If you ask Nomura’s Charlie McElligott, it’s still too early to get comfortable in equities.
Although Tuesday’s turnaround off the Monday massacre and Wednesday’s epic comeback off the morning lows might suggest to some that the selling has run its course, it’s worth noting that two key “downside flow risks” are still in play.
Those who have been following along already know the story. There’s still scope for more CTA de-leveraging and dealers’ gamma profile is still in the “selling begets selling” zone.
McElligott reiterates both of those points in a Thursday note. “[Our] CTA model remains +63% Long in SPX, but deleveraging levels [are] not far below market and absolutely within reach per this realized vol environment”, he writes, adding that his analysis “continues to indicate ‘extreme short’ $Gamma position for Dealers at 8th %ile for SPX / SPY since 2013”.
That latter point is important, although it’s still not well understood by the vast majority of market participants. “Any triggering of systematic downside deleveraging flows, say from a rogue ‘Trade War’ tweet, could then be exacerbated by Dealer desk hedging”, Charlie says, explaining the problem in the most straightforward way possible.
Still, Thursday’s yuan fix and a lack of new tweets from Trump seem to suggest that both sides are keen on avoiding further escalations, at least for a day or two. Recall that although the yuan fixed through 7 for the first time in a decade, the fix was stronger than expected, a sign that Xi is content to have made his point on Monday and will now await Trump’s next move.
That informs McElligott’s assessment that in spite of lingering downside flow catalysts, “the longer the trade situation goes ‘quiet’, you are likely to see increased likelihood of a slow-bleed in Vols, as ‘longs’ will look to monetize the recent moves”.
Assuming we do get some peace and quiet and those longs are, in fact, monetized, McElligott notes it will help alleviate the dealer negative convexity/short gamma trap for markets. Currently, that pain is what’s “keeping S&P downside [and] VIX upside ‘sticky'”, he reminds you.
Charlie expands on his Wednesday note a bit, reiterating that “the challenge for Dealers to place and hedge the massive ’50 Cent’ VIX OTM upside Calls trading over the past ~2m is keeping the vol complex ‘wound tight’, with some vol desks short convexity/gamma and keeping SPX downside skew so acute”. Here’s a snapshot of the shift in the distribution of index options over the course of the last week:
Ultimately, the hope is that the market will get a couple of weeks of respite from new shocks on the trade front. If that fingers-crossed scenario is realized, the manic rates moves and duration grabs that have turbocharged the bond rally could come off a bit, brining down rates vol., while stocks calm down. If equities can stabilize, Charlie would be looking for “the virtuous second-order benefits of volatility re-pricing gradually lower as downside hedges turn worthless and ‘crash’ gets sold”.
That said, we may still just be in the proverbial eye of the storm. After all, Fed risk comes back into play at the end of the month (Jackson Hole) ahead of the September 1 deadline for new tariffs and the September FOMC.