Vol Commentary: Hawkish Surprise Reflects the Market

Cumberland is commenting on the recent volatility and potential opportunities to take advantage of it.

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December 22

What we are seeing in the markets

Last week CPI surprised to the downside as goods inflation continues to fall yet the Fed delivered a hawkish surprise with higher dots for longer. Risk assets ended the week lower than pre-CPI and crypto vol fell from already suppressed levels. We now lean long volatility, and as per usual prefer owning ETH long dated call wing.

1) Central banks around the world are committing to tighter monetary policy for longer even as inflation seems to have found a peak. The Fed’s median dot increased to 5.125% for year end 2023 and 4.125% for 2024. In Europe, Lagarde spoke of a series of further 50bps hike. In Japan, caps were at last increased to 50bps. So why is guidance not softening? Despite falling goods inflation, ex-shelter services such as recreation and education actually accelerated in the US: they make up half of the PCE, the Fed’s preferred gauge of inflation. Yet the rates market isn’t aligning itself with that guidance. Peak rate is still priced under 5%, YE23 under 4.5% and YE24 under 3.25%.

2) It’s unclear what impact this dichotomy will have on risk asset volatility, but we find it difficult to accept that peak divergence between Fed and market should be met with year lows in backend volatility. In ETH, 6m atm vol has reached 72% (vs 85% 6m realized). Most of the supply has come from systematic call sellers, likely looking to improve yield by selling long dated 25d call options. This week already saw the sales of 100,000 calls in that sector, down to 68% on the 1800 strike. With limited risk appetite as into year end, this flow has yet to be met with significant counter.

3) Supply is concentrated in ETH backend, hence ETH backend looks cheap to about everything else. Speaking of dichotomy, there is a significant one between the term structures of BTC and ETH. For short dates, BTC atm stands at 75-80% of ETH. In June, the ratio is 90%. On the call side in June, the ratio is 92%. Over the last 6 months, the realized ratio has averaged about 70%. In comparison, even ETH Jan 6th straddles look expensive, implying 10.5% terminal breakeven on 62% atm vol.

Potential trades

A) We like owning calls vs atm options about everywhere on the surface. If vol really is to die into the first half of 2023, we don’t expect it to happen on a rally. We think both wings should trade above the money. With the asset class so under-allocated (ETH OI at 50% of what it was a year ago), the upside path wouldn’t quite be going perfectly in favor of positioning. Similarly continued selling pressure wouldn’t be catching significant interest by surprise. One can also argue that factors that can cause central bank forward guidance to meet market pricing, from lower earnings to degrading demand and higher unemployment; aren’t necessarily bearish signals for crypto. Conditional on repaired faith in the crypto system, these factors could help generate significant momentum for the asset class; yet market pricing is as depressed as it has ever been.