Are you starting to get the feeling that maybe the bottom is going to fall out of the short Treasury trade pretty soon?
We are too. As we showed earlier today, 10Y shorts aggressively trimmed their positions for a third consecutive week, taking their net position to its least short since November.
And all it takes is one look at a chart to see why:
The case for a sharp repricing higher of long end yields is getting weaker by the … well … by the week. Meanwhile, the Fed’s recent attempt to get back on the hawkish rhetoric horse kind of seems to suggest that when you put the pieces together, you’ve got a rather compelling case for bull flatteners, no?
Deutsche Bank sure seems to think so. Read below as the bank explains (in more detail than you probably care to read), why “despite considerable local stability, the market is vulnerable to a risk off trade” and relatedly, why there’s “an asymmetric risk between rally and sell off.”
Via Deutsche Bank
Market dynamics during the last month indicate a change in investor perceptions of the relative pace of Fed tightening and the delivery of fiscal stimulus. The initial bear steepening post elections was indicative of the market’s expectation of a swift arrival of fiscal stimulus accompanied by a slow Fed. As of early December, the market was pricing a very dovish Fed, while carried by the forcefulness of the political rhetoric of the new administration, it priced an imminent and fast pace of political action. These expectations were the main driver behind the significant bear steepening of the curve and general risk on trade. This lead-lag arrangement underwent a reversal in the last month as it became clear that the new administration’s legislative agenda would face serious political headwinds, while at the same time, the Fed showed a resolve to hike independently of these political developments.
What we have experienced so far is a typical sequence of events seen in the situations when the market is in a search of a new “equilibrium” — the initial phase is marked by repositioning in delta risk, followed by the carry play and activity in the options markets. Most recently carry has been the dominant theme which resulted ultimately in ironing out of any residual dislocations between first and second order risks. In rates, this has seen the convergence of curve carry and levels of vol. The same thing happened in equities. As investors gravitated toward short gamma positions for yield enhancement, the street became longer gamma and their hedging attenuated rates or equity shocks, reducing realized volatility further and creating the potential for a circular dynamic whereby the stable range, itself a product of dealer long gamma positions, attracted new capital to short gamma strategies.
There is evidence of a locally long gamma aggregate dealer position in the correlation of rate changes and spread changes. When the dealer community is long gamma, desks pay fixed rates in market rallies, and receive fixed rates in market sell-offs. This manifests itself in a negative delivered correlation between rate changes and spread changes. When dealers are short gamma, they received fixed in rallies and pay fixed in sell-offs, which produces a positive correlation between rate and spread changes. The classic example of the latter is market behavior during the taper tantrum of 2013, when vol increased and spreads widened as rates rose, creating an abrupt and significant change in sign of the rates/vol correlation. Note that this correlation was also positive during the postelection sell-off, but has now returned to modestly negative territory.
Any attempt to hedge against this growing complacency was punished by negative carry, which contributed to flattening of the implied volatility skew. The dislocation is reflected with low vol and flat skew. Normally, low vol makes skew steeper. This was especially visible in the sectors where options markets are sufficiently large that dealer’s hedging activities affected the underlying, including both rates and equities.
In the markets where options activity is relatively smaller compared to the underlying, like credit and VIX options, this was not the case. In these markets, standard stylized facts — low vol and steep skew — remained in place.
With time, the existing local stability is likely to be more problematic due to its self-reinforcement — the longer it persists, the higher the risks will become. As these yield enhancement strategies have been profitable for some time, they would have to face a significant drawdown in order to trigger an actual capitulation. This means that there has to be a considerable force, currently not anticipated by the market, which would be capable of undermining this stability.
The one-sided positioning that accumulated since the election now threatens to evolve into a latent condition that makes markets vulnerable to event shocks and further political complications. So, although subjective probabilities have been developing fatter tails, the pricing probabilities were unable to adjust due to persistent flows into yield enhancement strategies. The market is not adjusting despite political bottlenecks, but is taking a pause at this configuration, waiting for further resolution.
We believe that despite considerable local stability, the market is vulnerable to a risk off trade. We see an asymmetric risk between rally and sell off. The year started with a vicious repricing in the belly as the Fed’s reaction function remained the biggest unknown in the context of the interplay between politics and policy. As that uncertainty was gradually resolving, the sellers of vol, especially high strike payers, in this sector dominated, increasing the street’s overweight in this sector. In contrast, this dynamic did not materialize at low strikes. Specs remain significantly underweight duration and, in our view, a bull flattening rally below 2.25% 10y yields could cause substantial short covering activity, adding a tail wind to a rally below these levels.
