On Wednesday evening, after the S&P finished logging its second consecutive day of gains even as a rally bonds tipped considerable consternation about the outlook for global growth, we spilled some digital ink musing about the difficulty in deciphering what was behind the move in rates.
Reports out that morning suggested the Trump administration would delay the imposition of auto tariffs (that was confirmed on Friday), and while that was good enough to carry the day for equities, April activity data out of China showed the world’s second largest economy was decelerating again prior to Trump’s latest trade escalation. A pair of lackluster prints stateside (retail sales and industrial output) underscored growth worries. At the same time, rate cut bets were being pressed and swap spreads suggested the rates rally was exacerbated by convexity hedging, akin to what played out following the March Fed.
In that Wednesday post, we referenced one of our lengthy expositions documenting the March growth scare/bond rally. In “The Gamma See-Saw“, we highlighted commentary from Deutsche Bank’s Aleksandar Kocic, who, in characteristically eloquent fashion, explained what happened in the aftermath of the March Fed, when rates vol. suddenly woke up amid convexity flows and hedging dynamics.
On Friday, in a note to clients, Kocic weighed in on the subject again in light of this week’s action.
“Rates gamma is still not relaxing against other assets”, he writes, adding that “this is an overhang of positioning and a possible continuation of the March episode, but with lower intensity.”
(Deutsche Bank)
He goes on to lay out the backdrop/setup described here on a number of occasions in late March. To wit, from Kocic:
As a reminder, the street is generally long ATM vol and, in order to flatten their gamma position, they run a massive short OTM receiver position. So, while locally flat, they have a sizable dVega/ dRates exposure — when rates rally, they tip quickly to short gamma. This short OTM is a significant size and was probably not completely covered in March. However, it is less acute than what we saw in the past.
So, that’s a quick take on what we talked about Wednesday evening.
The rest of the street has weighed in as well. “Volatility is on the move, but still in the context of the recent ranges as the market tries to decide between which trade war scenario, brinkmanship or escalation, we are most likely to converge towards”, BofA’s Mark Cabana wrote Thursday, on the way to noting that “outcomes become quite binary from here, whereas brinkmanship is mostly a continuation of the recent dynamic, with volatility likely still contained, an escalation of the trade war risks derails hopes for green shoots, may push the Fed towards an easing stance, and increases the chances of a decisive breakout of ranges.”
(BofA)
In the same Friday note cited above, Kocic reiterates that the yuan is where the “uncertainty is concentrated”. Until such a time as there’s clarity on the trade front, you can expect CNH to be the outlier in the vol. space.
At the same time, VIX and JPY vol. are joined at the hip. Why? Because, as Kocic notes, “both are measures of risk aversion.”
The good news is that the Fed put has been restruck higher in 2019. It’s “about 10% OTM”, Kocic says. Marko Kolanovic said the same thing on Thursday.
For Marko, the “Trump put” will kick in well before the Fed put. For his part, Kocic suggests the VIX spike is probably “transient”.
