A day on from the worst meltdown for U.S. equities since February (and the worst day for the Nasdaq since Brexit), Nomura’s Charlie McElligott is out with a characteristically trenchant post-mortem.
Right off the bat, he dispenses with Thursday morning’s inflation “relief” (i.e., the below-consensus CPI print) on the way to imploring you to “take this sloppy Equities deleveraging move for exactly what it is.”
So what is it?, you might fairly ask. According to McElligott, it’s “another confirmation that we are deeply within the ‘Tighter Financial Conditions Tantrum’ phase 2 cycle ‘end-game’.”
He does concede that this is accelerating quicker than he anticipated. “The violent move in U.S. real rates and the re-pricing of UST term premium came a month ahead of my anticipated sequencing,” he writes, before reminding you that he’s “been goal-posting for the rate vol tantrum around the mega SOMA unwinds at the end of Oct / mid- Nov).”
Here’s what Charlie means when he talks about the “violent move in U.S. real rates and the re-pricing of UST term premium”:
As noted on Wednesday, this is the “wrong” kind of rate rise, as reals and the term premium trade are leading the bond selloff.
Here’s McElligott summing up what we’ve seen over the past two weeks:
Taken collectively, it has been the “violence” of the Rates selloff alongside Chair Powell’s extrapolated indications that the Fed is effectively “hiking until something breaks” and stoking “POLICY ERROR” concerns, which then has begun to shift the psyche ever-so-modestly towards the “end-game” view that we are “tightening ourselves into a slowdown,” which is an obviously negative pivot from the view that the U.S. economy is “growing faster than we’re tightening” held just two weeks prior.
Note that the rates selloff has been concentrated in the long end, leading to what Goldman described earlier this week as a fair “an unusual” rout. “While it isn’t uncommon for Treasury yields to increase sharply on strong economic data, a marked bear steepening in an aging hiking cycle is quite unusual”, the bank wrote on Tuesday. Here’s 2s10s:
That’s bad news to the extent it forces an unwind across strats that have become too used to the prevailing market landscape wherein everybody is implicitly or explicitly short vol., McElligott writes on Thursday (do note the humor in the following excerpt as Charlie uses a strikethrough for the VIX ETNs that blew up in February):
“Lower yields, flatter curves, suppressed vol” regime has allowed for the proliferation of heavily leveraged “negative convexity” strategies (Systematic Trend, Risk Control, Risk Parity, Vol Target Annuities,
Leveraged VIX ETNs), which in the hunt for yield reality of the QE-period, have sought means to take advantage of this by (explicitly or implicitly) selling volatility, which then contributes to Minsky-like feedback loop where then ever-lower vols and yields (low risk premia) facilitate larger positions being accumulated and more leverage to generate returns.
That’s just another way of saying that the low vol. regime began to optimize around itself. Here’s how Deutsche Bank’s Aleksandar Kocic described the same dynamic back in the halcyon days of January:
After years of this dialogue [between markets and central banks], the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.
The problem here is obvious. If/when systematic strats (e.g., risk parity and CTAs) are forced to pull back in response to, for instance, a change of sign in the equity-rates correlation or negative momentum signals, the selling cascades on itself.
“On top of the Rates thematic reversal, this market structure too is further challenged, particularly with volatility- allocation strategies built around the QE-era ‘negative correlation’ of Bonds / Risk-Assets”, McElligott goes on to write, underscoring the points above on the way to noting that “as higher real interest rates reset term-premia, the cost of leverage, cross-asset correlations and asset price valuation across this post-GFC era market structure, Minsky Moments are a simple fact of nature—STABILITY BREEDING INSTABILITY” (All-caps in the original).
With that in mind, he goes on to say that Nomura’s Quant Strategies CTA model “reduced down to 43% Long from 100% Max Long 1 week ago” by the end of Wednesday, “selling $88B on the 1-day move from 97% Long where we began the day down to said 43% Long”.
Going forward, he warns that a break of 2,719 could trigger further forced selling to the tune of $57 billion in S&P futs.
As far as risk parity goes, McElligott reminds you that they move more slowly, so the uptick in rates vol. has only catalyzed “a negligible selling-down in U.S. equities”. Specifically, he says the total was ~$600 million in S&P de-risking on Wednesday, again based on Nomura’s models.
All of that underscores the risks inherent in the current market setup. The post-crisis monetary policy regime has conspired with “innovations” in modern market structure to create a veneer of stability.
The problem, as ever, is that this setup hasn’t been truly stress-tested. Every single time we’ve seen a dry run of what a real rout might look like, the system has cracked, whether you want to look at August 2015, February 2018 or, as McElligott details above, Wednesday.
On that note, we’ll just leave you with a quote from Marko Kolanovic:
Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~US$1 trillion over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.