“The virtuous cycle that is collapsing index realized vol. is acting as a position re-leveraging/buy signal across systematic strategies”, Nomura’s Charlie McElligott writes, in a Friday note.
One should be able to immediately tell the rest of the story without having to read another word. As short-term, trailing realized moves lower, it triggers mechanical re-leveraging from key systematic investor cohorts, which acts as an ongoing short covering/buy flow.
McElligott notes that implied vol. is still “relatively sticky”, and it’s hardly a mystery why. Every which way you look, there’s something to fret about, whether it’s Sino-US tensions, virus flare-ups, or the distinct possibility that Donald Trump (ostensibly the “market-friendly” candidate, although I would quibble with that characterization) may have a tough go of it in November.
“But Vol too has stayed ‘up here’ at least partially due to my view that there is not a lot of discretionary/fundamental buy-side willingness (risk-capacity) to short it”, McElligott goes on to say.
While humans may be prone to getting rattled by the psychological overhang of knowing they’re navigating a minefield, systematic strats are simply re-leveraging apace, as trailing realized volatility declines.
This is the “volatility as the exposure toggle” dynamic that McElligott so often uses to discuss his world view (see “We’re All Momentum Traders Now“).
“It is critically important that short-term trailing REALIZED vol is really starting to decline sharply almost under its own prior weight, i.e. SPX 60d realized from 65 on May 18th to the current 28”, he writes.
When you think about volatility as an “exposure toggle”, remember what that actually means, mechanically. As Charlie puts it, “the size of each position is set to be inversely proportional to the security’s volatility input”.
Since the extreme “short” seen in early March on Nomura’s CTA model, net buying has approximated $380 billion in global equities futures, although as you can see in the figure (below), that just takes things back to “neutral”, effectively.
(Nomura, BBG)
Meanwhile, the vol.-control universe continues to act as an incremental source of equity demand, mechanically re-leveraging from levels best described as “nothing left to sell”.
“This matters when discussing ‘incremental buyers’ who are unemotional and take no explicit view on COVID case-growth, versus many discretionary traders who are rationally struggling with the fundamental backdrop and outstanding risks to sentiment”, McElligott remarks.
Note that’s more than $5 billion in added allocation over the past week, $19 billion of buying over the past two weeks, and some $39 billion over the past month.
Potentially, there’s much further to run on that source of re-risking assuming we don’t get another dramatic macro shock that starts to drive up volatility in a sustainable way. Target-vol.’s allocation sits in just the 6.4%ile, on Nomura’s estimates.
And speaking of positioning and room for things to shift, McElligott says that with rising case totals in “hotspot” US states perhaps losing a bit of their ability to shock the market by virtue of overexposure in the media (i.e., it’s not that it isn’t important, it’s just that there are only so many times people can read the same headlines, let alone trade them), there is considerable scope for a risk-on tilt. I’ll leave you with one last excerpt in that regard:
So with these “flow” and “macro narrative” catalysts, the final input is positioning: the Nomura QIS CTA model shows just earlier this week that the “Bonds” exposure is 98th %ile since 2011 (and predominately “long”), while “Equities” are just 18th %ile (and predominately “short”)–ripe for some unwind, some of which we’ve obviously already begun to feel in markets this week, with Spooz now+166 handles from lows, UST 10Y yields +8bps cheaper and UX1 down 7vols!
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