The Daisy Chain, ‘Crash-Up’, Equity Slingshot Setup Is Back In Play: McElligott

It’s far too early to say whether or not markets are out of the proverbial woods when it comes to the risk posed by the coronavirus outbreak.

Indeed, there’s something entirely absurd about measuring the success (or failure) of containment efforts by reference to bond yields, dollar-yen and US equity futures.

But, alas, we all do it. Which is why Wednesday morning’s headlines were full of references to, for example, 10-year yields having retraced all the way back to ~1.65% on headlines around early “progress” in vaccine development and experimental treatments in Wuhan.

Read more: ‘Extreme Bullishness’: Risk Assets Vaccinated

Of course, the price action over the past 48 hours (or so) is just a hard swing back in the other direction after last week, when equities (and especially bonds) started pricing in something akin to a worst-case scenario.

These are the perils of trusting manic markets to tell you something about the state of a pandemic.

“Markets throughout January and the final week of the month in particular went to a place where we began to price in a lot of worst-case scenarios in both the coronavirus-related global growth scare and the Democratic party ‘push hard-left’ in primary polling”, Nomura’s Charlie McElligott writes on Wednesday.

Those two worries (colloquially: “plague risk” and “Bernie risk”), led to a sharp deterioration in investor sentiment, exemplified most obviously in long-end yields collapsing back near August recession-scare levels, re-inverting the 3-month- 10-year curve, etc., etc.

At the same time, the accumulation of crash protection in equities sets up a familiar dynamic, whereby, in the event the worst-case scenarios don’t pan out (either with respect to the primaries or the pandemic), the purging of those hedges can act as a “slingshot” catalyst for stocks higher.

This setup is familiar to regular readers and certainly to anyone who has followed McElligott’s missives. It played out in August of last year and then, fairly dramatically, in October (see here and here).

Charlie revisited this on Tuesday, flagging extreme skews and “massive richness” in downside versus “almost no demand for upside”.

(Nomura)

“What we saw a number of times last year is that as the macro de-risking catalysts stabilize and/or ‘less bad’ inputs arrive, all of this ‘crash’ daisy-chain which has been hoarded by Dealers (e.g., short the VIX call wing and S&P downside) then increasingly is likely to be ‘PUKED’ as we approach expiration and the stuff decays”, he wrote, after noting that the market is seeing “the resumption of the short-dated VIX call wing ‘book hedge’ … with VVIX remaining very sticky north of 100”.

Of course, when that “stuff” is “puked” as the power decay accelerates into expiration, that then acts as an accelerant, which in turn “activates” re-risking from the “usual suspects” (if you will) who are mechanically yanked in.

As Charlie puts it, “This can then act as a second-order slingshot for higher Equities thereafter, with Vol selling lower which then creates mechanical re-leveraging of longs by ‘target vol’ strategies”.

That makes the market especially “vulnerable” (which will seem like something of a misnomer to the layperson, as in this case it has a positive connotation) to even marginally good news (e.g., vaccine rumors, Mayor Pete coming out on top in Iowa). That’s because incrementally market-friendly headlines have the potential to light the hedges on fire, kicking off the “daisy chain” described above. That is precisely what happened in mid- to late-October, following movement on Brexit and the announcement of the “Phase One” trade deal.

But wait, there’s more. Because with McElligott, there’s always more. (“More cowbell”.)

On Wednesday, Charlie noted something interesting. Namely that the February 2018 VIX ETN extinction event is finally out of the two-year look-back for Nomura’s QIS risk parity model. The inclusion of that black swan “has dictated a slow-moving, mechanical de-leveraging across our estimated risk parity ‘gross’ allocations, particularly in the Equities space”, he writes.

Now that one of the most unfortunate (and dramatic) episodes in recent market history is out of the sample, “the opposite move [is] happening”, McElligott notes. That is, there’s now “a slow-moving ‘gross-up’ as trailing realized vols drop and signal re-leveraging, from Equities to Rates to Credit to Commodities”.

(Nomura)

The point: That’s just one more potential source of re-risking flows to add to all of the above.

What’s crucial to understand about all of this (and I assume this is obvious to most readers) is that trading this kind of thing isn’t for the faint of heart. This is very “tactical” stuff. I’ll just leave that disclaimer/caveat there for anyone who needs it.

More broadly, all of this is clearly contingent on the news flow not suddenly taking (another) turn for the dramatically bad, whether on the virus front or on the political side of things.

As far as the virus goes, Reuters on Wednesday cited a WHO spokesperson reiterating that as of now, there are no known effective therapeutics against coronavirus.

On the political front, there are no known effective therapeutics against Bernie’s massive army of grassroots donors and supporters, either.