Nomura’s McElligott: ‘One Left Tail Down, One To Go’

Joe Biden’s resurgent, come-from-behind bid for the Democratic nomination has removed one of the “left tail” outcomes that set in motion the “multi-week, rolling gamma- and vol- ‘event'” that manifested in the most harrowing rout for US equities since the crisis.

The Bernie “black swan” is “now in the process of being downgraded as a probability for markets”, Nomura’s Charlie McElligott wrote Wednesday morning, in the wake of Super Tuesday.

He adds that when you see ridiculous rallies in futs, you should be aware that “short gamma [is] still clearly a partial culprit behind these extreme, ‘accelerant’ moves in both directions”.

(Nomura)

Between that, and the “squeeze” implications of the market’s embedded short, you get exactly what you’d expect – ridiculous, 100-handle moves.

Even as one left-tail comes off, the other remains. Italy’s decision to close schools and universities as part of the country’s virus containment effort is a stark reminder of the biological threat from COVID-19, although I doubt anyone needs further “reminders” at this point.

Can we drown a virus in liquidity? Or subject a plague to death by a thousand (rate) cuts?

Probably not, but what we can do is amp up market expectations by continuing to bend the knee to STIRs.

“Although essentially just pulling forward the 50bps of easing which the market had already priced in, [the Fed’s emergency cut] still set off a further daisy chain within markets, with front-end Rates / USTs seeing extraordinary rallies and a violent bull-steepening, as even more cuts are now priced into expectations”, McElligott notes, adding that Nomura’s econ team now expects another 25bps cut this month and one next month as well.

Libor fixed lower by a truly remarkable 31.36bp on Wednesday. That’s yet another “largest decline since October 2008” fix.

The BOC is all set to cut and, as noted first thing Wednesday morning, there’s all manner of speculation in the market about an emergency BOE cut. The Fed’s move also gives China even more scope for easing without worrying about yuan depreciation/capital flight. The rally in US rates has the 10-year US-China spread ballooning out to the widest in years.

Skeptical voices are a cacophony on Wednesday.

“Jay Powell knows that the days when central bankers could ride into town and lord it over markets and the economy with their rate moves, are nearly over, but with President Trump calling him out, the script was apparently written, and concerns that cutting now would smack of panic, use up diminishing ammunition and achieve little, were ignored”, SocGen’s Kit Juckes wrote.

“Most countries are now preparing for a serious virus epidemic [and] all governments are faced with a [menu] of unpalatable options over their next steps — yet all end with economic damage”, Rabobank’s Michael Every remarked, adding that “the conventional response is already well underway with the RBA cutting rates and the Fed making an emergency cut [but] conventional policy is arguably of little impact, as initial reactions to the Fed surprise show”.

But even as the virus hangs over the market’s head, traders and investors will cheer any further evidence that the Bernie black swan won’t ultimately splash down. If vol. starts to reset sustainability lower, we could get some re-risking by investor cohorts that recently purged their exposure as the volatility toggle was cranked to a Spinal Tap-ish “11” during the selloff.

“After the perceived removal of the US election ‘left tail’ last night, vol is again resetting sharply lower which… will mean a (lagging) re-leveraging to come from the systematic / target vol universe, as trailing realized windows begin to ‘catch-down'”, McElligott writes.

For reference, note that the vol.-targeting universe now sees their allocation to equities in just the 3rd %ile, after having purged some $120 billion in the space of a month.

For CTAs, spot is now trading right around a key re-leveraging level, or at least on Nomura’s QIS model.

For broader audiences, the point is simply that the ever-present COVID-19 tape bomb risk notwithstanding, extreme skew and the potential for vol. to reset lower (and stay there, at least for a time) means the pressure builds for an “upside”/”crash-up” shock, given what Charlie simply describes as “under-ownership by systematics” and the above-mentioned synthetic/embedded short.

But, again, it’s impossible to overstate the risk of another “shock down” given the distinct possibility that a major US city is harboring more virus cases than anyone yet knows.

That’s not an attempt at fearmongering, it’s just to state the obvious. An apocalyptic, “Hollywood”-style scenario isn’t necessary to trigger another big move lower in equities. Indeed, if we get that type of scenario, nobody will care about your P/L anyway.