, I guess, how are you handling the situation here? I mean, what's your strategy to trade this market? So yeah, I mean, that's a great question. Actually, someone just asked me that by email recently, or yesterday, saying like, their strategy wasn't working. How do you adapt as a short-term trader, et cetera? And I guess I start from a position of mean reversion in this market simply because that was the way in Trump one, and that was the way Liberation Day obviously. I know that's easier said than done. You can't just fade every single move, but you can fade a lot of the moves. And so I kind of start as that with that as a basic framework and then trying to incorporate positioning and technicals and looking for signs of mega-overbot, mega-oversold things. And then sometimes you can have an edge as well, just on reading headlines or assessing, like, what's the skew going into this event or into this headline? Because I know the market was one way that this headline means something or it doesn't. So I tend to just try to kind of run with things for like one, two, maybe three days and then get out. And a lot of what I'm doing is finding times when there's a mean reversion trade that positioning makes sense and technicals make sense at the same time. And then the other thing is just like to never have a core view because whatever, even if back end crew goes to $200, equities could still make new all-time highs. So I never get super locked in on a core view because it just like a liberation day, you could have just stayed short the whole way all the way back up because tariffs are bad. And tariffs didn't suddenly become good. It's just the market gets bored of stuff really quickly. And so even today, maybe you get Iran owns the straight of hormones, they charge tolls. Oil stays at $100 in the back end and stocks go up. I mean, that's a possibility, right? So I never lock into any kind of core view. I'm just completely agnostic all the time. Which is by far the hardest part of actually implementing your strategy brand. So it's really a full Bayesian update, right? I mean, just new fact comes in, you try to measure what the market expectation was and what the positioning is now. And then you see if there is any discrepancy that you think can be traded. But that means you can be long and short in the matter of a few days. Well, that's exactly it. And I think what you described, like I took about five minutes to describe it and you just described it in about 15 seconds. I mean, that's exactly what it is. And yeah, like I've over the years just have an ability. I don't care whether the thing's going up or down. I'm just trying to make money. And I never, like I just don't have any or really much bias. Like even Tesla or something like that, where it's so easy to have a bias because you either love Musk or you think it's 98% overvalued. I'll be longer short Tesla. Like I just don't care. Whatever the thing is, I think that I can make money. That's what I'm trying to do. And I mean, it took me a long time to get here because I had so many biases when I was younger, especially just being reflexively contrarian, always fading everything. And with no real framework around it, and you can't just reflexively fade either. Yes. So from my perspective, instead, we have one of the steps in our risk management is to look at the book you're running and then try to figure out if adding a new trade, what does it do to the balance of the book? Do you become to concentrate? Is it the same trade again? So to do this, you have this variance covariance metric. It's a pretty standard linear approach where you will look at the correlation, the average correlations, I should say, between your existing five trades, and then you will add two more, and you will see how this matter exchanges. Now, the problem with that is that average correlations don't mean much. I mean, they are OK. Your book will look uncorrelated most of the times, unless your book is-- I'm long SMP, docs, Nikkei, and Cospy, then I'm sorry. But you're not diversified. But an average wealth out book will look diversified. The issue is that when there are stress events in the risk assets or correlation convergence across asset classes, as we are seeing in March, your book might look uncorrelated on average, but during stress period, it won't hold. So we have a stress test there that basically looks at the-- let's call it like a conditional bar, but it's conditional correlation bar. If it makes any sense, we're just trying to see stress seeing this correlation matrix and brand. I mean, if I do it today, the system comes and says, oh, wow, OK, you manage to hold this 4, 5 using critic trades on because how you built them, whether they based on elections or whatever. Now you want to add trade number 5, 6, and 7. Well, nice. You're selling oil. Well, look, no, I'm not selling oil. I'm doing some-- whatever-- trading rates. I'm playing the hungry election or whatever, yeah. And then the system says, good, you're selling oil. So you want to sell three times oil with three trades. So can you buy some out of the money calls to hedge against a problem there? No, I can't because out of the money, coal-voling oil is like 120 volts. I mean, I'm not going to buy that. And you know what happens there, right? It's incredibly hard to run a very well-balanced macrobook. If you don't, generally speaking, it's fine until March comes true. And then you lose 5% or 10% in a month. And then you don't look that well. So the only way that I can find solace in running a portfolio at the moment is if you look very hard and you're able to structure trades that are indifferent to either a resolution, or an escalation in the In-A-NUAs situation, it's extremely hard to build those. It's very hard. But it's the only way, I think, a prudent macro investor can run the large amount of risk at this stage. Right. And one crazy thing about this episode and really the last five, six years in FX is that a huge issue has been you can't forecast the correlation of the things anyway. So like you can look back over the last one, two, five years or whatever. But in FX, like we just had a war. And one of the best performing currency pairs was Euro Swiss, Sterling Swiss was another one, which normally any model would say that those would go down and probably be one of the worst performing during an event, or like an oil spike in CAD is one of the worst performing currencies. So it is really hard. I think actually that can be a source of edge and short-term trading as well as correlation breakdown when you understand people are buying yen on the safe haven thing, but yields are going up. So that obviously makes no sense. So I'm going to fade it and things like that. And also to your point about the Varron, all that is that you can also, as a short-term trader, say, OK, well, everyone thinks that everything's correlated to oil now, but maybe it isn't. And so then you can structure something like short dollars and long oil, which would be things that people would expect if oil goes up the dollar, we'll keep rallying. Whereas I would argue that at this point, it probably won't. So then you can structure things that are kind of anti-correlation according to the look back, but like long oil, short dollars, or long oil, and long equities, or things like that, where sometimes you're getting a bit too clever, but also sometimes those can be really good RV or like pair trades. Yep. So now that we've done the interesting positive expected value part of the podcast, which is thinking about frameworks, now it's time to go into the negative or zero positive expected value part of the podcast, which is to pontificate with zero edge about what happens next, Brent. Do you want to do that? But you know what the good thing is, is that because this podcast is free, at least it's not negative expected value like trading in randomly in the market as negative expected value because of fees. Well, there's no fee for the podcast. So it's, you know, hopefully it's at least zero. And you know, you are spending time listening to this. So we hope that at least, you know, we are fun listening to us trying to figure it out together with you. So let's call it zero expected value yet. Let's still do the exercise just for fun. Also because I actually don't know what your opinion is. So, you know, in the way I would phrase this is, there is a game theory exercise in front of everyone. And then there is at any point in time, the market expected outcome out of this, right? It can be price more, or a kitchen or novish, whatever it is. But there is always it's an equation with two axes. So Brent, what's your game theory preferred solution or preferred most likely outcome? And what do you think the market is on the same side as you? And, you know, go on, just pontificate. So the framework I'm using right now, but my confidence is pretty low because I just feel like everyone's lying all the time, like the US and Iran are both lying. Obviously, that's just propaganda. That's what happens during a war. And, you know, if you look at the list of Iranian demands, to think that the US would completely surrender and offer all those demands seems wild to me, but whatever. Anyways, I'm not going to forecast the geopolitical part. One thing I will say is that it all feels a lot like exactly this time last year, even, you know, even the electricity in the air and the vibe and, you know, the anti-Trump hate and, you know, policy shock. And then it's like, I break the thing, but then I fix it and then celebrate that I fixed like the arsonist with the bucket of water, you know, kind of situation. And then the way that S&P is broke down through all the moving averages. And now we're right back up to the 200 day in the S&P. And if you look at a chart of what happened around liberation day, essentially we cracked through all the moving averages, then we rally back up to the 200 day, kicked around for a week or two and then just ripped. And so as much as like I can't really explain why that would happen, that does feel like the parallel is the one that I think is probably the model of the market that makes the most sense to me right now. Why S&Ps will go all the way back up and retest the highs. I can't really explain other than there's a few ways you can, you'll be able to explain it X post if it happens. One is that the US consumption of energy, share of spending is way lower than it ever used to be oil at a hundred bucks. Is really not that expensive compared to oil at a hundred bucks in 2008, which was very expensive, you know, inflation and wages and everything have gone up substantially. And the price of oil has not over the past 20 years. So there's that. I think the other thing is that the people just get bored of themes and, you know, the market if this just becomes like a thing that's on again off again and nothing's really happening at Carg Island and Hormuz is open and Iran's just generating a shitload of revenue now that they weren't before because their oil is worth more and they charge a toll. Obviously that's a massive, you know, own goal for the US, but in this at the same time, maybe for the economy, it doesn't matter as much as, as the bears would like to think. So that's what I'm looking at for now. But like I said, I mean, my confidence on this is super low. In fact, I generally was feeling like the market was too complacent on the war, but then I squared up before the ultimatum day just because it felt like a coin flip, not because I thought they would sign a deal. I actually didn't, but it just felt like too much of a coin flip random event. And so now I just feel like as agnostic as I possibly can be, that's what I want to be. And, but I think the stupidest, since we're on the stupidest timeline, the stupidest thing that would happen now would be for us to go back up and retest the highs into earnings. Okay, fair enough. Now, my pontification of this, or what I can try as well, zero edge, okay, just for listeners here, I don't have any edge here, just a total exercise. What really matters here is whether the molecules are flowing. The argument by which CL6 is through the 6th crude oil contract is trading at $75 or nothing is happening. Can you put CL6 in your car? Does your car work on CL6? It doesn't. It works on an actual physical barrel of refined product. That's what matters. So if you can't make the molecules flow through, then you will have higher prices. Now, therefore for me, on the game theory point, the only thing that matters is are the molecules flowing. How they flow, whether it's Iran, with a tall system, whether it's Iran and the US, this was so funny, as they joined danger, proposed by trap, you first bomb a country, and then you want to do a joint venture. That's so funny. But okay, whatever the format is, I personally do not care. The only thing I care about is how much molecules are flowing, are they flowing and is their visibility? They will be flowing in the future. The other thing is at what cost? So if you apply a tall system, then you have to wonder like for tariffs who's paying the tall, is the producer or is it the consumer? Is the importing nation or is it Saudi Arabia? Now, the way I see it, it could be both, but at the end of the day, oil contrary to gold, for example, the supply of oil is very elastic, it can be expanded. So if after the tall system, the marginal price of a refined product is higher than before, we will find ways to basically bring the price down over time by the means of more production or diversified production. So the Arabia is shipping a lot through the Yambo port, they weren't doing that before. People will innovate to make sure that demand supplies balanced again. Okay, so I'm done with my game theory approach here, but at the end of the day, that's the only thing that matters at the moment. There is nothing flowing through the state of our moods. There are some irrelevant vessels, but when you look at actually the vessels that carry LPG, LNG, crude oil, that is basically nothing flowing through now. You know, one thing that's confusing is, you know, obviously we're reading as many experts as we can, because we have no idea what we're talking about with this stuff. And when you were reading the experts, as far as I aggregated them, my understanding was that around week four, week five, you're going to start to run into supply shocks in the global economy because of fertilizer and oil and this and that. I mean, we're in week seven, we're almost, we're going to be in week seven soon, we're in week six. And there doesn't seem to be anything other than like, I know in some countries in Asia, they are actually starting to ration fuel and things like that, but that's more preemptive, but it seems like the actual tsunami wave hasn't hit yet. And it was supposed to hit my now. I don't know. Do you have any thoughts on that? I'm surprised that we haven't really seen any, you know, like in Australia, they were talking about running out of gas at the gas stations. Four weeks ago, they were saying in four weeks, we're going to run out of gas, but yet they haven't. And so what are people missing or what's going on there? Any ideas again, brand, I'm not an expert far from it. So I can only relay what I read from other more or less experts in the topic, let's say. What I read is that actually the dates are the hardest to where let's say where this becomes more convex as a problem rather than linear. Are anywhere between April 12 and April 20. So the next okay, all right, you know, eight to 10 days, which by the way, would be funnily enough very close to this, you know, truth and deadlines. And supposedly the truth was also built on molecules flowing, physical commodities flowing through the straightaway moods, which we are not seeing. I repeat, because this you can actually track. You can track how many ships that's completely relevant. And also you can track how many vessels carrying energy and fertilizers are passing through and nothing is passing through very, very little. So this would be a pretty weird ceasefire so far, considering like no one's really doing anything other than the US stopped Yeah, but otherwise nothing really has. So the physics, the physics of this brand is super interesting because there seems to be two different markets. One market is the physical commodity market and that is quite tight. I mean, physics, you can't deny physics with some future contract. That's on how it works. You actually need the jet fuel in Singapore. And you know, the price of that has gone up a lot. Makes sense, right? I mean, it's simply there is no availability of that thing anymore. And then there is a financialized market and there are different degrees like the most financialized assets. You can say stocks, props. They are. Actually, I mean, the Euro stocks, which is a, Europe is a large importer of energy or Japan, they're down 0.6 standard deviations since the war started. I talk in standard deviations, so you can have an idea. It's nothing. 0.6 standard deviations is just a random event. And the market was like balls long European equity, too, so that's even more interesting. It's super interesting. And, you know, of course, you can say, "Yeah, but rates have sold off." Of course, but what would you expect? Because the demand destruction part is something that we also should talk about, and my assessment says, depending which country you look at, what demand destruction are you talking about? You need prices much higher for a much more prolonged period of time to even start to remotely talking about it. So there is an inflationary component that happens first, and therefore, bonds have to reprise those probabilities. But even there, the sale of hasn't been ridiculous. If I would tell you, brand the price of a diesel barrel in Europe to put in your diesel car or tractor or whatever, hit $200 and something dollars a barrel a few weeks ago, and that directly feeds into the CPI basket. If I would tell you the market implied CPI expectation for Europe at the end of the year is 3.5% CPI, 3.5% for a central bank that does not have a labor market mandate. The ECB only has an inflation mandate. Where do you think the front-end should trade probabilistically? I mean, you're 150 basis point above your inflation target. At the very least, you should trade, I would say, 75 to 100 basis point above your neutral, at the very least. So you should trade with 3 or 4 high, exprised in by the end of the year. And that, I think, it's relatively okay. And the market is in the mean trading there. So same story as per the stock market. It's been pretty mild. So the more financialized the market is, the less it seems to care about the spot physical problem. And then there is crude oil, which is super interesting because crude oil future contracts are also financialized. Of course, there are less financialized, right, to a certain degree, because you need to actually deliver physically the barrels. But you have to deliver them in a month, two months, three months, four months, depending on the contract. So there is really this dichotomy between the physical market and the financialized market. And then there is a clock that you refer to before, right? We don't know exactly the clock. I mean, I don't know. It seems to be anywhere between the next three and 10 days that the clock starts to become a little bit more pressing. And then, brand, there is everything else about Iran, Saudi and US and Israel and what China thinks and what Russia and Ukraine think, by the way. One comment I would like to make here is that this has already become a global affair. Ukraine did not basically touch any oil refineries in Russia throughout the entire war and now they're strategically going after oil infrastructure in Russia. Why? Because they see Iran doing the same and they understand, they get leveraged their way. So this has already become a global affair. And there, I just have no clue. I will not even venture, you know. Longer saying, what do I think is the final solution that I don't know. But at least I wanted to share my framework to look at this. Yeah. And I mean, I think that's the best we can do is think about what could happen different different scenarios and then kind of you can sometimes see them playing out before they've fully played out. So then you say, like, okay, I got my three scenarios. Oh, this is obviously scenario two playing out because I had already thought about this now. And I already know how I'm in a position for scenario two. So you see it starting to unfold in front of you and then you take the positions on the right side. I think it's interesting because everyone's knee jerk is just like, ah, too much is priced in. This is stupid. They're not going to hike it. And in a scenario where which you're kind of slightly describing and I'm describing, like if you combine what we've just described with oil hire for longer, but stocks up on, say, strong earnings and the underlying economies are already pretty tight in a lot of places. Like there's not a ton of slack in in most of the countries. There isn't some but but in Europe, for example, there's not a lot of labor market slack. So you have oil hire for longer, which is inflationary strong earnings, equities back to the highs. Economies okay. I mean, why why wouldn't why couldn't they hike? They could easily hike. Um, now I'm not forecasting that they will, but I'm saying like that I agree with you that there's not necessarily too much priced in. There's a think about where the Fed was. The Fed, we were talking about a captured Fed that was going to cut four times. Now they're we're talking about, you know, in the minutes yesterday, the Fed said they need to add a possibility on both sides. So their possibility of hiking rates, even Stephen Moran is not really that dovish anymore. So like the reality has changed so much and rates are reflecting that. And I don't know to me, it just kind of makes sense. And and I feel like fading it does not make a lot of sense. You know, one thing that we haven't talked about, can we talk about it? FX? Yeah, of course. Go ahead. I don't think we touched it. So it's a really interesting and weird setup because the market, so we have a positioning indicator that aggregates a bunch of things that aggregates a couple surveys and then what's going on in the options market and CFTC. And it's pretty good over, you know, since 2022, which is when we started at the mega extremes which is generally my experience with all positioning indicators is that they follow the trend and only at like the two and a half three standard deviation point. Do they actually become reverse indicators? And our indicator tends to work that way. So the crazy thing though is that it's max long dollars right now. But if you talk to any human being in the world, almost every single person is barris dollar over any, you know, time frame more like if you go out more than a week or two. Basically, everyone in the world is barris dollar. So the market's long dollars and bearish. And it's an interesting setup because the reason people are long dollars is that they views things like short euro dollar as good hedges for, you know, further escalation and energy terms of trade shock and all that kind of stuff. And then at the same time, there was a lot of forced dollar buying because going into the war, everyone was short dollars. So there was a lot of unwinds there. And then it coincided with a lot of corporate and and real money dollar buying for hedging as well. And then also US investors buying a ton of dollars to hedge as well. So you had everyone kind of going the same way. And ironically, so people are like, oh, the dollars of safe haven again. But if you look at what happens around every single crisis, the dollar reaction is just a function of positioning. So if the market was short dollars like in 2008, the dollar was a funding currency and the whole world was massively short dollars on the liability side and on the funding side. And so, you know, obviously the dollar ripped. But in 2001, 2002, 2003, the market was long dollars and long US. So when the stock market sold off, dollars sold off. And then in 20, 28, 2020, 25, everyone was long dollars. So yeah, an event and the dollar sold off. This time, everyone's short dollars and the dollar rallies on the on the risk of version. So the dollar status as a safe haven is bullshit. It's just whether people are longer short. And then when a crisis happens, people on wine, because they need liquidity and they other buy dollars or sell dollars, depending on what their position was. Now you have a you have a situation where all that has now happened. And I think it's sowing the seeds for a larger dollar sell off because, you know, the US, there's so many reasons. But the one big one being that like all dreams of deficit reduction, you know, doge and all that have just completely been blown out of the water. Like the, you know, they were talking about reducing deficit spending in 25 now. They're talking about increasing it by 40%. It's just like the nothing stops this train debasement trade on steroids with like another aspect of mild questions about US's role in the world as like more allies get pushed away more and more like more of an isolationist approach to global conflict, which is not necessarily bullish dollar either. So now you have a pretty good setup for short dollars. However, you kind of need a little bit of comfort on either this conflict is over or the markets board of the conflict. And then I think you'll probably get a pretty big dollar sell off. Yes. I think it's also important that the market must have some real visibility about physical commodities flowing because if you don't, then you're going to have, you know, energy importers, squeezed on terms of trade. And there this is not good for their currencies brand, right? Which would be the other side of what you want to belong against the dollar. It's the board part of the conflict is super interesting because for tariffs a long time ago we discussed, you know, at some point the market won't care anymore if it's 10% or 15% because also the economic impact is visible. You can see that this thing doesn't really make a whole lot of a difference at 10 or 15%. And the market had some evidence in the month of May, June, July and they realized, okay, you know what, like we don't really care that much. Here it's the price of energy, which is an input into anything. Actually, because it's crude oil and fertilizes as well, the impact on second round effects in the CPI basket in economies that have a tight labor market already. I don't think you can underestimate that too much. So you do need some specifically-- - Yeah, I mean that's very-- - Financial conditions have tightened a lot. I mean, that's the main reason that being bullish feels insane right now because financial conditions are way, way tighter across a lot of metrics. So yeah, that makes it harder to be bullish. - At the same time, we are watching here, the SMB at 68, Android on February 28, it was 68, 75. I mean, we're literally like 1% below. It's crazy. Like, and so there, you know, it's something that you can only try to work out with frameworks. So I hope that in this podcast, we share some thoughts you can find useful and try to, you know, think about them, put them in your process or think about how they interact with your process. Something else I would say is do not chase headlines. When the headlines are out, it's probably too late. Being in bold, don't have an opinion. You don't know. I think I can say this in this podcast, yes. We own it. You don't know shit. You have no edge. I don't have an edge. Brand doesn't have an edge. So, you know, sometimes also good to repeat this mantra is to make sure we remain humble. This is a very hard market to trade. I lost brand. - No, I'm still here. I just was, I was thinking about if there was any kind of big areas that we didn't cover, but I think that's it. And honestly, that's, there's always the tension with this stuff is that you have to have some courage to stick with your conviction, but you also have to be flexible and those things are obviously intention or in contradiction. So finding a way to, and that's why I think actually that's one of the great benefits of technical analysis is that if you actually are disciplined, you can pick your level and say like, okay, I'm bearer stocks, but if we close about the 200 day, I'm gonna give up because then the pattern looks too much like liberation day. And that gives you, that allows you to have strong conviction that I'm, you know, I'm bearish equities, but also the flexibility to not just ride it all the way up to SMP 10,000. - Yes, indeed. So we will try to update you again. We also have skipped a couple of weeks and episodes because to be very frank, it's really hard to say something that makes sense more than just some telenovela updates from without any edge to be honest. So we'll try to keep this up and going when we think that we have something to share from a framework or maybe big conviction because of events have changed. In the meantime, if you wanna be in touch with us, I'll put my email and brand's email in the description of the podcast below. So you can just send us an email and we will be gladly talking to you for whatever you think it's worth. And I would say that's it for today. - All right, thank you very much, chef. Thanks everybody for listening. Hopefully we'll see you next week. - Ciao. - Content provided on the MacroTradinflow podcast is for general information purposes only. No information or other content provided in this podcast should be considered as investment advice. Seek independent professional consultation in the form of legal, financial and fiscal advice before making any investment decision. Always perform your own due diligence. (upbeat music)