Nomura’s McElligott Tells You ‘Why We’re Here’ And Where He Thinks We’re Going

In a Thursday morning note, Nomura’s Charlie McElligott kicks things off with “a reminder on why we are here”.

That “reminder” comes courtesy of a lengthy quote from Jerome Powell, as excerpted from the transcript of the October 23-24, 2012, FOMC meeting.

There are a number of notable soundbites, but here are the ones that market participants most often harken back to (again, these are from Powell, ca. 2012):

• It will never be enough for the market.
• Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so.
• Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.

These quotes come up a lot. And there’s a lot of nuance to the “unloading our short volatility position” bit, nuance that surely doesn’t escape McElligott, but which certainly did escape the bucket shop “brilliance” of a number of ostensibly “smart” bloggers when the transcripts were released in January. There’s more on Powell’s comments in the linked post below.

Read more on Powell’s short volatility remarks

The Fed’s ‘Short Volatility Position’: A Closer Look At Jerome Powell’s Comment

Having thus set the stage, McElligott dives right in, hitting some familiar themes and topics on the heels of this week’s absurd price action that found U.S. stocks careening from the worst Christmas Day trading in history to the best rally since 2009 all in the space of two sessions.

“As previously stated, the lack of dealer balance-sheet and VaR- / calendar- constrained buy-side (enormously de-risked over the past 2 months) was likely to set the table for horrific market illiquidity and thus, absurdly gappy price-action into year-end and et voila, take a look at the last two sessions’ worth of cross-asset price-action”, Charlie implores you. Here’s the table he includes:

(Nomura)

Beyond that, McElligott reiterates how the calendar and thin liquidity are together contributing to wild price action before again suggesting that January could be better.

“This seizure-like behavior isn’t endearing risk-taking in the final days of 2018, despite panicking some who are always under the grasp of FOMO, however, my belief of ‘the January effect’ is alive and well on the buy-side, with many PMs stating to me that they plan to significantly gross-up both longs- and shorts- as the calendar turns”, Charlie writes, adding that his view “continues to be that we will see powerful risk-rallies in standard bear-market fashion in the coming-months which ‘traders can trade’.”

That said, this is all “for rent” – so to speak. “In time [these] will be faded 1) as long as the Fed continues with normalization and 2) against the backdrop of the simple realities of the late-stage business cycle”, he continues, before warning that similar to October, January is set to be another large “QT month” as “the Fed’s balance sheet run-off continues including two heavy weekly QT periods during the first- and third- weeks of January along with [next month] being the first month following the cessation of the ECB’s bond-buying program.”

(Nomura)

As far as the broader macro backdrop, McElligott notes that the stage still appears set for the U.S. econ to come in weak. The catalysts are familiar and include steady real yields despite the bleed in breakevens, the waning of the fiscal impulse, the lagged wealth effect from plunging stock prices and “the cyclical reality of corporate deleveraging which inherently means lower CAPEX.”

With all of the above in mind, the environment is conduce only to tactical trading, with directional expressions stuck in suspended animation and conviction lacking until we get a definitive sign from the Fed. On that, Charlie flags the Eurodollar 2nd-6th inversion as ‘confirmation’ of a Fed easing cycle.

“Our work shows that of the past five easing cycles, the ED2-6 has inverted prior to each, ~6.5 months on average before the first Fed cut, albeit admittedly with a very wide range out timing outcomes”, he writes, adding that “over the past nine ED2-6 inversions (not including this current one being #10), a Fed easing cycle has followed in seven, at an average length of 8.2 months after the inversion.”

(Nomura)

Finally, McElligott reiterates one more time the notion that folks could go on offense again once the calendar turns and he pairs that with an update on CTA positioning.

We’ll leave you with the relevant quotes and visuals which are presented without further editorializing:

I’ve been on the record as anticipating an “unshackled” institutional Equities set—which is massively underexposed as per Mutual Fund Cash levels-, Nets-, Grosses- and the performance of “Beta” factor M/N—to likely “get offensive” again come the turn of the year into 2019, as risk can again be deployed and PNL / performance no longer constrains. 

This view is also partially-based on the potential for this past month’s freshly accumulated “Max Short” in global Equities (as indicated across our CTA Trend model) to act as “fodder” for a short-squeeze (although all “well away” from current levels, as this position has been a massive +++ PNL contributor to CTA’s MTD via the powerful down-trend)