If you were looking for a struck match to ignite any dry kindling that wasn’t torched earlier this month, China’s retaliatory tariffs on US goods (which include a new 5% levy on soybeans and crude from September 1 and the reinstatement of a 25% duty on autos beginning in December), will work in the absence of an offsetting dovish message from Jerome Powell.
“The pieces were already aligning for a potential ‘clustering’ of macro-, seasonality- and flow- risks into September [and] now with Chinese retaliation reopening the wound we could certainly see this ‘selloff window’ scenario pulled-forward”, Nomura’s Charlie McElligott writes, in a note out shortly after the latest tariff headlines hit.
Notably, McElligott says dealer positioning in SPX “has now flipped-back incrementally into the ‘Short Gamma’ zone”, which can be an accelerant if things get moving in the wrong direction.
On the bright side, Charlie writes that “CTA deleveraging levels for Equities remain well below” spot for the time being, with SPX selling under 2852. So at least that’s one systematic flow risk that’s some ways away.
He also reminds folks about the potential for VIX seasonality to add to the mix “with September posting the 2nd best average monthly return for VIX since its inception” at +6.9%, second only to August at +9.2%.
(BBG, Nomura annotations)
Of course, manic moves and choppy markets are a symptom of “still-weak post-Summer holiday volumes [and] depth of book” along with “tight liquidity and VaR constraints from dealers into quarter-end”, McElligott remarks.
As a reminder, a disappearance of market depth was a major contributing factor both to the rally in rates this month and to wild swings in equities. For instance, market depth dried up entirely in S&P futures on August 7, during Wall Street’s stunning turnaround which saw the Dow erase a 589-point drop to close basically flat (top pane below). In rates, market depth disappeared into this month, meaning that large hedging flows and the forced duration grab hit in thin markets, driving up rates vol. and contributing to outsized moves in yields.
(Goldman, top; JPMorgan, bottom)
McElligott elaborates a bit on the sequencing risk in September, adding that there’s obviously some scope for disappointment from central banks which lines up with “the removal of a key ‘demand / stabilizer flow’ in US equities, via the commencement of the Q3 EPS season corporate buyback blackout”.
And then Charlie flags more VIX call wing trading, “which looks a lot like the footprints of the ’50 Cent’ hedge program, which could see us again back in the same spot we were in this past month of August, meaning Dealers may again have to then go out and buy loads of ‘crash’ protection to offset their VIX ‘Short Gamma'”.
Backing out of the weeds, McElligott notes the obvious, which is that Friday’s China tariff news has the potential to weigh heavily on fragile sentiment, fraying nerves further and exacerbating growth worries with the possible effect of pulling forward any September selloff window.
Powell can change the dynamics. The question is: Will he?