Daily Analysis 18 February 2022 (10-Minute Read)

Hello there,

A fantastic Friday to you as leaders from Washington appear to be fanning the flames of conflict, declaring that Russia will invade Ukraine in the next few days and roiling already battered markets.

In brief (TL:DR)

  • U.S. stocks were lower on Thursday with the Dow Jones Industrial Average (-1.78%), S&P 500 (-2.12%) and the Nasdaq Composite (-2.88%) all down as the ceasefire in Ukraine's restive eastern border with pro-Russian separatists broke down.

  • Asian equities pared losses Friday as traders weighed geopolitical concerns and the likely path for U.S. Federal Reserve interest-rate increases.

  • Benchmark U.S. 10-year Treasury yields fell to 1.99% (yields fall when bond prices rise) as investors sought safety amidst mounting geopolitical tension.

  • The dollar was steady.

  • Oil dipped with March 2022 contracts for WTI Crude Oil (Nymex) (-0.54%) at US$91.26 as traders balanced the potential return of Iranian barrels against the risk of disruption to Russian energy supplies.

  • Gold held a recent rally with April 2022 contracts for Gold (Comex) (-0.56%) at US$1,891.30.

  • Bitcoin (-7.20%) fell to US$40,855 as investors took a risk-off stance against a backdrop of monetary policy tightening and a possible Russian invasion of Ukraine.


In today's issue...

  1. U.S. Equity Options Expiry Will Frazzle Markets on Friday

  2. All That Glitters is Gold

  3. Venture Capital is Doubling Down on Cryptocurrencies


Market Overview

Global stocks are set for a second week of losses, sapped by the standoff between Russia and the West over Ukraine as well as the prospect of tightening Federal Reserve monetary policy.

Some $2.2 trillion of option expirations set to hit the market Friday may exacerbate volatility.

Bets on a sharper Fed interest-rate liftoff in March have eased somewhat in light of geopolitical tension. But investors continue to be vexed by the question of how markets will cope as stimulus ebbs.

Asian markets edged lower on Friday with Sydney’s ASX 200 (-0.52%), Seoul's Kospi Index (-0.26%), Tokyo's Nikkei 225 (-0.57%) and Hong Kong's Hang Seng Index (-0.19%) were all down in the morning trading session.



1. U.S. Equity Options Expiry Will Frazzle Markets on Friday

  • Stock investors will have to contend with new challenges, as US$2.2 trillion of option expirations are set to hit the market today.

  • When the option expires, a market maker will typically reverse those hedging moves and buy back the underlying security, potentially helping prices to rally.

With Russian troops still positioned threateningly on the border with Ukraine, stock investors will have to contend with new challenges, as US$2.2 trillion of option expirations are set to hit the market today.

Every month, trillions of dollars’ worth of options go into the market, either expiring worthless, or being exercised.

An option gives an investor the right to buy or sell a security or stock, without the obligation to do so and are often employed by investors as hedges to their existing portfolios.

According to one estimate by Goldman Sachs, about US$985 billion worth of S&P 500-linked contracts and US$165 billion in options tied to the benchmark S&P 500 ETF Trust alone, will expire on Friday.

Because the options market is focused on short-dated expirations, recent volatility has seen more and more investors hold positions until the very end, which makes it difficult when it’s time to exit those options, especially if they’re being exercised.

Options volume has exploded in the post-pandemic era, fueled in part at least by their increasing availability to retail investors through trading apps like Robinhood and SoFi.

Overall volatility has also risen, with intraday swings of over 2% for major indices increasingly common and efforts to hedge positions using options has proven capable of exacerbating volatility in cash equities.

Market makers who dart in and out of shares to balance positions, especially around options expiration also contribute to greater price swings than under normal market conditions.

Bullish options, once the favorite among Robinhood traders betting on meme stocks have also since given way to increasing demand for bearish put options (the right to sell at a specific price) against a more uncertain macroeconomic landscape.

But the options market only paints one half of the picture, far from bailing on stocks, investors poured US$34.1 billion in U.S. large-cap stock funds in the first week of February, the most ever, according to EPFR Global data compiled by the Bank of America.

And today’s options expiry (provided that Russian tanks don’t roll into Ukraine) could actually help propel equity gains, which has happened before.

When a market maker sells a put option (the buyer is taking a bearish bet, a put option is the right to sell at a predetermined price), they’re essentially betting that the underlying security will go up in price.

In order to offset this unwanted directional risk, the market maker then typically sells some of their existing stock of the underlying security, to maintain a neutral position.

If the underlying security goes up in price, the option is deemed “out of the money” because it is a right to sell at a price lower than the current price of the security and will then expire worthless.

When the option expires, a market maker will typically reverse those hedging moves and buy back the underlying security, potentially helping prices to rally.



2. All That Glitters is Gold

  • Today, as Russian forces amass along the long border with Ukraine, investors are finding comfort once again in gold, with the precious metal advancing to an eight-month high over US$1,900, on concerns over a prolonged standoff.

  • But with the U.S. Federal Reserve set to raise rates, it’s less clear if the recent rally in gold can be durable and if nothing else, gold is likely to remain volatile.

Without gold, the Battle of Waterloo could have ended very differently. As gold coins poured into England from across the world on Rothschild ships, the Duke of Wellington was able to pay the combined army of soldiers from various nations, that helped to defeat French forces under the leadership of Napoleon.

Today, as Russian forces amass along the long border with Ukraine, investors are finding comfort once again in gold, with the precious metal advancing to an eight-month high over US$1,900, on concerns over a prolonged standoff.

Almost every other day, Washington is warning that a Russian invasion of Ukraine is imminent, with U.S. President Joe Biden saying a “false-flag” event may be under way to give Moscow the excuse to retaliate against Kyiv.

Amidst soaring inflation, gold was off to a strong start this year, but the possibility of a European conflict has buoyed prices even more in recent weeks.

But with the U.S. Federal Reserve set to raise rates, it’s less clear if the recent rally in gold can be durable and if nothing else, gold is likely to remain volatile.

In the event that Russian forces invade Ukraine, gold could see another rally, but a commitment by major central banks to put a lid on inflation through tighter monetary policy could see a cap to that upside as well.

Both Goldman Sachs (-3.05%) and Citigroup (-3.35%) analysts had forecast gold to hit US$2,300 this year, but efforts by central bank to tamp down inflationary pressures has so far prevented that outcome from materializing.

Ultimately, higher real yields and stronger equities will weigh on gold prices, and while gold used to be payment for wars, a lack of conflict could see demand recede.



3. Venture Capital is Doubling Down on Cryptocurrencies

  • Sequoia Capital will be launching a dedicated fund that allows it to play a more active role in cryptocurrency networks, including validating transactions (through staking) and voting on governance matters.

  • Sequoia Capital’s new fund will allow it to become a bigger participant in cryptocurrency projects it backs and over 20% of its investments in the U.S. and Europe last year went to the cryptocurrency sector.

One of Sand Hill Road’s marquee names, Sequoia Capital, plans to move deeper into cryptocurrency markets and has earmarked at least US$500 million for investments in digital assets.

While Sequoia Capital may be better known for its prescient bets on TikTok, Snowflake (-6.05%), InstaCart and Robinhood (-9.33%), as well as WhatsApp and LinkedIn, its latest fund won’t be betting on equity at all, but tokens instead.

As part of a wider business-wide restructuring, Sequoia Capital will be launching a dedicated fund that allows it to play a more active role in cryptocurrency networks, including validating transactions (through staking) and voting on governance matters.

The shift is a marked departure from traditional venture capital investing, which typically involves holding equity stakes and represents a growing recognition that in a web3 world, tokens themselves can have far more value than equity.

As more blockchains shift to a proof of stake system to secure and validate transactions, investors are coming to increasingly recognize that the tokens or cryptocurrencies themselves, which typically have both staking opportunities and protocol voting rights, give them far more access and control over the development of a network.

Minority shareholders typically aren’t able to influence day-to-day management decisions, but cryptocurrency token holders can, whether voting on shifts in the protocol’s fee structure or incentive mechanisms.

Sequoia Capital’s push shows how big tech investors are increasingly recognizing that cryptocurrency markets are able to provide explosive financial returns that have so far been the exclusive purview of specialist hedge funds and enthusiasts.

Last year, Tiger Global Management, one of the world’s largest tech investors, made its first token investment.

Sequoia Capital’s new fund will allow it to become a bigger participant in cryptocurrency projects it backs and over 20% of its investments in the U.S. and Europe last year went to the cryptocurrency sector.

Unlike traditional startups, most cryptocurrency projects do not have traditional boards of directors, instead distributing tokens that allow investors to vote on major decisions using their tokens.

Blockchain technology has enabled such voting to be done relatively smoothly and seamlessly.

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