“We are now seeing the ‘soothing’ phase begin, as macro catalysts are introducing local ‘Vol Killers’ into both US Rates and Equities”, Nomura’s Charlie McElligott writes, in a Monday note. The macro catalysts are fresh headlines around German fiscal stimulus and, to quote Charlie, “POTUS shifting back to ‘good cop’ mode on trade and tariffs”.
While it’s not clear how long we can count on Trump donning his “good cop” hat in favor of his “Tariff Man” costume, the German fiscal stimulus rumors are likely to stick around for quite a while, and the more detail we get on that, the more (welcome) bear steepening pressure they’ll be, absent some stronger force.
Adding to the long-end selloff impetus to start the week is Friday’s news that Steve Mnuchin is once again sounding out relevant parties on the prospect of ultra-long issuance.
Read more: Argentina Has A Century Bond, Why Not Us?, Is What Treasury Wants To Know
If long-end yields move slowly higher for a time, that would likely be good news for risk, something McElligott underscores on Monday.
“Regarding rates, the recent (VERY clear) directional correlation between USTs rallying and the upper half of the vol grid jumping higher would then suggest that an easing of the ‘duration grab’ would too then see vols ‘ease up’ too”, he writes. Given that August has been all about bull flattening, the manic rally at the long-end and concurrent moves in the rates vol. space, any abatement there may serve as “a broad cross-asset ‘vol dampener'”, McElligott says.
Still, he notes that the convexity flows aren’t just going to dry up, especially not in the face of looming rate cuts. To wit, from Charlie:
Longer-term, however, and in light of the simple fact that (negative) convexity hedgers of all types (from MBS / Mortgage REITs / Bank Portfolio hedging to Vol Dealers to Insurance Co’s / Annuities to Systematic players) have seen this ‘unstoppable’ rates rally either shorten their target duration massively or force massive buying to maintain targeted exposure levels, this source of ‘mechanical demand’ will not be going away anytime soon, especially just as global central banks ‘rev”’their stimulus- and easing- engines.
That’s a critical dynamic in explaining the ferocity of the moves in US yields this month. We talked about it at length on Friday.
On equities, McElligott revisits a theme he’s been pushing for a couple of weeks now, updating it to take account of “crash” bets rolling off.
“Here we are now, with all of this ‘crash’ now increasingly likely to ‘bleed out’ and decay further, thus risking further ‘short gamma’ selling in VIX futures [as] the lower we grind, the more needs to be sold”, he notes.
When you throw in vol. longs in the VIX ETP complex monetizing, the return of roll-down players and possible re-leveraging from CTAs as things stabilize and spot SPX moves up, Charlie sees a potential “‘tailwind’ for higher stocks in the near-term”.
(Nomura, BBG)
Notably, his estimates have dealers’ gamma positioning back near neutral and close to flipping positive, which would obviously serve as a further vol.-dampener.
Of course, the danger is that this is all into Jackson Hole, and the Fed minutes, with the latter almost sure to be disappointing for markets given the two dissents in July and the fact that the account of the meeting will not, by definition, include any references to the August turmoil and the need to take account of it when setting policy in September.
You’d like to think markets will simply discount the July FOMC minutes given how stale they are, but in the current environment, anything that suggests the committee is more divided than anyone thought or that the “mid-cycle adjustment” characterization is too deeply entrenched to be easily cast aside, may serve to create turmoil.
Powell will have to work extra hard to negate the minutes (to the extent they’re seen as reinforcing the “mid-cycle adjustment” narrative) in his Jackson Hole remarks or risk more dollar strength, a further collapse in inflation expectations, lower long-end Treasury yields, more bull flattening and, in all likelihood, significantly elevated equity volatility as market participants struggle to resign themselves to a Fed that is prepared to risk it all in defense of its independence and a tacit effort to forcibly restore some semblance of order to US trade policy.
Two points…If you reduce Charlie’s thesis to the more easy to comprehend points one can say that intuitively one sensed nearly all his points prior to reading his flow based documentation…It all in a word makes sense !! Secondarily though…… all this reminds me of how the Government operates when a project is presented to an Agency and the end goal is outlined in the instructions to the persons charged with implementation of the work.. Often very critical issues of (Federal Law ) are totally ignored with the idea of just getting it all to Point X…..If someone of conscience objects based on facts well they just are literally ostracized by higher ups and thus an inefficient dangerous Political Drama ensues… This usually stops at higher levels when someones advancement and career is jeopardized by the consequences of the rigging that has taken place …Then begins the process of “looking for the fall guy” called finger pointing….
The point is ….If you constantly rig the deck you will build a house of straw or sticks not Bricks…..(Three Little Pigs ) We are doing just that and inevitably the chickens come home to roost….I see this to Powell’s Dilemma..
Seems likely trend this week is up (for stocks) until Friday, then sell the Powell news.
Market sentiment has become very bearish – price action shows that, never mind surveys like BAML PM. Recession calls are everywhere. More bullish strategists cracked – lowered equity allocations. Trump blinked (tariff delay) and blinked again (Huawei delay), despite the feebly bellicose tweets. Chart readers will see some bounce setups. Light econ data week. Plenty of earnings but dour tone already set.
Seasonals coming up – higher investor caution around Sep+Oct. Then in 4Q dilemma for equity managers: if you’ve matched SP50, you’re +17% YTD (as of now) which looks great, but only +3% L1Y which is weak, do you try to add to the YTD and run the risk of going negative L1Y, considering you’re measured on trailing years not YTD.