If you frequent these pages, you’re familiar with Nomura’s Charlie McElligott, whose followers Bloomberg has variously described as “devoted” and “cult”-like.
McElligott’s ability to catch a moving train in the morning – i.e., to pick up on whatever the macro thread happens to be and immediately run with it – is quite something to behold.
His daily cross-asset strategy missives are, in a word, addictive and they’ll jumpstart your brain – especially if you read them just as the coffee starts to work its way through your bloodstream.
Well, as a special treat for readers this week, below we present some highlights from a new interview McElligott gave to Erik Townsend’s MacroVoices podcast.
Below are selected excerpts from the transcript (organized by topic). At the end of the post, you can watch the full interview.
On the evolution of the overall market/macro narrative
Look, I think that initial conversation a little over a year ago was and remains still very consistent with what we’re seeing now, which was that, at the time I think people were really – you know, this is probably closer to last summer – people were still very much believing in this idea that, look, we were late cycle. Well, we were above trend growth, above trend inflation, we were just so many months into the actual fiscal stimulus.
And, at that point, a slowdown or a recession seemed, was very unlikely, I would say, per most people’s beliefs. But there was a lot of consternation with regards to what was happening with the shape of the yield curve. And at that time we were seeing this powerful flattening.
And that message (I think, went on one of our first podcasts a year to a year and a half ago) was that, actually, the signal with regards to the actual recession is the steepening of the curve.
The flattening happens when the market sees this kind of slowdown building, sees financial conditions tightening. The steepening begins to happen once the market begins to price in Fed easing, the front end moves lower.
And then, ultimately, you hope that the long end moves higher in conjunction with that, under the easing of financial conditions and the stimulus added from the Fed.
The idea was that, typically, traditionally, per back-testing analogues, that you see curves steepen in those final moments before the recession. And that’s the actual signal there.
And as that relates, say, back to equities, it’s really a thematic – it’s less about directional equities at that time. It’s more about the thematic change.
Typically, a flat curve is associated with slow growth, low inflation, or just what I’d call this muddle-through of the last umpteen years of what it feels like in a post-crisis period, which is this 2%-ish, 1-1/2% to 2% GDP growth, sub-2% core CPI, which has grown this very crowded and of everything duration trade over the last few years.
Generally speaking, you’re long the bond proxies, which is everything from typical minimum volatility defensive sectors – you know, the way that Utes and REITs and staples have really been the best-performing S&P sectors over the past year, in addition to those secular growth names like the high-flying SAT software types of names, the FAANG tech type stuff, which actually acts like a bond because of valuation – it benefits from the lower yields justify the expensive valuations.
And they return – they grow earnings, they grow as in this world of low yield and low growth.
On the flip side, people have been short cyclicals.
So that is a product of this slowing growth kind of grinding, muddling-through world that we’ve come to expect.
The thing that started happening last year was that the curve began to steepen because the market began sniffing the slowdown. And the market sniffs the slowdown, then you price in that Fed action.
We got all that. That steepener call that we made last year, and then the catalyst for some of this momentum unwind that comes with that, and then the momentum unwind of trend trades has very much been the theme of the past year. You know
these very stark sharp kind of shock-down periods where prior carry-type trade, prior momentum trades really, really come unglued.
Now we are at this point again where – in the last two months specifically – where I’ve been talking about the implications of the bond market rally over the course of 2019 having overshot. That people were potentially misinterpreting that absolute level in interest rates as this kind of signal of imminent recession.
When, instead, we were actually still kind of holding that muddle-through.
So my message over the last two months has been, look, if bonds unwind some of this overshoot rally, you’re really going to get another shock-down because the market is underweight cyclicals, overweight the bond proxies, and underweight anything growth-related. And that has also been this very tactical story. And that’s been bang on too.
So now I think everybody is trying to readjust for a world where they are starting to get rid of that probability of the now recession and now beginning to push it back into a 2020-2021 story.
On the false recession optic from plunging bond yields tied to convexity flows
Whether it was just speaking with clients about how crowded in a qualitative sense the narrative became with regards to this end-of-cycle skepticism and the trade war had thus pushed this already end-of-cycle slowdown view into an outright imminent recession view. That overshot.
There were two big bond rallies over the course of 2019. The first was March, where we had just a vapor move lower in Treasury yields. And the most recent power bond rally was in August. Both of those were very much convexity related in my mind, meaning mechanical buying.
The March episode was due to big bank dealer desks that have been shorting options to clients for, frankly, the last two years, who were buying these big crash recession hedges. And those trades were – the curve-cap trades that I started advocating last year on the podcast were basically bets on the curve going steeper and bets that the Fed was going to have to cut rates into a slowdown.
Big banks had sold tons of these options structures to large clients, from asset managers to family offices to hedge funds, for the past two year and were just collecting premium. And they were expiring worthless. It was a great trade.
Well, in March you had a really significant global growth scare, a slowdown scare, you started seeing some bad data come out of China, especially as it related to some of the rhetoric around the trade wars.
And all of these dealers that were short these options, they were basically tied to low strike receivers, which were calls that Treasuries were going to go higher, or short options that the curve was going to steepen, which were basically bets that the Fed was going to ease in the front end and the market was going to have to price in more Fed cuts in the front end. They just got lit on fire.
So that was the first part of the rally, where it was very much just about dealers having to hedge in the short-options exposures.
The most recent one in August was convexity hedging of another sort, which was really from the mortgage space. We had another large global growth scare over the course of August and July. Frankly, the European data was absolute garbage and the Asian data was really accelerating worse. And from there you ended up having a situation where mortgages are inherently negatively convex.
So as bonds rally, those that play in the mortgage base, whether it’s MBS accounts or bank portfolios or bank treasuries or mortgage REITs which are heavily leveraged, 7 to 10 times type of entities – they had to go out and buy more and more TY – more 10-year futures – to stay hedged, the lower that yields went.
So in both of those cases the point I’m making is that it was a mechanical feature, not necessarily though a view of this imminent recession. And that was at risk of being misinterpreted.
So you were seeing, whether it was bonds, whether it was record buys in duration across Treasury futures, or eurodollar positioning in 95th percentile extremes to equities, where there also was this end-of-world, end-of-cycle slowdown trade that I just spoke about earlier, along with the bond proxies, both secular growth and the defensive min vol stuff, and you’re short cyclicals, which are the growthy stuff, the inflation stuff.
We saw that with prime brokerage data, where tech was 99th percentile owned by hedge funds and, conversely, energy financials materials are kind of 10th percentile down to zero percentile (if that actually is a word) with regards to historical ownership.
So everybody had this trade on. It was very crowded. It was levered. We saw the hedge-fund data show that funds had low net exposure. So they had a very low directional lean long, by historic measures. But they had big grosses on.
Because both sides of the trade, from the long side, being long secular growth and long defensives, it worked so well, and they were very short the cyclicals that kept going down every day over the course of the year.
My point was in August that the moment that we get some positivity injected into this market, you’re going to have a way outsized market response as we’ve overshot. And now this positioning would have to unwind, and probably painfully so. And that was at the core of this cross-asset momentum reversal that we’ve seen.
On viewing the world through the lens of volatility
I view the world from the lens of volatility.
You know, I think the most powerful and most meaningful flow in the market is gamma, which, in some ways, is saying that the tail wags the dog with regards to what people think moves the markets actually does not move markets.
I spend a lot of time working with our vol teams. And we have a tremendous look under the hood with regards to what investors are doing and, particularly, what dealer desks are doing with regards to hedging of their risks.
And this is very important because I think the CTA is such a hot topic, not simply because we’re talking about this actual universe, where BarclayHedge estimates that the actual size of the AUM – they update this monthly on their website via reporting CTAs into them, up $360 billion.
And it’s clearly one of the most heavily leveraged strategies out there on top of that. Which matters because then we’re talking about, ultimately, trillions of dollars of notional exposures being managed and moving around (not necessarily sloshing around, but with the potential to slosh around) – is more on this idea that (certainly in the post-crisis world) desks, whether a long/short equities or a long-only real money account or a relative-value 10-times-levered fixed-income arb shop or a 20-times levered market-neutral strategy, quant strategy, generally speaking are all under kind of a VaR constraint.
That is the world of risk management in the post-crisis world. And specifically with the buy side, as it relates to investor expectations for managing that risk. Investors and their consultants expect certain risk parameters met, certain institutionalized risk management structures built.
And the point is that volatility is the trigger. Volatility is the toggle by which positions are grown or reduced. And volatility is that tail that wags the dog.
The other is that, in the post-crisis period, banks, through regulatory oversight, now manage their risk very differently. And have to manage their risk very actively on a daily dynamic fashion.
So CTAs are important because what they are is picking up a very unemotional reversal of a trend.
And when you get a reversal of a trend and, as I said, these are the size of the positions are inversely proportional to the instruments ex-ante volatility – that is picking up a shift in positioning, a shift in volatility that then ripples out across all types of strategies that are not pure momentum.
And the point is that everything – when you’re allocated in this current real-life 2019 into 2020 market structure, volatility is the toggle. And everybody becomes a de facto momentum trader.
Why ‘Vol-pocalypse’ can never happen again – or at least not as it happened during the week of February 5, 2018
The dynamic of February 2018 will never be seen again. And I don’t like saying this, but, unless a bomb goes off in the middle of downtown Manhattan in the middle of a trading day, point being, that we will never see that amount of short vol need to be rebalanced at the end of the day.
And why is that?
Because February of 2018 was the extinction event of the leveraged short vol complex. Those products don’t exist anymore. And that just created an impossible amount of rebalancing into a tiny window at the end of the day where, God forbid, you had this filing – filing meaning a bankruptcy event for some of these products – where there was a macro catalyst over the month of that prior January where, all of a sudden, inflation became a thing and the market had to suddenly shock-adjust to the possibility of the Fed power-tightening.
Which is exactly what happened over the course of last year.
Now the reality is this. Those products are gone. And if those products are gone, we can never have that kind of squeeze.
On how to correctly interpret spec positioning in VIX futures
More importantly, I think, right now, you’re seeing this discussion where people are taking in isolation a snapshot of the CFTC non-com, meaning spec, spec position in VIX futures. And they are hyperventilating on the fact that the net position is the most short it’s ever been.
The trick, to me, is this. A lot of folks don’t realize that the VIX ETN complex on the other side actually more than offsets that short vega position in the CFTC futures because it is the other side of the trade.
So the short-term VIX ETNs, which, if you back-test this type of extreme long that they have, which, again, more than offsets the net vega short in the non-com futures position, the ETNs tend to have the near-term forward returns. They are long vol. And you actually tend to see higher near-term volatility when you see this type of extreme.
Right now, the net vega position for ETNs is 99.7 percentile since 2011. If you look at that non-coms spec hedge-fund mixed-futures net vega position, yes, it is extreme. It is 0.2 percentile since 2011.
But, again, the point is there is the other side of that trade. And it’s the VIX ETNs, which, to me, a lot of people aren’t advertising the full story here. So that’s why I appreciate the opportunity to clarify it.
I am of the view that equities are going to pull back in the next two weeks to one month – it might be down 2%, it might be down 5% – because of this extreme positioning. And, yes, VIX is low on an absolutely level, let’s say. Kind of like a 13 handle in the index, not necessarily front-month future.
But one other point that I’d like to make on the non-com VIX futures position is that it’s so short right now because systematic roll-down players who play the shape of the VIX curve are massively into that trade because of the shape of the curve right now. The curve is so steep.
And that is part of what’s happening right now is they get a signal due to the steepness of the curve, where the front month’s vol has been smashed, partially because of the VIX ETNs just had to rebalance.
And for seven months in a row, when VIX ETNs rebalance, you’ve seen the VIX trade down multiple vol points one week into the event. They have to sell the front month to buy the second month. That is an inherent steepener of the VIX curve. That is then a signal for systematic VIX roll-down guys to come in and try to trade the shape of the curve, with such a steep roll-down.
And, to me, they actually end up getting run over on this trade.
Why I think there is VIX upside in this next two weeks to one month, I think that type of roll-down, systematic roll-down, they hedge indiscriminately in some ways.
So I think that’s a big story to me. But you can’t talk about vol without really going into the larger offsetting other side from the VIX ETNs.