Listen, you guys, Nomura’s Charlie McElligott is a man who has a lot to say.
As regular readers know, we try to inject a little humor into things whenever possible, and when it comes to Charlie, that effort generally manifests itself in lines like these, from a December post:
The elephant in the room this week was obviously Nomura’s Charlie McElligott, the living embodiment of “more cowbell” when it comes to real-time updates on systematic flows. If you’ve “got a fever” and the “only prescription” is more rapid-fire analysis of programmatic de-leveraging/re-leveraging, McElligott is your Gene Frenkle.
That was in reference to McElligott’s infamous December 4 “CTA deleveraging is now ‘live‘” call, which precipitated conniption fits not only among quant managers (which is predictable), but also among a handful of other sellside strategists, some of whom suggested Charlie’s model might not be accurate. McElligott wasn’t generally having it, and so, less than 48 hours later, he delivered a sweeping defense of his model, which we documented here.
Obviously, the impact of systematic flows (e.g., CTAs, vol.-targeting strats, option hedging dynamics, etc.) is a hot topic these days. As we put it on Wednesday, the general investing public’s understanding of how systematic flows impact the market is not growing commensurate with that same investing public’s awareness of that impact. That disconnect sets the stage for a lot of nuance to get lost in translation, but it also means folks are scrambling around for the latest available analysis. Because McElligott covers it in real time, on a daily basis, interest in what he has to say is running high.
Even in the context of growing public interest in the subject, coverage of Charlie’s daily missives has taken on a life of its own since late November. Earlier this month, Bloomberg described his notes as having “a small but devoted Wall Street following” and last month, in an amusing article documenting the December 4 call mentioned above, Dani Burger characterized it as “something of a cult.”
I don’t know what that makes me – I always wanted to join a “cult” with the title of “information minister”, so maybe I’ve found my calling.
Anyway, the point is, we try to provide some context to all of the various sellside calls we highlight here and that, in brief, is the context for Charlie’s rising star for anyone who isn’t aware of the backstory.
Ok, so over the course of the YTD bounce off the December doldrums, McElligott has had a lot to say and we’ve highlighted key excerpts from his notes as they make the rounds each day.
Read the latest
For a lot of readers, staying up to speed on all of this is well nigh impossible, especially given that McElligott’s analysis also incorporates quite a bit of macro, big picture themes which he ties in with his updates on how modern market structure is affecting assets of all stripes from day to day.
Fortunately for those who might be feeling a bit overwhelmed by it all, Charlie delivered another sweeping interview with Erik Townsend’s MacroVoices podcast this week.
In true McElligott fashion, the interview lasted over an hour because, as noted here at the outset, Charlie is a man who has a lot to say. The transcript of his interview is (literally) 22 pages long and as we were reading through it, we found one soundbite that perhaps sums up Charlie’s style better than any punchline we could conjure ourselves. To wit:
… what is important to note here are a number of things.
Yes, if McElligott had to pick out the single most important thing to note, that thing is: “a number of things”.
We jest – again, it’s all in good humor.
What we’ll do below is simply provide you with the full interview and then some selected excerpts from the transcript. You can get the slide deck here.
From the transcript
Erik: Now, let me make sure I’m not missing something. Because what I’m hearing is you’ve got the Fed threatening at one point last fall to tighten, tighten, tighten until something breaks. And people are panicking, and you’ve got these big Fed balance sheet roll-offs that are equivalent to a hike in many respects – and a lot of people have proven the numbers behind that.
Now what we seem to have is the Fed has blinked and it’s saying, okay, the market is no longer pricing lots of hikes in 2019. We’re down to either no hikes or, even, some people are talking about cuts. Everybody is breathing this huge sigh of relief. Okay it’s better now.
Well, wait a minute. The Fed still has a whole bunch of balance sheet roll-offs in 2019. And Powell has been pretty darned adamant in saying that they’re sticking with that.
So am I missing something? Or they’re really, effectively, stealth hikes in the form of balance sheet roll-offs that maybe the market hasn’t fully priced in yet?
Charlie: QT is unequivocally a financial conditions tightener. It saps dollar liquidity. And shrinking, contracting dollar liquidity is the reason that we’ve had rolling volatility events for the last year plus.
So, yes, unequivocally the balance sheet tightening, the balance sheet runoff is an ongoing negative risk asset impulse. It’s an ongoing financial conditions tightener.
What the Fed did, from a very forward-guidance central-bank-speak perspective – think about Mario Draghi and “whatever it takes,” that commentary – singlehandedly turned for a multiyear period the European crisis on its head without spending one penny of euros on their emergency bond-buying program.
In this sense, the Fed hasn’t just capitulated with this code-speak for patience, which is equivalent to the Fed pause thesis – I think last summer when I was bringing up the concept of a Fed pause, 90% of the fixed income world was laughing at me saying no way, this thing is preset, autopilot, lights out. And my point was that the markets wouldn’t allow it to get to that point because the impact was too massive. The perceived impact was too massive.
What they also did too was open up the possibility of decreasing or outright cessation of the balance sheet unwind over the last week and a half since this most recent Fed meeting. And what that has done has thrown a lifeline to folks that are concerned about this.
That said, you’ve got it exactly right. In the meantime, it’s still going on at the same clip.
And that is part of my longer-term structural thesis why, if you are an investor, if you are an owner, and you are looking at this end of cycle trade – and remember, the catalyst for a US slowdown at a minimum, or a recession – whether it’s late 2019, if you’re on the bearish side, or a 2020 story, which I think would put you in the consensus – these are very much tangible and, frankly, accelerating.
So you have a still ongoing and lagging negative impact of Fed tightening.
So real yields, yes, have come off significantly. But they remain at multi-year highs while inflation expectations and break-evens have dropped to multi-year lows.
You have the fading US fiscal stimulus. The tax cut impact continues to diminish and half-life.
You have the dragging wealth effect of what happened last year with all assets in investor portfolios and people’s retirement accounts and things that make them feel like they have paper wealth. At the end of the day, we have to acknowledge what a large part of quantitative easing was, and that was to create a wealth effect. That was to create a sense of wealth that will help stimulate discretionary spending. And that just took a wallop to the face.
On the CTA model
Erik: Charlie, I want to move on to your CTA model, which has become extremely popular with our listeners.
I wonder if you could just explain the big picture of how this model works, what it predicts, and why the numbers that you use for thresholds are moving targets.
Last time we had you on, you mentioned gold, really, had a magic number around $1,245, which it was on the day that we spoke. Three or four weeks later we had people on Twitter saying, hey, we hit the number. Charlie said the magic number is $1,245. What’s going to happen next?
And, of course, at that point your number in your daily note was up to $1,298 or something. Why is it a moving target? And what do we actually learn from this CTA model? How does it work?
Charlie: There’s a number of proprietary signals of momentum that are everything from traditional classic technical measures as well as – because of the vol component to any sort of trend strategy, any sort of strategy that is levering onto lower realized volatility assets levering more, there is a negative convexity.
And, because of that realized volatility, are critical to sizing and scaling the long or the short position, meaning the size of the overall position within this large portfolio of 58 cross-asset futures contracts that our model replicates.
So what’s important to note, and, to your point – our QIS team creates these, we have these outputs – what is important to note here is a number of things.
CTAs in general, trend models in general, are shorter-term in nature. And certainly CTAs got a ton of press last year because they got lit on fire, in all honesty. And that’s the purest representation that last year was the anti-trend.
You had this huge macro regime shift. You had rolling volatility events. You had the unwind of systemic leverage accumulated over the 10-year post-crisis period in quantitative easing. And it forced a lot of positioning overshoots, positioning asymmetry as leverage blowouts bar events. You had this incredible shock, intra-day, across the days, different vibes from one day to another, from one week to another, month over month, quarter over quarter, complete reversals.
So that’s why CTA models did so poorly last year. The fact of the matter remains that these are short-term in nature. And especially in a market where fundamentals tend to get pitched and people are trying to get their legs on what is the new macro regime? What is the policy backdrop? Where is growth going with this rapid deceleration in global data?
These types of strategies become that much more important in becoming the price setters. Because, one, there still is a massive amount of assets in them. And it’s one of the most heavily leveraged strategies on top of that.
And with that the same confusion that I spoke to with regards to the fundamental backdrop, and where we are in the cycle, and all of these questions on policy, and all of these geopolitical issues that are still floating out notwithstanding as well, you’re in a situation where the fundamental discretionary, active folks of the world are an even smaller part of the overall liquidity profile.
So the impact of these systematic strategies, whether it’s a CTA trend model, or whether it’s risk parity, or whether it’s a target volatility variable annuity fund – all of these different strategies have an outsized impact because the liquidity deteriorates due to this tightening liquidity environment, the reduction of leverage in the environment – they’re having an outsized impact.
So that’s why the CTA model, I think, received so much notoriety and attention last year. And it’s a really good model. This thing back-tests to the index on a three-year lookback within 50 bps of the actual index. This thing has been engineered brilliantly by our QIS team
Erik: Where so many people fear an inversion or a flattening of the yield curve, you say we should actually fear the steepening of the curve. What do you mean by that? It seems counterintuitive to a lot of people.
What do you mean by it? And maybe talk us through the charts to explain your point.
Charlie: My long-time message has been that the key here with regards to the hyperventilation on curve inversions – The inversion obviously precipitates the steepening of the curve, but what really matters is that the curve-steepening side of the where-we-are-in-the-cycle indicator is telling us that – I have used the term in a number of my pieces, and maybe even on our last call – that the market has finally sniffed out the slowdown.
We’ve figured out that the policy tightening, the normalization, have impacted the real economy, that the lagging impact of tightening is starting to lead into financing and funding and the costs of capital. And it’s causing behavioral shifts with corporate management, CAPEX discussion that we had before, and, ultimately, it’s affecting the actual output in the real economy.
So when I say that what matters most is actually the steepening, as the cyclical risk-off signal, that’s exactly what we’ve seen – over the last number of US recessions – is that you don’t need to worry about trying to reverse engineer the timing of the inversion into when does the US recession start, just because there is no historical kind of signal there. It’s incredibly noisy.
What does signal – because it’s closer to the real event happening – is that, when you get this steepening, that’s the market picking up the slowdown and confirming the slowdown.