US equities were under pressure for most of the cash session on Tuesday, as a three-day bounce off the August 14 rout stalled.
Treasurys were back in rally mode, with 10-year yields falling to 1.54% shortly after Mike Pompeo weighed in with cautious comments on China and Huawei.
The mood was subdued as traders peer through the summer haze towards Friday, when Jerome Powell will or won’t commit another communications error in Jackson Hole with make-or-break remarks that will be heavily scrutinized for any hint that the Fed is intent on altering the “mid-cycle adjustment” characterization of current policy.
For now, most observers doubt the durability of any selloff at the long-end, and not just because the market is losing faith in central banks’ ability to reflate the global economy and counter a downturn.
“The resumption of bull flattening [would] speak to the likely ongoing flow demand from various assorted convexity-sensitives and hedgers in order to close their duration gaps which have violently accelerated over the past few weeks”, Nomura’s Charlie McElligott wrote in a Tuesday note, referencing the hodgepodge of market participants who are forced to chase the rally in bonds.
JPMorgan’s rates team on Tuesday attributed more than half of the recent bond rally and concurrent curve flattening to positioning, hedging flows and lackluster liquidity.
“A pick-up in swap volatility relative to Treasuries points to convexity hedging, and the flattening of the curve in a rally suggests their impact has increased”, the bank said.
This has, over the past two weeks, created something of a false optic when it comes to what bonds and the curve are purportedly “saying” about the economy and the proximity of a recession. Call it another “Fata Morgana” moment.
The perception that bonds are screaming about an imminent downturn has weighed on sentiment in equities, while the duration grab has driven up rates vol., in turn contributing to higher cross-asset volatility. The impact of the hedging flows in rates has been magnified by an acute lack of market depth, as illustrated rather poignantly in the following figure:
Mercifully, the dollar pulled back on Tuesday, after pushing to YTD highs to start the week. The greenback clearly needs to come off a bit in the interest of not squeezing emerging markets further at a time when idiosyncratic risk in Argentina and Turkey is flaring up again, trade tensions remain on the front burner and Fed policy remains relatively hawkish.
From here, it’s something of a toss-up. “Hedge fund equity beta is currently near all-time lows, in its ~4th %ile [and] volatility targeting strategies also have low exposure, in the 27th percentiles”, JPMorgan’s Marko Kolanovic said Tuesday. “All else being equal, such low positioning is positive for equity performance going forward”.
Of course, all else is never equal when Donald Trump is tweeting, but it’s also possible that rebalancing flows could bolster stocks into month end. “Given the large outperformance of bonds over equities this month, equity inflows are likely to occur next week”, Kolanovic went on to say.
From a tactical perspective, McElligott says a re-steepening of the VIX curve should “gradually signal for the return of systematic roll-down strategies”, serving as another vol.-selling flow to the market. Any short vol. flows should help to pull down trailing realized vols, which, as Charlie reminds you, “are a critical allocation and leverage input [for] systematic target vol. and risk control strategies” which can add equities exposure if volatility remains suppressed.
And yet, we’re not out of the VIX seasonality yet, and “tweet risk” is arguably as high as it’s ever been.
(BBG, Nomura’s annotations)