McElligott, Kolanovic And The ‘Max Pain’ Trade

For Nomura’s Charlie McElligott, this is all very simple – and also very repetitive.

“Stop me if you’ve heard this before”, he half-quips, on Thursday, describing the current market mode, which is dominated by a grinding duration rally, bull flattening in the US curve (as the short end is anchored by an “on hold” Fed), a buoyant dollar, surging gold and US equities perched near record highs thanks in part to dealers’ long gamma position, which keeps things well-behaved.

A couple of weeks back, McElligott suggested that stocks could very well melt-up into OpEx as long as there’s no overtly terrible news. “Markets throughout January and the final week of the month in particularly, 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, he wrote earlier this month.

The accumulation of crash protection in equities set up a familiar dynamic whereby, in the event those 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 to go higher.

He mentions that on Thursday. “As we still have yet to get that ‘worst-case scenario’ with coronavirus, while perversely, we’ve also seen the ‘worst case’ expectations of economists ‘miss’ as US economic data surprise indices [move] back to their highest levels since early 2018”, he says.

The read-through is that “dealers’ ‘long crash’ in the (admittedly smaller than Mar) Feb expiry (tomorrow) is decaying and bleeding P&L”. That, in turn, acts as a second-order catalyst for equities, as those dealer hedges get unwound.

Charlie also touches on the same points (see here and here) mentioned by JPMorgan’s Marko Kolanovic on Wednesday – namely, he discusses what it would take to get a re-run of the September snap-back (higher) in yields, and a concurrent reversal of all the various equities expressions tethered to the vaunted “duration infatuation”.

“The ‘point of max pain’ trade is the same ol’ scenario”, Charlie writes. That scenario is a “sustained cyclical/reflation impulse” which at this point “likely requires improvement in the [virus situation] and increasing ’tilt’ towards global fiscal stimulus in order to be anything more than just a multi-day asymmetric positioning cleanse”.

That latter bit is crucial, and I’ll return to it shortly.

In the near-term, in order to kick off a similar episode to that denoted by the red circle in the visual, a spike in yields would be necessary. Kolanovic suggested on Wednesday that 10s at 1.75% might compel folks to start rotating into cyclicals and value.

McElligott reiterates the potentially dramatic ramifications of an acute bear steepener (and yes, it seems absurd to even posit an acute bear steepening episode in the current environment, but that’s the whole point – it’s the unexpected that kicks off dramatics). Here’s Charlie:

This ‘bear-steepener as we’ve seen so many times would then cause massive US Eq factor reversals (and likely trigger shock de-grossing unwind considering how much leverage is deployed onto both longs- and shorts- and general crowding into WHAT HAS WORKED), as bear-steepening is POSITIVELY correlated to Value factor (think Cyclical / Beta) and NEGATIVELY correlated to Momentum (think Secular Growth / Min Vol / Defensives)

In his Wednesday missive, Kolanovic wrote that “in January, hedge funds’ allocation to momentum stocks reached all-time highs [and] over the last few weeks, funds started to shift their allocation away from momentum and into defensive low volatility exposure which now also has a record allocation”.

That’s in keeping with everything noted above. What’s surprising about the visual from Marko below is that it shows funds upping their exposure to value from rock-bottom levels.

(JPMorgan)

“Perhaps some market participants realize that the value rally can happen quickly if the virus epidemic subsides, and are starting to position for reversion”, Marko wrote.

Coming back to the crucial point above, for any such pro-cyclical rotation to be sustained beyond a fleeting bout of position squaring in the face of higher yields and the realization that the pandemic fears are overdone, there would likely need to be a reason to believe that a serious fiscal push is in the cards.

Asked what was most likely to increase global inflation expectations, respondents to BofA’s popular Global Fund Manager survey chose Modern Monetary Theory in February.

(BofA)

The irony, McElligott notes, is that in “order to see that political capitulation into a ‘stickier’ fiscal stimulus willingness” which could compel a “secular re-think” from the market and thereby a sustained rotation, as bond yields move higher on the back of breakevens, things would have to get worse first.

By that, he means “COVID-19 escalating and forcing [the] PBoC back into a ‘property easing’ / ‘PSL 2.0’ policy adjustment or a US recession into the election which could tilt the presidential / Senate / House races more towards a ‘hard left’ outcome, with potentially ‘reflationary’  MMT- / universal income- / infrastructure- odds increasing”.