Ahead of Tuesday’s overblown client call, JPMorgan’s Marko Kolanovic was out with a brief note discussing the reasons behind this month’s market tumult, both in equities and especially in rates.
As we discussed on Sunday (see the linked post below), the bank’s clients are just like everyone else – that is, curious to know whether and to what extent systematic flows (e.g., CTAs, vol.-control funds, gamma hedging, receiving in rates, etc.) played a role in exacerbating market moves.
“How much of the move can be attributed to increased recession risk vs. technical flows in an environment of poor liquidity?”, Marko asks, in his Tuesday note.
As far as the rates side of the equation goes, Kolanovic cites the bank’s rates team as estimating that “more than half of the recent move in interest rates and inversion of the yield curve was caused by technical drivers”, where that means convexity hedging of mortgages, bank portfolios, and variable annuities, all into an environment characterized by lackluster liquidity.
That, in turn, means that less than half of what you’ve seen in rates is explainable by reference to worries about growth, inflation and/or the Fed being behind the (figurative and literal) curve.
Clearly, the action in rates had an impact on sentiment in equities. Those hedging flows, to the extent they contributed to the rapid descent in yields, sent a dire warning to stocks about what the bond market purportedly “thought” about the economy. “This is an important data point for equity investors, as moves in rates (e.g. yield curve inversion) significantly impact investment sentiment”, Marko writes.
As far as equities go, Kolanovic says the situation is similar. All told, he attributes more than half of the action to systematic flows.
Specifically, he says that a breakdown of equity flows during last Wednesday’s rout (i.e., when the Dow plunged 800 points following the inversion of the 2s10s) and as a result of that selloff, shows the following:
~$75bn of programmatic selling, with ~50% of it coming from index option delta and gamma hedging, ~20% from trend-following strategies, ~15% from volatility targeting strategies and the remaining ~15% from other products (e.g. levered/inverse ETFs, etc.). While these outflows would have represented ~25% of futures daily volume, in an environment of low liquidity they can be a dominant driver of price action.
Market depth in S&P futures fell in August approaching the December lows, Marko goes on to say, adding that “on average there were just ~900 e-mini futures contracts bid/offered”. That, in turn, means a ~$130M sell order “could have moved the market by ~1 index point”.
Earlier this month, Kolanovic’s colleagues noted that “even by August standards, when market depth tends to decline and volatility to rise, this month is delivering numerous unusual events and milestones”.
As far as what happens next, Kolanovic notes that “dealers’ gamma positioning is now close to neutral (from a sizable short position last week), and this may reduce volatility and marginally improve liquidity”. We flagged that on Monday, using the following visual (left pane) from the latest daily missive by Nomura’s Charlie McElligott:
Marko also expects “some marginal stabilization” in de-leveraging by vol.-targeting funds and notes that given the outperformance from bonds, next week could see equity inflows tied to rebalancing.
Of course, trade headlines will likely continue to whipsaw both humans and algos alike.
“Equity flows will to a large extent be driven by developments around trade, and hence the market will likely continue to be dominated by market disruptive tweets and announcements related to the trade war”, Kolanovic sighs. “Those are likely impossible for anyone outside of policymakers’ inner circle to forecast”.