“Here is the issue”, Nomura’s Charlie McElligott wrote Monday morning, as markets grappled with a deluge of unfavorable pandemic news.
He then rolled out a phrase that, while timeless, has become even more germane over the last decade, as modern market structure reinforced its explanatory power: “Stability breeds instability”, Charlie reminded folks, on the way to describing how another “halcyon” stretch for volatility has precipitated the accumulation of leverage and exposure.
“The prior ‘short vol’ halcyon referenced in Equities (‘Long SPY’ with a 2.2 Sharpe Ratio) has allowed for a massive accumulation of gross-exposure to US Equities futures positions for CTA Trend funds”, he notes, adding that on the Nomura QIS model, through last Friday that exposure was sitting at extremes last seen in January of 2018.
As you can see, that is a nearly 3-standard deviation position going back almost two decades.
The problem with this is that, when taken in conjunction with the potential for dealer gamma positioning to exacerbate price action, it again sets the market up for the kind of cascading, domino effect that has been a defining feature of modern selloffs. As dealer hedging exacerbates downside price action, it can push spot through key levels, triggering forced de-risking from CTAs and other systematic strats.
Earlier this month, we noted that volatility-targeting leverage had risen to levels seen during previous market peaks, stoking fears that a negative catalyst could lead to “elevator down”, so to speak:
Of course, the vol-targeting crowd wouldn’t just de-risk en masse, all at once, in one afternoon. The scary-looking plunges shown in the chart belie the fact that, as Deutsche Bank reminds you, “they would need to see a large and sustained spike in vol for their selling thresholds to be hit”.
Still, the point stands: Stability breeds instability everywhere and always, but especially in modern markets where volatility “is the toggle by which positions are grown or reduced”, as McElligott put it, in an expansive November interview.
This is all made more precarious by the relationship between market depth (i.e., liquidity) and vol. That relationship, JPMorgan’s Kolanovic reminds you, “is very strong and nonlinear e.g., market depth declines exponentially with the VIX”.