Call it “payback” for the inherent “laziness” of piling into trades predicated on the economic apocalypse narrative.
That’s how Nomura’s Charlie McElligott is framing the reversal seen in rates and momentum this month.
On Monday afternoon, JPMorgan’s Marko Kolanovic said crowding into the long Momentum/ short Value trade has “reached levels that will ultimately make it another ‘XIV'”, a reference to the infamous VIX ETN “extinction” event of February 2018.
In his note, Marko explained why the trades are similar. “The more money that went into selling volatility, the better it worked via direct suppression of implied volatility and feedback loop suppression of realized volatility via long gamma overhang”, he remarked.
McElligott made a similar point in his first missive of the new week, in which he walked everyone back through how we got to where we are now.
“This has not been and is not an equities ‘Quant Unwind’ event at all, but instead a discretionary Long-Short HF ‘crowded positioning unwind’ dynamic”, he said, adding that the Long-Short crowd (and mutual funds via their Overweights and Underweights) have been “loading into” this trade for a simple reason – namely that it continued to work.
What’s crucial to keep in mind is that this is, at the end of the day, just a long duration expression put on via equities, which explains why it’s performed so well in the face of the “duration infatuation” in rates, and why it blew up last week when the long-end sold off the most since the US election.
Charlie calls it “a classic ‘stability breeding instability’ trade”, which is just another way of saying what Marko noted while recounting the mechanics behind the short vol. bubble.
Although the specifics are familiar to some readers, the more attention this gets, and the higher the likelihood of an ongoing, rolling unwind, the more important it becomes to reiterate. Here is McElligott explaining, in a very straightforward way, how this trade works (or worked – past tense):
“Long Duration” expression in particular was the “risk barbell” of “Long ‘Secular Growth’ and Defensive ‘Bond-Proxies’ (GROWTH and MIN VOL) against ‘Short Cyclicals’ (VALUE)”—so both legs would reverse sharply on any bond selloff catalyst(s), which is especially importantly in-light of the massively overextended positioning seen in Rates / Bonds from both Asset Managers and Systematic Funds.
How often did we suggest that crowded positioning in rates was likely to tip over to dramatic effect at some point? Pretty often. And as Charlie goes on to point out, the three-standard deviation long in global developed market bonds reflected in Nomura QIS’s risk parity model has been pared to two standard deviations in September, with “very significant estimated notional selling last week”.
On top of that, he notes that CTAs have dramatically de-leveraged some of that legacy “Max Long” ED$ position, which has worked so well that on Nomura’s model, systematic trend has been positioned “100% long every day this year but one”.
Add to that liquidation of duration longs from asset managers.
As that extended rates positioning is unwound amid better-than-expected economic data out of the US and trade optimism, the selloff in bonds then manifests itself in the equities expressions tethered to the long duration trade.
“As the Rates stuff got sloppy, that ‘lit the match’ for the equally/massively ‘Grossed-Up’ Equities long- and short- expressions of the same ‘Duration’ sensitivity to ‘go wrong’ as well”, McElligott went on to say Monday, before driving home the point by noting that “because it was nearly impossible to trade Equities ‘directionally'” thanks to the schizophrenic nature of the trade war headlines, leveraged funds simply “slashed their nets to low single digit %iles” while “aggressively continuing to load 90th+ %ile ‘Grosses'” into the longs and shorts mentioned above.
JPMorgan’s Kolanovic talked about that at length last week. “While net equity positioning is near lows, gross exposure of hedge funds is very high”, he wrote, in a September 10 note, adding that “given record high gross and near record low net exposure, the most likely way to increase exposure is by closing shorts”.
Given the evolution of the trade (see above) that would necessarily mean Value, cyclicals, high volatility, and small caps outperform, while Momentum and defensives lag.
Because this long secular growth/bond proxies/min vol. against short cyclicals/value trade has worked for so long, the unwind is probably just getting started.
“We believe the unwind is in its early stages”, Kolanovic warned on Monday. “There was and still is a TON of leverage remaining to come out of the trade if Rates remain under pressure”, McElligott said.
This becomes particularly problematic in light of the crude surge, something both Marko and Charlie cautioned on Monday, and something McElligott reiterated in a new note out literally as I wrote this very sentence, if you can believe that.
“Today was all about the Energy sector idiosyncratic explosion higher on 50% of Saudi production offline for potentially months”, he wrote, reminding everyone that nearly a quarter of Nomura’s one-year price momentum shorts leg is comprised of the energy sector, while at the same time, energy is heavily represented in Value proxies.
And so, it was rough for some folks – or at least for a model which ostensibly represents some folks. Here’s Charlie (and do take a second to appreciate the header above the screengrab, which is particularly colorful, both figuratively and literally):
Thus, we again saw “brutality” in my model L/S hedge fund, experiencing its 2nd worst day of the year at -250bps on the session (following last Monday’s beyond-stunning -330bps move in the model L/S HF following the -7.7% “1Y Price Momentum” shock move, the largest down-move for the factor dating back to the 1984 entirety of our data.
This would make the three worst days for my model L/S HF since the Feb 5th 2018 (and Feb 8th knock-on aftermath) of the leveraged VIX ETN “extinction event” all-having come clustered over the past six sessions alone.
When it comes to energy, McElligott reminds you that nobody owns it. “It’s either a placeholder short or a massive underweight”, which means Monday was a “death blow”, with energy “most shorted” ripping nearly 11%.
And just to pound the table a bit more, see the 1-, 2-, 5-day, and MTD % columns in the following table:
Charlie sums it up as only he can in his Monday evening blast, timestamped 10:06 PM:
The performance bloodshed felt across the Equities Long-Short & Market-Neutral universe over the past two weeks as “Momentum” came unglued (with many participants somehow not realizing they were running a leverage “Long Rates / Duration” strategy tied to both “Longs” and “Shorts”) has now taken another turn for the worse, as the legacy “placeholder short / structural underweight” in the Energy sector sees Momentum Shorts RIP another +3.4% today and now +15.2% MTD alone.