Nomura’s McElligott Explains The Market’s ‘Embedded Short’, Looks Ahead

Equity futures predictably trimmed gains as the sparse headlines from a perfunctory-sounding G-7 communique crossed on Tuesday morning in the US.

There was no mention of specific policy prescriptions – only vague allusions to doing what’s necessary in a timely fashion.

As a general rule, if the opposite of a given policy statement (and this is applicable to anything – not just to monetary and fiscal policy) makes no sense, then the statement itself is inherently meaningless.

Read more: Strategists ‘Fight To Keep Their Inner Cynic At Bay’ As G-7 Deus Ex Machina Disappoints

For example, the G-7 statement closes by saying that “G7 Finance Ministers and Central Bank Governors stand ready to cooperate further on timely and effective measures”. That’s great, but what would be the opposite of that? That finance ministers and central banks don’t stand ready to cooperate, aren’t prepared to react in a timely fashion and will deploy only ineffective measures?

You get the point: Nobody is going to be particularly enamored with what the (apparently short) teleconference produced. Folks want to see (or at least hear about) concrete policy actions.

This marginal letdown could deflate equities after yesterday’s manic rally, but we’ll see. One thing worth noting is that, as mentioned here on Monday afternoon in “A (Dove’s) Wing And A Prayer“, the market is prone to being squeezed.

“Yesterday’s predictable risk asset squeeze off the back of coordinated central bank messaging storm was even more remarkable than the ‘violent’ one I was already anticipating [and] that’s because it exploited the embedded ‘short’ in the market”, Nomura’s Charlie McElligott said Tuesday, on the way to noting that “SPX / SPY options’ $Delta is a massive source of the ‘synthetic short’ at an incredible -$599.5 billion implied into yesterday morning’s session”.

(Nomura)

That, he goes on to say, is “practically unprecedented in recent history at just 0.5%ile since 2013”.

He proceeds to explain precisely what that means.

“Clients willfully ‘chase’ in order to cover/monetize, while the dealer short gamma profile has them in a position to need to buy monster delta into the upside breakout to hedge themselves”, Charlie writes.

Late Monday evening, in the course of documenting some understandable skepticism from many market participants headed into Tuesday’s G-7 flop, I noted that despite what some will invariably see as an irresistible urge to fade any further upside given a lack of clarity on the evolution of the virus, “one can’t underestimate the possibility that, as volatility falls and spot surges back up through key levels, deleveraging from the vol.-targeting crowd abates and CTAs begin to re-risk”.

McElligott touches on that Tuesday, noting that with vol.-targeters having shed some $140 billion worth of US equities exposure over the past month or so, they’re now “susceptible to [a] repricing lower of vol and thus, mechanical ‘buying thereafter in order to rebalance from this extreme with little left to sell, and a lot of potential $ to buy”.

As far as CTAs go, Charlie says they’ve deleveraged their S&P 500 futures position dramatically.

“Since the exposure highs of a 61% allocation on January 27th”, CTA trend has reduced to what McElligott describes as a “non-position”, where that means “an inconsequential 2.8% gross-allocation”.

(BBG, Nomura) 

“A further reset in vols would push CTA’s closer to re-leveraging”, he goes on to say, but does note that any such re-risking on another signal flip would entail a “small notional” given the extent to which exposure has been cut.

Finally, Charlie writes that, on the bank’s estimates, risk parity has slashed their US equities allocation to “just 8.6% of the overall gross portfolio”. That would be a half-decade low allocation and, similar to the target-vol. discussion above, would mean that any sustained move lower in trailing realized could mean re-engaging stocks.

And yet, through it all, McElligott suggests that “any further squeeze… into central bank joy is another opportunity to leg back into S&P downside”. (Don’t forget, “Bernie risk” comes calling again Tuesday.)

As far as policymakers go, SocGen’s Kit Juckes writes that “the most effective economic policy reaction would be to tackle the spread of the virus first, and use fiscal policy to offset both the economic side-effects now and to ensure that growth recovers quickly once the health crisis is past”.

The concern, Juckes said Tuesday, is that “the best of the sentiment reaction will come from anticipation of a monetary policy move, and euphoria will fade once that has been enacted and we return to watching the virus’s global spread”.