Between rising yields, record coronavirus fatalities in the US, and the prospect of a double-dip downturn for western economies, there’s plenty to fret about if hand-wringing is your thing.
It doesn’t help that US stocks are trading at some of the most extreme valuations since the dot-com bubble. Neither is it particularly comforting that swelling US hospitalizations are forcing state and local officials to institute new lockdown measures and reinstate restrictions on business activity and mobility.
However, balancing that out are multiple vaccines, the promise of stable US politics, and a Fed that’s determined to keep financial conditions as loose as possible. Pick a side. And remember that the incoming Treasury Secretary is Janet Yellen, who presided over the short vol bubble (figure below).
If you ask Nomura’s Charlie McElligott, “it’s going to be a challenge to see the market experience a ‘real’ near-term pull-back, at least until after December Op-Ex.”
McElligott doesn’t lean entirely on the myriad risk-on narratives noted above to make the case, although he does mention some of them. “We have a lot of ‘pinning’ flows,” he wrote Thursday, noting “peak ‘long Gamma vs spot'” at current levels. That, of course, means dealer hedging will tend to insulate the market from large swings.
On top of that, don’t forget about the lagging, mechanical “buy” impulse from the vol-control universe as realized grinds lower. This is a substantial upside catalyst, and McElligott put some numbers to it on Thursday.
“The lagging-but-substantial re-leveraging flows from systematic ‘Vol Control’ strategies upping their Equities exposure in VWAP ‘latent-bid’ fashion is kicking in harder now,” he said, noting that on the bank’s model, vol-control added $7.5 billion in S&P futures on Wednesday (right pane above). That would bring the total to nearly $14 billion on Nomura’s estimates over the past two weeks. Note that one-month realized is now back through three-month (figure below).
Obviously, the risks are myriad, and Charlie raises the specter of “big moves and macro shocks” in January, which will become more precarious if stocks do, in fact, continue to climb into year-end.
It should be noted that McElligott, covering every base, flags the potential for an upside exposure grab (e.g., retail investors going “YOLO” again) to get out of control as it did in August, leading to the dangerous “spot up, vol up” conjuncture that can presage trouble. But the gist of his analysis on that score is that we aren’t quite there — yet.
In the (very) near-term, the flow catalysts mentioned above should be considered with, as McElligott recaps, “bullish pro-cyclical 25 year seasonality… which goes hand-in-hand with extreme ‘risk-on’ Real $ fund flows, ‘vaccine reflation,’ the accelerated lame duck $900 billion December stimulus pro-cyclical macro narrative catalyst, and heightened dovish expectations for both the ECB and Fed at the December meetings.”
It goes without saying that given those heightened expectations for the Fed, any failure to at least strongly telegraph WAM extension could contribute to the recent rise in yields, thereby tightening financial conditions. By now, I think it’s fair to say the market expects an actual announcement on WAM extension.
Given that, failure to deliver and then a communications faux pas at the post-FOMC press conference could be bad news. But Jerome Powell long ago learned what not to say. And even if he hasn’t quite mastered what to say, he’ll soon have a Treasury Secretary that knows precisely how to talk to markets.
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