We are changing the title of this from “model” to “story” because stories are about change and the goal here is to listen to the stories the markets are telling us. Whether you realize it or not change is what every market participant spends all their time thinking about: buying an underappreciated company that has some revolutionary technology before it takes off, calling the top or bottom of a market cycle, forecasting a change in policy, predicting some black swan-like event. Change captivates us because it brings about volatility. The markets and life are all about moving between the mountaintop to the valley. On the mountaintop things are bright and hopeful, you can see far out into the horizon, the world makes sense, is peaceful, and in balance. Things change in the valley: unexpected events create chaos, there is divisiveness, fear, and darkness creates a sense of hopelessness.
We frequently hear commentators talking about the narrative in the markets; so, it makes perfect sense to review the past year as a story so that we can pick up in the New Year understanding where we are in the story so that we are prepared for the twists and turns that may come. Market generated information not only tells the story, but prices provide us with betting lines, or stakes in the story so we can not only take part in the unfolding story but also influence the story. As the story unfolds the stakes change and different opportunities appear. We don’t want to predict the outcome of the story, because then we wouldn’t be listening, instead we want to look for the contradictions and key moments in the story as it unfolds. As Kris says, “I’m buying this for X, because that is Y bid.
Since embarking on the first leg of the journey down the other side of the secular bond bull market in 2021-2022, the focus has been on short-rates and monetary policy. Below is the picture of market expectations for Fed policy from this time last year. The red box shows where we landed and how the Fed did not cut rates nearly as much as the market expected.
If we had predicted that outcome, what sort of trades would we have recommended? We’d probably have been bearish on stocks, bearish on bearish on bonds, bullish on the dollar, and bullish on gold. This mostly worked out however, with the exception of stocks which delivered the best risk-adjusted returns of 2024.
The primary reason behind the surprising performance of stocks has to do with expectations. This time last year consensus expectations were for a recession which led to the overly aggressive assumptions on Fed easing and the two-year dropping by over 100bps in the last three months of 2023. The dollar was dropping during this time as well but neither the two-year nor the dollar were able to breakout of their trading ranges and remained within balance during 2024. This stability allowed stocks to “climb the wall of worry” last year.
Even though the Fed did eventually lower rates last year, it did not cause any meaningful change in either the two-year or the dollar. This continued stability allowed for other markets and investors to take leadership. The big story in the equity markets was the dominance of big-cap tech companies led by Nvidia. This culminated over the summer with a correlation trade blow up that delivered a 65 VIX event but ultimately remained contained. This continued stability allowed for even more speculative buyers to take leadership of the market.
Most of the realized volatility we experienced in 2024 is attributed to some of the most speculative corners of the market such as Bitcoin and the market generated information from the ES and NQ futures markets shows that momentum buyers are dominating the market.
In the past, these types of flows were regarded as weak, however with the amount of money invested in various momentum-based strategies these investors can no longer be considered “weak.” The top 5 momentum strategy ETFs have over $15 billion in AUM which is just one example of the explosive growth we have seen in fast money strategies. However, the nature of momentum strategies is inherently less stable than your traditional buy and hold real money investor. Momentum investors extend trends by investing more as the trend continues but also make the turning points more volatile by exiting the trade entirely when certain thresholds are violated. While 2024 saw a low-vol trending higher equity market the nature of the leaders of the market creates latent downside volatility for the market.
However, as we can see from the March 2025 QQQ options, the market is more focused on the low-vol directional rally and pricing a thin distribution of potential outcomes. While there is always put skew in equity options, we can see that the OTM puts are not pricing in a higher probability of downside outcomes than they would from the flat vol pricing which is consistent with what the Qs have been consistently realizing. The market does what has worked most recently, and this is evident in the option pricing we are seeing today.
Just like the increase in momentum strategies has influenced the directional trend in the markets the increase in options market activity has influenced the pricing of risk in the options market. Over 12.2 billion options contracts traded last year, which is up nearly threefold from ten years ago. Since a single option contract typically represents 100 shares these volumes represent close to half of the total number of shares traded in a year. This growth in the options market has been accompanied by the growth in option selling strategies such as buy-write and covered call strategies, which are changing the supply and demand dynamics for out-of-the-money options. It is impacting the pricing of volatility like we see in the picture above. During the 2022 sell off many investors were surprised that downside puts were not bid up as they normally are during market sell offs. More recently commentators have blamed 0DTE options for the persistent flattening of option skew which has come to be known as “The Taming of the Skew.”
To recap, a year ago we thought we’d have a recession that never ended up materializing. With the dollar and short rates contained, and the economy strong, the coast was clear for momentum investors to take the reins and drive the market to new all-time highs.
As we enter 2025 the elephant in the room is the incoming Trump Administration. The knee jerk reaction to the election has been a replay of the “Trump Trade”. While the dollar rallied initially during the first Trump administration, the DXY spent most of his first term under 100. So far, the second Trump administration is making a lot of noise about deficit cutting and other strong dollar policies that has delivered an upside breakout for the DXY index (chart above) and a downside breakout in the Euro. After bottoming in 2022 amidst the record Fed rate hikes the Euro rebounded and came into balance after the US regional banking panic in March 2023. Since that time there has been no real change in the Euro until recently. The primary trend for the Euro has been lower since 2008 but that trend is aging and weakening. The inability to find acceptance below the post-Japanese devaluation and COVID lows is a sign the trend is weakening, however in our 2021 Macro Model we noted how the odds of success for that breakout were low and the subsequent inability for the Euro to find meaningful upside acceptance keeps the primary trend lower intact.
The Yen is a different story as it has been in a 30+ year balance from which is started trying to come out of starting in 2014 with “Abenomics” which significantly weakened the Yen and put it into a new balance which it subsequently broke out from higher in 2022-2023 during the Fed rate hikes. After the first attempt on the 30-year range high failed in 2024 it is now making another attempt to breakout higher. The Yen is stair-stepping its way higher (weaker) and following the US bond market in embarking on a new secular trend.
The long-term charts of the Yen and the 10-year treasury are some of the most significant charts because they show the 10-year treasury in the early innings of secular change and the Yen attempting secular change. The fact that these two things are happening together is meaningful.
Speaking of secular change, the Chinese economy is undergoing secular change. Change in this part of the world does not look like change in other parts because the Chinese economy is centrally managed. Andy Fately has pointed out that Xi may be letting the Renminbi weaken as Trump talks tough on tariffs. The Chinese economy is structurally weak and fragile, and many have argued the only way out for Xi is a lower currency, but that antidote comes with a lot of political risk which he has been unwilling to bear. This has resulted in balance in the Renminbi for the past ten years which coincidently lines up with the peak of China’s FX reserves at $4 trillion in June 2014. Back then we said that was the beginning of the end for China’s investment-led boom which wasn’t all that precent since investment as a % of GDP peaked in 2011. What was going on was that the flows into China were drying up and as China worked through its reserves and other measures it was shooting bullets to keep its economy growing; but it was running out of bullets. Time moves more slowly in China than it does in elsewhere and today we are still in that balance, but Xi has spent pretty much all of his bullets and now he may have been gifted the Trump 2.0 Administration which will give him the political cover to let the Renminbi weaken.
With the dollar perking up we’d expect commodities and precious metals to be feeling the pressure since they all tend to trade negatively correlated to the dollar. Looking at gold, crude oil, and the broad commodity index we find all three are trading at the highest correlations to the dollar in years. While still negative, the realized volatility in these markets is coming primarily from the volatility we are seeing in crude oil instead of the dollar.
But there is nothing going on in crude, the market has been in balance since the huge rally above $120/barrel. Once again, with the primary source of volatility in the market in balance it creates room for other factors to take leadership. Without the pressure from the strong dollar gold has embarked on an upside breakout to new all-time highs from four years of balance.
Gold is stair-stepping higher just like the Yen but is also showing signs of limited participation behind the rally. Trading mechanically on trendlines and moving averages is a sign that the market may not be as strong as price makes it seem; like what we are seeing in equities. Gold is trading more with equities these days as it becomes less influenced by the dollar.
Equities are rallying with the dollar which lends further support to both markets. The risk for equities and gold is that these relationships have been established while the dollar was not undergoing change, but today it is threatening to change with this upside breakout. If the dollar moves significantly higher it may cause many investors globally to reevaluate their allocations.
The dollar is the most important chart in the markets right now because of this potential for change. A stronger dollar story aligns nicely with the stories we are hearing from interest rates and the Yen, but it could throw a wrench into the stories we are hearing in gold and equities.
The yield curve has failed to steepen materially, and it might surprise you that this is not historically unprecedented. The yield curve remained inverted for a decade in the early 1900s and prior to WWII it was normal for the yield curve to remain inverted for long periods of time. The slope of the yield curve is not subject to the same auction process dynamics that other markets are because it is not a market, it is an indicator. It is an important indicator, and it is based on two very important markets: US short and long rates which we have already covered. The lack of change in the yield curve is evidence of the sanguine growth and inflation environment we have experienced recently. That environment has also led to the balanced commodities markets we have experienced. Copper, Wheat, Soybeans, and Corn are all in big trading ranges like the yield curve as growth and inflation have not experienced a lot of volatility absent the inflation scare we saw in 2021-2022 which created a lot of volatility for a period of time but little lasting change outside treasuries, Yen, and gold.
As the yield curve remains at the low end of its long-term range it is not contributing a lot of volatility and uncertainty to the markets, which gives room for other sources of uncertainty to take control of the narrative. It also means that as growth and inflation remain sanguine, more speculative forces can take leadership.
Bitcoin has broken out to the upside and has finally eclipsed the $100,000 level and it has been the leading contributor of volatility to the broader risk markets over the past year. Without fundamental uncertainty (growth and inflation) we are free to experience the benefits of this upside volatility. We can continue to reap these benefits if the other forces lay dormant, but the longer they lay dormant the more risk accumulates which ultimately makes any future change more violent.
During any time of balance investors become accustomed to the status quo and increasingly press their bets to earn the same returns on a diminished opportunity set. Failed breakouts from balance (attempts at change) lead to even narrower balance ranges as investors are further emboldened in the status quo after change has failed to take hold. Balance can act like a compressed spring that violently expands once the forces holding it down are released.
The commodity markets pictured above are all still feeling the lingering effects of the deflationary bust we experienced during the GFC. We have begun to see signs in other markets, like US Treasuries and gold, that the long-term story is changing, but we are still in the early chapters of that story. We lived through the first chapter in 2021-2022 with the inflation scare and record Fed tightening, and since that initial jolt was not enough to dislodge all markets from their long-term balance or trends investors have been emboldened to continue going back to what has worked most recently.
