The best strategist on Wall Street, Deutsche Bank’s Aleksandar Kocic, has returned from a brief hiatus and given what we’ve seen over the past 7 days in terms of nuclear saber rattling and the dissolution of America’s democracy, not a moment too soon.
One of the ongoing themes we and plenty of others have discussed is the extent to which equities are one of the only “Trump trades” that hasn’t been unwound.
“Long USD” and “short USTs” were supposed to be “no brainers” headed into this year and all you have to do is look at the evolution of spec positioning in the greenback and TY to understand how sentiment has shifted.
Meanwhile, the small caps’ post-election relative outperformance to the S&P has completely evaporated and market breadth is getting worse seemingly by the week.
The message: the only thing still hanging on here is the broad market (i.e. the benchmarks Trump likes to tweet about), and that thanks in no small part to support from a handful of high-flyers.
Well needless to say, all of that suggests that the risk from a continued unwind of the Trump trade is asymmetrically skewed.
Here to explain this and more is the above-mentioned Aleksandar Kocic…
Via Deutsche Bank
In the light of the recent geopolitical and domestic tensions, the market is taking a closer look at the Trump trade. This is reflected in pricing in a higher probability of a short-term risk off trade. While this could lead to a substantial correction in risk assets, it is unlikely to produce a comparable effect in rates simply because about a half of the Trump trade has already been unwound there. The figure shows the history of the 10Y UST yield overlaid with the S&P in terms of their distance from the pre-election levels (bp for the yields and % for the S&P). While rates shot up right after the event in a 80+bp sell off, they subsequently rallied by another 40+bp cutting the gains in half. Rise of the S&P, on the other hand, has been more or less a straight line to date with nearly 20% net gains.
Clearly, a complete unwind of the Trump trade carries asymmetrical risk across these two asset classes. The reaction of the underlying volatilities has been consistent with this distribution of risks, with VIX clearly shooting up from below 10% to nearly 16% in a matter of days, while 3M10Y rates vol remained practically unphased.
Volatility skew tells an interesting story which triangulates with what rates and vol markets are saying. The concerns about the risk-off trade in rates are perceived as strictly short-term, while in equities unwind of the Trump trade could signal an onset of problems in the long run. In rates, this is reflected by a bid for short-term receivers. However, decline of rates towards 2% or lower, if they settle there, would be bearish for vol. Because of that, vega has not seen a material bid and neither has long-dated receiver skew repriced. The figure shows 3M10Y and Y10Y receiver skew in terms of difference between 25bp OTM and ATM vols. There is a clear attenuation of the skew with maturity.
This should be contrasted with the situation in equities where both short- and long-term skews underwent commensurate corrections. The Figure shows a history of the 25-delta put skew for 3M and 1Y S&P options.
As we cannot be certain about the depth of the possible correction in either market — there seem to be too many factors at play at the moment — we hesitate to sell low strikes by engaging in 1X2 receiver spreads, for example. Rather, we prefer receiver flies as a leveraged play of skew
