“Do not dismiss what the Fed and other central banks are in the process of doing”, Nomura’s Charlie McElligott wrote Tuesday, a day when global stocks staged a massive rally thanks to the combination of fiscal stimulus hopes and, of course, the promise that monetary policymakers will backstop everything by keeping the liquidity spigots wide open, gorging themselves on a hodgepodge of assets and accepting anything that can be even loosely described as “investment grade” as collateral for cheap term loans.
The Fed is “not just acting as liquidity-, short-term lending- and USD funding-provider of last resort, but also now as the ‘chief risk-taker and CIO'”, McElligott goes on to say, adding that as of Monday, the Fed resumed building a ‘short volatility’ position”.
Some readers may recognize the reference. Back in January of 2018, transcripts from the Fed’s 2012 meetings were released, giving investors a chance to get a read on what incoming Fed chair Powell thought about the evolution of the central bank’s extraordinary measures taken in the aftermath of the financial crisis.
Two excerpts from those transcripts stuck out and quickly made the media (and blog) rounds. The following is from the transcript of the October 23-24, 2012 meeting which found Powell expressing reservations about the extent to which the Fed was encouraging risk-taking:
Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think. Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.
There’s a lot of nuance there in terms of what Powell was technically saying about the mechanical effect of the Fed’s MBS purchases (i.e., absorbing prepayment risk), and back when those transcripts were first published in 2018, a number of bloggers (wittingly or unwittingly) suggested Powell was somehow saying the Fed was literally knee-deep in short-VIX ETNs.
But without getting too far into the weeds, suffice to say those excerpts are now very relevant in light of Monday’s latest “bazooka”.
“Fast forward to now, where we actually see the Fed in the game of not simply suppressing the risk-free rate, and thus term premium, as they did last time, but now buying spread product (beyond MBS alone) with risk assets outright and through the new SPV, it’s reasonable to believe that investors will ‘reverse engineer’ the Jay Powell playbook noted above, and go with their muscle memory from [the] Fed ‘short volatility positioning’ prior conditioning”, Nomura’s McElligott goes on to say.
As a kind of segue, consider this summary of Friday/Monday from Bloomberg’s Luke Kawa:
The S&P 500 [fell] more than 7% over [those two] sessions while the VIX tumbled by more than 10 points. Before this, there had never been a combination of a two-day equity drop of at least 5% and a VIX retreat of at least 5 points. The dual declines could be a function of a market normalizing after high-profile blowups of short volatility bets, less demand to roll hedges after a major option expiry, or simple exhaustion
Later in his Monday missive, McElligott highlights what he describes as a “breathtaking collapse in 1m ATM Vols over the past two-and-a-half sessions”:
This is all on the heels of last week’s “peak panic”, a harrowing stretch which was clearly made worse by rolling stop-outs that turbocharged the vol. spike, McElligott writes, adding that “Monday’s crush in the VIX space” alongside a multi-standard deviation decline in vol-of-vol thanks to the Fed effectively removing the left-tail (or so Powell hopes), “was about the gradually-slowing ‘stop-outs’ of those caught short gamma over the past few weeks”.
He elaborates a bit, noting that Monday’s “jarring VIX/SPX term-structure selloff was about the unwinding of ‘long vol’ winners, particularly as expressed with the enormous profit-taking in TVIX”, the 2x leveraged long VIX ETN.
Here are some granulars from Charlie:
We estimate TVIX alone had nearly 24k UX1 (VIX futures) to sell upon rebalancing yesterday, UVXY had ~1200 for sale; SVXY ~2200; and VXX ~3100—for a total sale of ~30,500 UX1 (VIX futures) across these various VIX-products yesterday!
Stepping out of this nightmarish space (i.e., out of the retail VIX product world, where sanity goes to die and former Target managers went to make millions before being summarily wiped out on one horrific afternoon two Februarys ago), the broader read-through for the comparatively sane world of programmatic/systematic investors is that if vol. can manage to normalize, those strats can begin to rebuild their exposure.
Again, that’s assuming a sustained normalization, which reverses the dynamics that led to the worst VaR shock (at least) since Lehman.
“Ultimately, this will create a lagging RE-leveraging from those systematic investors who, over the past two months, were forced to de-lever after the realized vol spike blew though their price-signal and exposure triggers”, McElligott says, underscoring the point.
All of this with lawmakers on Capitol Hill set to pass a third (and this time massive) virus bailout package, and the Germans moving to abandon their almost pathological disdain for borrowing/spending in favor of saving lives and the economy.
The DAX surged a ridiculous 11% on Tuesday.
Meanwhile, under the hood stateside, a massive short squeeze appeared to be underway as some of the most unloved names surged.
“The Quantity-On-Loan, of the SPY US Equity ETF… shows that this short interest proxy had increased steeply over the course of the past four weeks, exceeding its previous high in December 2018”, JPMorgan’s Nikolaos Panigirtzoglou said, in a Monday note.
“This indicator appears to have peaked and is now declining, pointing to early signs of short covering”, Panigirtzoglou went on to write, adding that “there are even bigger shorts to be covered in stocks outside equity ETFs”.