‘El Chop-o’ And What May Be Next, According To Nomura’s Charlie McElligott

As expected, this week has been defined by impeachment banter and trade war headline hockey, with the latter manifesting itself in a series of rather remarkable escalations on the US side.

In addition to blacklisting Chinese surveillance giant Hikvision (and a hodgepodge of related companies and entities), the Trump administration rolled out a travel ban on Tuesday. China looks poised to respond to both escalations. Reuters reported that “China’s Ministry of Public Security has been working on rules to limit the ability of anyone employed, or sponsored, by US intelligence services and human rights groups to travel to China”, and various Chinese officials have decried the ill-timed US “aggression”.

And yet, “hope springs eternal”, as it were. Wednesday brought a new set of headlines centered around the prospects of an interim, or “limited”, trade deal, that would see the US forgo planned tariffs in exchange for “non-core concessions” from Beijing, including farm purchases.

Read more: China Aiming For Limited Trade Deal Including Billions In Farm Purchases Despite Recent Escalations

The on-again/off-again, “will they or won’t they” nature of the US-China headlines has conspired with underlying market dynamics (systematic flows) and fundamental catalysts (ISM surveys) to create some serious “chop” this month, including last week’s Tuesday-Wednesday rout, Friday’s surge and this Tuesday’s selloff.

Some of this price action is attributable to a setup detailed here late last month. Nomura’s Charlie McElligott revisits the discussion in a Wednesday note called (hilariously) “El Chop-o”.

“Many of the ‘macro shock’ catalysts we spoke to [last month] have indeed realized thus far MTD, which in turn has created the anticipated second-order market ‘knock-ons’ particularly, the impacts on both extreme ‘vol of vol’ and downside skew, all caused by a number of ‘outsized’ buyside hedging programs in the Oct. VIX Call Wing and Mar20 S&P downside”, he writes, recapping the “daisy chain”, “crash-down/crash-up” scenario discussed here in September.

He goes on to reiterate that “these extremes in vol signals” represent the knock-on effect of dealers hedging what they’re short as a result of the client trades mentioned above. “Thus they remain rather ‘long crash’ to stay hedged themselves, especially in an environment where market maker risk capacity remains ‘tight'”, Charlie continues.

And so, the conditions are in place for the cascading, accelerant flows which led directly to last week’s two-day crash. When a fundamental catalyst comes calling and pushes spot lower at a time when “dealers are short Gamma in both VIX Call Wing [and] S&P Downside [they] have to buy more VIX upside [and] buy more SPX downside and/or short more Spooz”, McElligott writes, recapping what should, by now, be drilled into the brains of anyone who frequents these pages.

(Nomura’s updated gamma/ delta profiles)

In a low liquidity environment, that acts as a “struck match on kindling”, so to speak. As spot careens lower through key levels, CTA de-leveraging is triggered, driving up volatility further. Because the relationship between liquidity and volatility is nonlinear, market depth declines exponentially with the VIX (more here), thus activating the dreaded “doom loop”.

(JPMorgan)

The “downside accelerant flows” from dealer hedging “into worse and worse liquidity [as] other dealers [are] in same risk constrained position can then trigger Systematic Risk Control [and] Trend deleveraging ‘in the hole'”, McElligott goes on to say Wednesday.

So, what’s the good news? Well, the potential good news is that assuming we do get the anticipated “limited” trade deal where further tariffs are taken off the table (at least until Donald Trump loses his temper on a random Sunday evening), the same underlying setup and dynamics can trigger a “crash up” outcome.

“If we then do settle down with regards to the macro shock catalysts, the daisy-chain of forced Dealer ‘crash’ hedges they have had to take on will then again likely need to be ‘puked’ as they decay into next week’s expirations, creating a ‘crash-UP’ catalyst via [the] unwinding of VIX upside hedges, unwinding [of] S&P downside hedges or simply forced-covering of short Spooz dynamic hedges”, Charlie says, again recapping the overarching theme of his recent daily missives.

What happens after that (assuming it plays out and there’s not some kind of epic market meltdown kicked off, for instance, by an equally epic presidential meltdown) depends on your time frame. But looking out into year-end, McElligott rehashes the “rinse and repeat” cycle of mechanical re-leveraging. To wit:

Systematics “negative convexity” strats would then likely see mechanical RE-leveraging and 2) “vol longs” take profits with 3) yield enhancement “vol sellers” re-emerging to “short” vol at more attractive elevated levels, this then too would likely cluster with the 4) return of the post-EPS corporate buyback bid alongside 5) the powerful seasonal ‘upside’ dynamic into YE…all of which creates a compelling case for a local rally –especially against ongoing VERY light positioning.

Meanwhile, if you’re into seasonals and analogs, “you are here”…

(Nomura)