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An Excited Charlie McElligott Details ‘The Makings Of A March Surprise’

"The punchline then is this"...

On Monday, Nomura’s Charlie McElligott suggested that the details of recent Fed communications combined with China’s increasingly manic stimulus efforts and the currency stability pledge in the fledgling Sino-US trade pact together serve as a “tactical trading ‘green-light’ to pursue ‘reflation’ themes.”

As noted, all of that (with a particular emphasis on an assumed move by the Fed to shorten portfolio WAM in the interest of freeing up room for another Operation Twist later as well as a prospective change to the way the committee thinks about inflation) plays into the idea that the stars are aligning for a steepener, something that would have clear ramifications across assets.

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Nomura’s McElligott On ‘The Reflation Window’, ‘Breathtaking’ Policy Pivots, Credit Creation ‘Binges’ And More

On Tuesday, Charlie is back and he is in rare form.

After noting that the tactical reflation (i.e., reflation as theme for a trade) is still trending across global markets (helped along by three straight days of dollar weakness), McElligott gets right to it, posing the following question:

So here we are, with the US yield curve flattening having stalled and now a nascent but sneaky steepening (again, 5s30s from 21bps in late Sep19 to current 56.7bps) —but when does the US yield curve steepening really accelerate?

For Charlie, there are two possible catalysts, one being a material weakening in the data which would pull forward expectations for rate cuts, prompting bull steepening. The other is the converse, where the reflation catalysts he highlighted on Monday gather more momentum. To wit:

We see this “reflation-impulse” from the triple-impact of 1) the still-developing Fed inflation framework shift; 2) the de-facto Fed “easing” which has already occurred after pivoting away from B/S QT and forward-guiding towards “even odds” on either a cut or hikeand 3) the PBoC’s credit- / liquidity- surge gain further steam and this would alternatively likely drive a “bear-steepening” driven by long-end yields repricing inflation relatively higher than any hiking impact in the front-end—especially in light of the Fed’s new inflation framework shift to “run hot” on inflation.

That last bit sounds convoluted, but it’s actually not. The idea, simply put, is that if the Fed is willing to let inflation run hot, the presumed impact on the long end would trump any impact on the short end from a repricing (higher) of the rate path in response to rising price pressures, with the end result being bear steepening. That, presumably, would be a risk asset positive up to a point – you obviously don’t want to see a scenario where a vicious bear steepener threatens to drive up rates vol.

In any case, below are two notable charts from Tuesday’s note, with the visual on the left showing how important the Chinese credit impulse is for the reflation story (where that here means industrial metals) and on the right, a more poignant illustration of something McElligott talks about all the time, which is the importance of the inflation expectations factor for equities (he notes it explains some 20% of the S&P’s variation).

CMTues

(Nomura, Bloomberg, Quant Insight)

Despite the current state of affairs that finds risk assets supported by the prospect of the dovish pivot from developed market policymakers, China’s efforts to reflate and progress on the trade deal, Charlie says folks are still asking him what could go wrong. Here’s how he puts it:

Even though it might seems like an impossibility right now with this “foaming at the mouth” market, I’ve recently been repeatedly asked “what could cause this Equities rally to see a reversal?“

To answer that question, he details a “developing scenario” characterized by seasonality around March quarterly options expiry and a potential pivot point in his famous CTA model.

“The first potential catalyst would be the SPX seasonality around March quarterly Op-Ex, where we typically see stocks trade up into, then trade down out of massive quad-witch ‘serial expiry’ (this year on March 15th)”, he writes, adding that “this is particularly important in light of the currently VERY high %iles in SPX / SPY / QQQ consolidated $Delta / and QQQ $Gamma”.

CMTues2

(Nomura)

As noted above, Charlie says this is especially critical right now because it will collide with i) Nomura’s estimates that three quarters of the S&P will be in their blackout windows, and ii) what he says are “potential outright SELL flows, as our forward-looking CTA model indicates that over the next two weeks, we will see US Equities deleveraging / sell ‘pivot’ levels being mechanically pulled-higher, as 1Y ago, we saw markets rally powerfully into March Op-Ex—as per standard seasonality.” That latter bit is related to the weight of the 1-year window in his model.

Here’s a visualization of the blackout point:

CMBlackout

(Nomura)

And here is yet another new way to visualize what’s going on with McElligott’s CTA model – I haven’t seen this particular variant yet, but I think you’ll agree it’s particularly colorful (figuratively and literally):

CMTues3

(Nomura)

The gist of this is that while the reflation trade made be viable for a time assuming the market continues to believe that a combination of i) the coordinated dovish pivot from DM central banks, ii) China’s ongoing efforts to juice anything and everything in sight with new credit creation and an apparent rolling back of the years-old de-leveraging push, and iii) the implicit weak dollar policy (not to mention generalized risk-on vibes) baked into the prospective Sino-US trade deal, is sufficient to sustain the risk rally, the end-of-cycle worries aren’t going away and even if they dissipate (say, on the back of some positive data), there are technical factors that could precipitate turbulence in March.

And with that, we’ll leave you with what Charlie says is the “punchline”:

The punchline then is this: IF we saw the seasonal post-OpEx pullback look even more extreme on account of the $Delta / $Gamma meet the “demand vacuum” of the onset of the “corporate blackout” window—all against now higher “sell pivot” levels in the 1Y CTA model for both SPX and NDX potentially driving outright SELL flows—we could have the makings of a “March Surprise”

10 comments on “An Excited Charlie McElligott Details ‘The Makings Of A March Surprise’

  1. I didn’t develop such a technical reason, but my take since a while is that so far the market focused on central banking policies + earning season 2018 Q4 and then trade war improvements, and correctly repriced the excesses of December ( I expected to see 2650-2700 but not 2800 so quick to be fair), then in some weeks it will weigh better how the macro situation impacts 2019 Q1 earning season.

    Either the market ignores it and focuses on 2019 Q3 straight away (but I give it a small probability), or it will take a pullback of 5-10% when reality hits and realizes that earnings are really flatlining.

    An efficient market should price all that, but among algos, sytematic flows, buybacks, tweets, and speeches by central banks every day, these markets aren’t so efficient again. Too many winds from too many directions.

    I expect a pullback but not the resumption of the 2018 Q4 short bear market. I don’t think we will see again the December lows.

  2. Since we can’t accurately predict inflation or its impacts, and if we can’t time the market, and buy-and-hold is dangerous, and program trading rules the day in milliseconds, Shouldn’t we just buy the volatility index? Or should we test our casino gambling skills with day-trading? Or maybe the most rational investment for safety and “income” is treasuries and bank cds. Comments, anyone, please?

    • Keep a lot of dry powder and don’t fire till you see the whites of their eyes !! If you have a short term group not related to the mainstream influences and trades independently you can dabble on short term. Cannabis stocks worked well the last 14 months or so. At some point even with all the spin and hype this “thing” is going to collapse into at least a moderate 25-40% correction. Reason being , this time ain’t different.
      Probably, a well thought out series of shorts can be accumulated, like a Spider builds his web…The high fliers will come. That strategy, however, proved unsuccessful for the last two years so therefore the dry powder… and keep reading H…….Good luck

      • Thank you George, I appreciate your insight and your good luck wish. I do have about half in cash. For the most part, I plan to “ride it out” with a few etfs, dividend “aristocrats” and a couple of big tech companies. Just heard Powell talking: “with muted inflation, rates in a neutral range and some downside risk”, that the Fed is going to be patient. It was the Fed’s apparent lack of patience that wreaked havoc on the market in the fourth quarter last year. Hopefully things will now stabilize for a while…. A financial commentator on NBR just said that we are nearing the end of this cycle after 10 years of recovery and that 75% of economists surveyed said they thought there would be a recession “sometime over the next 3 years.” They really narrowed it down there, didn’t they?….So, (as always) be prepared to cover the downside.

        • Anon,
          Perhaps consider tactical asset allocation (i.e. trend following) like Meb Faber. It’s designed to ride most of a trend and then give some back and get out.
          The SA

          • SA, Thank you. I appreciate your offering a good idea to help navigate the complicated world of “risk assets”. I think Meb’s diversified funds wth tail end protection are definately worth a try. I like his transparency comittment, looks like he is a straight shooter.

  3. Right, the stock market needs more investor enthusiasm in order to continue climbing higher during the blackout period.

    That’s the limit of my technical expertise and interest, so if that didn’t translate then I’m completely lost on what’s being said here outside the fact that people love seeing their options head ITM.

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