‘Previously Unthinkable’ CTA Deleveraging ‘In Play’, As Legacy ‘Long’ Signal Vulnerable: McElligott

Everyone knows it: The Fed is going to have to do something. And probably sooner rather than later.

Richard Clarida spent last week insisting that the Fed doesn’t suffer from the “hall of mirrors” effect (or “affliction”) as he called it, but they can’t ignore market pricing forever – not when financial conditions are tightening and not when wrong-footing the market has the potential to unleash an even more powerful impulse in that regard.

“UST yield curves have now pivoted toward a clear ‘bull-steepening’ on the week, as Fed action SOONER and LARGER is now assumed by the market into this coronavirus / Sanders ‘growth-scare'”, Nomura’s Charlie McElligott wrote Wednesday morning.

Charlie goes on to remind you that Fed messaging last year emphasized the relative utility of going “big” and “fast” rather than slow-walking the policy response when rates are already near the lower bound. Officials cited the Fed’s own research in that regard.

After two straight days of what certainly felt like one-way selling, McElligott notes that while he’s typically predisposed to fading “the pension month-end rebalancing stuff as ‘noise not signal’, I do believe that there is increased potential for this ‘Equities bot, USTs sold’ rebalancing-flow over the next few days”.

That’s intuitive. After all, bonds have screamed higher while stocks, not so much, in February. The difference between the S&P’s total return this month and the total return on bonds is in the 10th percentile going back more than a decade and a half. “The more extreme it gets, the more ‘signal’ there tends to be”, McElligott writes.

Among the problems for equities (well, beyond the never-ending flow of dour-sounding virus news) is there’s still an overhang from lagged de-leveraging from the vol.-targeting universe, which came into the selloff extremely long.

“Our ‘Vol Targeting’ implied rebalancing model has estimated selling of nearly $70 billion of S&P in the past 1 week period, with the %ile ‘gross allocation’ from 91st % allocation 1 month ago to today’s just 18th %ile gross notional exposure”, McElligott says, adding that “this selling continues to passively execute in the market… in standard ‘lagging’ fashion on account of the ‘drag-up’ in trailing realized vol above ‘trigger’ levels”.

On Tuesday, McElligott described the “next battle” in equities – essentially, there are a lot of downside hedges (a “wall of puts”, as he calls it) which, if monetized, changes the dynamic for dealers, which could, in turn, provide a stabilizing flow for markets.

He mentions that on Wednesday in the context of overnight gyrations, as clients sell weeklies back to dealers, who then buy futs, but notes that “spot S&P remains deeply into ‘Short Gamma’ territory”. Despite a smaller overhang (i.e., a lower $Gamma %ile rank), McElligott cautions that this is still “a real flow that will continue to dictate that market makers by-and-large will be ‘selling into sell-offs'”.

And how about CTAs? Well, long story short (and there’s a market pun in there somewhere) the last few days have made the unthinkable suddenly thinkable.

[As a quick aside: Please mind the nuance in all of this. These outcomes are not preordained. These models are dynamic and none of this should be seen as a definitive take on the future. There are no guarantees – not in markets, and not in life.]

“Just last Thursday, the deleveraging trigger per our Nomura QIS CTA model in the S&P 500 position was ~8.5% away from spot, and now as a snapshot in time (ref futs 3127 vs today’s ‘trigger’ at ~3139), we would expect to see CTA deleveraging today on a close in Spooz below said 3139 level”, he details, before delivering this key bit:

[This] would see the legacy “+100%” signal drop to just “+15%” with very significant notional$ in S&P futures for sale (as the trade has been so “in-trend” for a year now on the Fed-pivot induced “vol suppression” environment, which meant more leverage deployed into this “winner”).

That’s significant.


Charlie goes on to say that on the bank’s QIS CTA model, the 3-month look-back window “now has ‘loading’ (vs previously ‘just’ 6m and 1y windows)”. Thanks to the rapid decline in equities over the last four days, that window’s signal “is likely to flip ‘short’ tomorrow”, he adds.


Lastly, if you’re looking to point fingers when it comes to who the incremental seller is, you could reasonably point to that massive asset manager long mentioned here earlier this week.

Remember, that long position in SPX was on the order of $190 billion. Although you can’t really say anything definitive about what’s happened with that until the CFTC data comes out Friday (obviously that will matter a lot, considering it’s “week through Tuesday”, meaning it will include both massive selloffs), McElligott does note that on Nomura’s ‘ES Trade Imbalance’ monitor for lot sizes 100-500 in futures, “Tuesday was a ‘one-way’ SALE flow for what we consider as the proxy for this participant-type”.


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