Nervous Traders Fear New Wave Of Selling As Quant Questions Linger

Maybe the market crash was “fake news” – or at least that’s what US investors are hoping.

Wall Street logged its best session since June 4 on Tuesday, bouncing emphatically off Monday’s 3% wipeout in a session defined by optimism around purported PBoC “restraint”.

Whether that optimism will prove to be misplaced remains to be seen.

China’s central bank delivered a sharply-worded critique of Steve Mnuchin’s move to label Beijing a currency manipulator, and you’d be naive to think we’ve seen the last of the fireworks just because Tuesday came and went without another serious incident.

In addition to the rather obvious fact that more escalations on the trade and currency fronts are imminent (it seems entirely plausible to suggest the US will intervene in FX markets if and when China countenances more yuan weakness, for instance), some expressed concern on Tuesday evening that what we saw over the preceding six sessions wasn’t an honest-to-goodness purge.

“The sense of panic was missing in the Arms Index or TRIN”, Bloomberg notes, adding that at 1.74, it’s not even close to levels seen in May and December. Meanwhile, the 200-DMA hasn’t been tested yet.

And while the S&P’s 6% drop in just six sessions does count as the third-swiftest pullback of more than 5% dating back to 2009, the selloff pales in comparison to the December rout and has yet to even reach the “depths” seen in May, the last time trade tensions flared. Clearly, recent escalations in the Sino-US dispute are far more serious than Trump’s decision to break the Buenos Aires truce on May 6.

Another lingering question is whether the systematic selling is out of the way. On Thursday, immediately after Trump’s tariff tweet, we noted that dealers’ gamma positioning had likely flipped negative and then, on Monday, Nomura’s Charlie McElligott warned that CTA selling had probably been triggered.

Read more: ‘Never Get Caught Short Gamma In August’

“Volatility across asset classes had been running much lower than implied by the slowdown in growth and has plenty of room to rise further”, Deutsche Bank’s Binky Chadha, one of the Street’s biggest bulls, warned, in a note dated August 2. He also cautioned that wild intraday swings on the S&P generally presage sustained upticks in vol, “which in turn would lead to systematic funds reducing equity exposure”.

Chadha puts some numbers on things. “Vol Control funds, which are quickest to move, have in our estimate already started trimming equity allocations from maximum levels (70%), and we believe they could sell $5-6 billion in the next couple of days”, he said Friday. Some of that likely came through on Monday, but it’s probably not over yet. “A typical de-risking cycle on a sustained higher vol episode, which sees them reduce equity exposure all the way to 50%, implies them selling about $50 billion in a relatively short period of time”, Chadha continued.

(Deutsche Bank)

As far as CTAs go, Chadha warned that their equity exposure hadn’t really budged as of Friday.  “Additional selling is likely if spot continues to stay lower for the next couple of weeks and triggers crossover of short —term MA below medium term MA”, he went on to muse, before speculating that “the current CTAs net long S&P 500 position was likely initiated around the 2800 range”.

It goes without saying that Nomura’s McElligott has been all over this the past several sessions (see the linked post above and work your way back for more).

For his part, Chadha sees around $20 billion in selling from CTAs over the next several weeks assuming uptrend signals are broken. De-leveraging of that magnitude would only bring exposure levels back to where they were in mid-July.

(Deutsche Bank)

On risk parity, Deutsche simply notes that a more sustained increase in realized vol. would be necessary to bring about a sizable reduction of equity exposure.

Again, those estimates are from Friday, but it gives you an idea of the extent to which some of the systematic selling likely hasn’t run its course. Nomura’s McElligott will probably be out with a fresh take on Wednesday, but we brought you highlights from his latest on Monday morning. For those who missed it, below were the key CTA trigger levels (these will have moved since):

(Nomura)

With markets still on edge despite Tuesday’s bounce, traders will watch the PBoC and Donald Trump’s Twitter account for clues as to what comes next.

It’s just a matter of time before Beijing opens the doors to another leg lower for the yuan in light of Treasury’s “manipulator” escalation. At this point, it’s doubtful that China cares much about the bad optics around encouraging more depreciation.

Oh, and don’t be surprised if rumblings about China preparing to sell Treasurys get louder. That’s Beijing’s other “nuclear” option, and the odds of Xi going down that road are probably greater than anyone figures, despite the myriad reasons why it could hurt China just as much as everyone else and the risk that it would be counterproductive.

After all, all’s fair in love and (currency) war.