Heisenberg Report

A ‘Rare’ Local ‘Red Flag’ And A 30,000-Foot Reminder

“Risk gets spooked”, Nomura’s Charlie McElligott wrote Thursday morning, as equities came under pressure from news that China is catching up to the reality on the ground when it comes to reporting the real scope of coronavirus contagion.

It’s important to keep in mind on Thursday that even if you aren’t inclined to take a glass-half-full approach to the new virus data (e.g., by noting that it may suggest the mortality rate is lower), the macro backdrop remains broadly similar to how it looked in December.

For all the hand-wringing, we’re really just reading the same macro script from last year, only with a different villain. In 2019, the trade war was the antagonist that threatened to deep-six global growth. In 2020, it’s a virus.


The “hero” (if that’s how you want to frame things) is still central banks, who haven’t yet completely exhausted their capacity to drive risk assets higher by keeping the liquidity spigots open.

Charlie describes the current bullish US equities thesis in terms of a narrative around a “goldilocks US economy, Fed policy asymmetry, OMOs [and] QE-Lite”, all with monetary policy sticking to a shadow mandate centered on “maintaining easy ‘financial conditions [which] keeps rate vol and thus cross-asset vols suppressed”. But he doesn’t discount the impact of the virus on short-term sentiment.

On Thursday morning, BMO’s Jon Hill, Benjamin Jeffery and Ian Lyngen wrote that although “we have both top-tier fundamental information and $19 billion in upcoming long-bond issuance, market attention will continue to struggle to disentangle itself from developments surrounding the disease, even if actual financial conditions haven’t seriously tightened”. They continued, noting that “the VIX, while off its YTD lows, is still somewhat tame, similar in nature to the MOVE index [while] FX vol as measured by the CVIX is at an all-time low”.

(BBG)

From a tactical perspective, McElligott recently spent a good bit of time documenting the potential for a familiar “crash-up” scenario to play out as various hedges decay and are purged headed into expiry (assuming the news flow doesn’t turn sour) creating a second-order “slingshot” for equities to move higher still.

On Thursday, he offers a caveat in the form of a “larger ‘local’ issue”.

“Investors have gotten extraordinarily (and mechanically) ‘long the market via options and the overall index trade to ATH, with $Delta across SPX and SPY currently 99.5th %ile ($572.7B)”, he writes, adding that “this $Delta rank has only been seen to such an extent on three prior dates: 11/27/2019, 1/23/2018, 12/11/2017 and, now, 2/12/2020”.

(Nomura)

If you’re wondering what the forward returns look like after such extremes, they aren’t great, depending on your window. Charlie calls it a “rather rare ‘red flag’ signal” and notes that since 2013, 3-month returns in cases where SPX/SPY Delta > 99.5 %tile were -1.9%, and 12-month returns were -3.6%.

As ever, there’s much more in the way of granular details in Charlie’s full note. We simply hit the high points in summary fashion, and that’s the highlight from today. It’s local/tactical issue, that some may want to consider.


Panning (way, way) out to the 30,000 view (and in the process touching briefly on the notion that the market is now once again enthralled with the idea that central bank liquidity and forward guidance can keep risk assets buoyant and volatility suppressed come hell or high-pandemic), I’d reiterate that after a decade, monetary policymakers have seen their armory woefully depleted.

It’s high time for fiscal stimulus and a Stephanie Kelton-inspired rethink of how policymakers in developed economies approach the monetary-fiscal policy nexus. (This goes without saying, but any “partnerships” between monetary and fiscal policy cannot be presided over by autocratic executives.)