What Just Happened? The Historic Selloff Explained By Nomura’s Charlie McElligott

China’s record-low PMIs combined with what will almost surely be more dour news flow over the weekend around the spread of the coronavirus look poised to compel the Fed to do more than issue perfunctory remarks.

Friday’s brief statement from Jerome Powell contained key language (“closely monitoring” and “act as appropriate”) that probably presages a move, but the sense of urgency was lacking.

As I discussed at length on Friday evening, it’s not clear how effective a policy rate cut will actually be given the nature of the problem, but what it can do is restore confidence in the market, help ensure borrowing costs don’t become prohibitive for corporates and, perhaps, push the dollar lower.

At this point, the market is effectively split on whether the Fed will cut 25bp or 50bp in March (see top pane below).

But, as Bloomberg’s Richard Jones wrote Saturday, any extension of the risk-off move when trading gets going next week would probably see 50bps get fully priced for the next meeting.

In “Getting Involved“, I wrote that although what happened this week makes for an astonishing turn of events, it in many ways encapsulates the sum of all fears for those who have followed markets closely in the post-crisis years.

Crucially, it underscores the role of modern market structure.

The lingering sense of incredulity among many clearly suggests the dynamics which drive quite a bit of the price action these days are still underappreciated by large swaths of the investing public.

Virus or no virus, some still seem incredulous at the sheer rapidity of the move. Of the 25 fastest-occurring corrections (i.e., from market peak to a 10% drawdown) over the last 75 years, four of them have happened since August of 2015. This one took just six days.

This is yet another example of stability breeding instability – until something triggers an avalanche.

For those interested in a short, concise play-by-play of “what just happened” (so to speak), below is a 7-point, chronological explainer from Nomura’s Charlie McElligott, who summarizes all of the dynamics and turning points we spent this week detailing in these pages.

Via Charlie McElligott

1. Two “left tail” macro-catalysts surged into last week (Coronavirus “black swan” and the stunning ascent of Bernie Sanders as “candidate #1” acting as a clustered “negative growth shock” impulse) hit at the perfectly wrong time into US Equities- and US Rates— markets
2. Into options expiries for both US Equities and USTs / Rates late last week, we had seen Dealers extraordinarily “Long Gamma” in each of these “ultimate” asset-classes thanks to recently placid “financial conditions” thanks to Fed “policy asymmetry” and a relatively “Goldilocks” US Economy which incentivized “vol selling” behavior from investors looking for “yield enhancement” / “income generation”–helping in-turn drive S&P and Nasdaq to hit their all-time highs just last Wednesday
3. This (now ancient) Dealer “Long Gamma” choke-hold over prior months had acted as an insulating / vol suppressing flow that buffered against shock-moves and, generally speaking, had kept us in relatively tight directional “bands” (as Dealers short options need to “buy dips or “sell weakness,” especially as we neared expiry)
4. However and following the large expiries late last wk (VIX last Weds, everything-else last Fri), these two “macro shock catalysts” created a profoundly negative price impulse which sent “spot” levels in Equities Index, Equities Vol and Rates deeply through prior ranges, which drove Dealers into “Short Gamma”  territory–meaning that instead of insulating market moves as they had been previously, that now Dealer hedging flows would see them pressing into the directional moves (in this case, shorting into the new lows in Equities index, or buying VIX- and USTs- / STIRS- the more they “rallied”)
5. And as [I’ve] stated for nearly a decade–in a market structure which is now built on “negative convexity” / “short vol” / “short gamma” strategies in order to generate “yield,” as you’ve been incentivized by the global central bank “put,” financial repression” and their complete submission to “financial conditions” (the politically correct form of saying that Central Banks are beholden to markets and the “wealth affect”), any spikes in volatility are to be “sold” and dips in equities are to be “bot,” while said vol / term premia suppression policies (rate cuts, large scale asset purchases, liquidity injections) too “green light” carry- and momentum- trades, especially with the cheap cost of leverage
6. The problem is, the more something “trends” the more leverage you need to apply to maintain target exposures–which is the working definition of “stability breeding instability”
7. So on that macro catalyst “shock down” which forced Dealers into “Short Gamma” territory then exacerbating the moves further at the “extremes” (selling lows in Equities to remain hedged, or buying Vol / USTs / ED$ at highs), we then exposed the MECHANICAL DELEVERAGING FLOWS of systematic “vol control” / “target volatility” universe which now need to gross-down–because VOLATILITY IS THE EXPOSURE “TOGGLE”