Last week, Nomura’s Charlie McElligott found himself at the center of a debate around what “caused” the harrowing lunchtime drop in U.S. equities that played out on Tuesday and effectively dashed the hopes that the G20 trade truce rally would prove sustainable.
For McElligott, the culprit was CTAs – or at least they contributed, according to his models. As a reminder, here’s what that episode looked like:
“Our CTA Trend model is again deleveraging massive notional in ‘long US Equities’ expressions across SPX, RTY and NDX”, McElligott wrote, just minutes after that plunge started to accelerate, adding that his “SPX model was triggered to sell down at 2763 with $32.8B notional for sale, reducing from “+100% Max Long” down to ‘+65% Long'”.
To say that explanation was controversial would be to understate the case. Not everyone agreed with Charlie that CTAs were de-leveraging right there and the debate, which we documented in real-time as it developed, became the subject of a Dani Burger special released the following day.
On Thursday, McElligott mounted a sweeping defense of his contention that trend followers contributed to the declines.
Fast forward to Monday and U.S. stocks traded poorly again following Friday’s rout and news over the weekend that China is stepping up diplomatic pressure on Washington with regard to the arrest and detention of Huawei Technologies CFO Wanzhou Meng. Poor data out of China isn’t helping sentiment and neither is Brexit uncertainty.
If you’re wondering whether McElligott has a thing or 500 to say about the situation the answer is: “more cowbell”. He’s out on Monday with a truly in-depth take on quite literally everything.
The overarching point (and this won’t please the bears) is that the stage is set for a tactical rally, or at least that’s Charlie’s view.
“Now despite the fading inflation impulse and slowing global growth due to ‘restrictive financial conditions,’ we see near-term macro and positioning catalysts for a powerful blast of Equities upside, which must be respected in classic ‘bear market’ fashion”, he writes, citing the following list of possible catalysts:
- The recent overshoot in US Rates has been more about positioning stop-outs and performance destruction (especially with the unfortunate proximity to funds’ year-end) than a “pure” read on the “end-of-cycle” US economy alone (despite clearly weakening global growth and fading inflation impulse)
- In addition, large long-end buying (in turn, bull-flattening the curve) is acting to EASE U.S. financial conditions as a near-term catalyst for Equities
- Additionally, the obvious “dovish pivot” from Fed removes the “policy error” left-tail from market
- The potential for the crowded “Long Dollar” trade to “tip over” with on the end of policy normalization and data weakness will help feed higher “inflation expectations” as a POSITIVE macro factor sensitivity for SPX
So there’s your fundamental backdrop. If you’re wondering (and you know you are) whether McElligott is going to update everyone on his CTA model, the answer is: “Yes!”
“Finally, there is an enhanced-risk of positioning squeeze in Equities as the performance purge across fundamental and systematic strategies has seen them slash net exposures, while our CTA model shows nearly consensual ‘Max Shorts’ across global Equities now”, he writes, before noting that “SPX [is] within reach of again tactically pivoting from ‘Max -100% Short’ to again ‘+21% Long’ ~ 2668”.
After delivering his take on the rather disconcerting string of lackluster econ out of Asia, Charlie moves on to address a long list of topics including (but by no means limited to) the Huawei story, the canceled Brexit vote and the Patel resignation. Do try to appreciate that all of that happened this morning and judging by the timestamp on this note, Charlie was literally analyzing all of this in real-time.
Skipping right along (after assessing China, Japan, the U.K. and India), McElligott gets back to what’s going on stateside and here he’s got a “false optics alert” for you. This is actually something we’ve been talking a lot about over the past week, especially in “Curve Inversions & The Reality Distortion Loop Of Reverse-Engineered Growth Slowdowns.”
“The overshoot in US rates is more due to positioning stop-outs in the front-end/the return of long-end buyers than pure read on ‘end-of-cycle’ doomsday”, he writes, underscoring the notion that last week’s dramatic long bond rally (Tuesday) and massive short-end repricing (Thursday and Friday) is at least as much a function of a purge/washout than a reflection of “real” recession fears.
Implicit there (and he makes it explicit in the note) is the idea that falling yields serve as a kind of circuit breaker to they extent they mitigate tightening financial conditions. He continues:
As a reminder, there were simply MASSIVE shorts in the front-end which facilitated this beyond-epic trade unwind, i.e. a much discussed position (and one of many similar structures in the market) accumulated across the first half of 2018 where somebody was long approx. 900k long-dated red and green Eurodollar options Put ratios, which has embedded enormous gamma-risk in the market and thus exacerbated the insanity of the short-squeeze (and corresponded talk of ‘stop-outs’ through buyside fixed-income pods in recent weeks).
Ok, so the idea is that bull flattening will be risk positive to the extent it eases financial conditions and building on that, McElligott writes that the “clear dovish” pivot from the Fed should then cap dollar upside which, if it pans out, could squeeze the still-stretched long position in the greenback.
He goes on to note that his CTA model similarly shows extended USD longs and in the event they trim that, it could add further fuel to any dollar weakness, thus feeding into any bounce in risk assets and/or the presumed bolstering of inflation expectations that might occur around a rebound in commodities.
“As a bullish (risk) ‘tell’ and against this legacy ‘Max Long’ Dollar position in the market (vs broad G10), we are beginning to see Commodities positioning pivoting back towards ‘Neutral’ vs broad ‘Shorts’ just one-month ago—this is another signal of potential upside for inflation expectations,” he writes.
Charlie goes on to describe the S&P as a “pure play” on dollar-weakness-inspired loosening of financial conditions. Here’s the money line (figuratively and literally in this case):
And with ‘Max Short’ equities positioning from trend followers re-established, a rates sell-off/reversal (yields higher) could spur a violent short squeeze in stocks.
Our Nomura QIS CTA model now show “Max Short” positioning re-established across nearly all global Equities futures it tracks, with -100% Short positions in SPX, Russell, Eurostoxx 50, Nikkei 225, DAX, FTSE100, CAC40, Hang Seng, Hang Seng CH, ASX 200 and KOSPI 200 (NASDAQ the last remaining U.S. Equities “Long” but at a very scaled-down +21% long / 3.1% overall portfolio size, while Bovespa actually remains “Max Long”)
Now, you might be asking yourself: Does Charlie have anything to say about gamma effects now that he’s updated everyone on his newly-famous CTA model? The answer, unsurprisingly, is: “Yes.”
“SPX / SPY net Delta now -$451B (and front-month -$306B of that as hedges are held and ‘kicked in’) but notional bias [is] to the UPSIDE’,” he writes, before cautioning that even with that in mind, “we are back to negative Gamma, with the move per 1% move + or – now -$9B and across strikes bias to downside.”
Oh, and then he needs you to know that the 2,600 strike with $4.4B gamma and the 2650 strike with $4.3B gamma are “the two big ones which matter most”. Well, except for “that 2500 strike” which Charlie says is “‘creeping’ with $3.0B of gamma.”
And there’s more. So much more. But that’s the gist of the overall call, which, in all-caps (as per the original) is this:
DANGEROUS SET-UP FOR A BEAR-MARKET SQUEEZE IN EQUITIES DESPITE WORSENING GROWTH- AND INFLATION