Is Modern Market Structure Ready For A Macro Regime Shift?

On several fronts, one could argue that uncertainty has diminished materially over the last few months.

Notwithstanding the notion that achieving herd immunity is now seen as unlikely and despite some Americans’ irrational aversion to inoculation, the US vaccination push went surprisingly well. The biggest wild card of them all (Donald Trump) was removed from the equation, even as House GOPers seem incapable of escaping his gravitational pull. Irrespective of your partisan affiliation, it’s impossible to argue that 1600 Penn. isn’t more stable now than it was when it was modeled on Survivor.

And yet, there’s still a very real sense in which the steady grind higher in equities is set against a backdrop of heightened uncertainty characterized by frightening narratives around surging inflation, higher taxes and what’s been called an “unprecedented” macro environment.

That perhaps helps explain what Nomura’s Charlie McElligott on Thursday described as “unbelievably consensual anticipation of a downside move” as manifested in extreme readings on SPX Put Skew, VVIX/VIX and Put/Call signals, juxtaposed with depressed realized vol.

“The past few days have finally begun the ‘trueing up,'” he said, noting that regressions of UX1 versus the S&P “show the ‘catch up’ is finally occurring after the prior lag.”

The vol control universe — which has done its patriotic duty lately by serving as a “background” bid for equities — is now likely shedding some exposure as realized vol ticks higher (figure below).

Specifically, Nomura’s model showed some $9 billion in selling on Wednesday and almost $14 billion over the past week.

Meanwhile, CTAs are piling on. The bank’s estimates suggest “large deleveraging from prior legacy” max long signals across US small-caps, tech and Japanese equities, as well as Hong Kong shares. The signals are now roughly neutral.

All told, Nomura estimated almost $33 billion in aggregate selling over the past week from CTAs (figure above).

Finally, McElligott again flagged the “accelerant flows,” as dealers are in short gamma territory, suggesting “more spastic ‘crash down’/ ‘squeeze up'” action, as hedging amplifies directional moves. The situation for tech is particularly extreme (figures, below, from Nomura).

What does all of this entail going forward? Well, the takeaway (locally) is that more harrowing oscillations between “crash up” and “crash down” days are possible.

Market participants are jittery around the prospect of an inflation overshoot prompting a sudden Fed rethink. This week’s scorching CPI data was billed as a potential turning point.

Since the election, the discussion has revolved around the idea of a macro regime shift. Q1’s bond rout and what counted as “consistent” outperformance from longtime pro-cyclical laggards (at the expense of perennial “slow-flation” regime winners) ostensibly represented the market anticipating the shift.

But anticipatory rotations predicated on what I think it’s fair to call a “best case scenario” spin on the “new” US economy are something different from staring down the realization of an inflation cycle and an economy that actually runs hot for a sustained period with implications for monetary policy.

It’s by no means clear that the market is prepared for that, not just from a simplistic “Can value take the baton?/Can the market move higher with the tech titans as laggards?” perspective, but (far) more critically, from a modern market structure perspective.

With that in mind, I’ll leave you with a few excerpts from McElligott’s “annual reminder” of how we got to where we are, and why the brave new run-it-hot world could trigger rolling “blasts” of volatility, as he put it Thursday (below, from McElligott).

Since the “big” crisis of 2008, as the perceived “core” Central Bank mandate has become maintenance of easy “financial conditions” in order to generate wealth-effect at all costs (higher 401k’s, trading accounts, home values = consumer confidence and spending “virtuous” feedback loop), this in-turn conditioned investor behavior into strategies which benefitted from the “Fed Put”—as such, the birth of the “Short Vol” era.

The persistence of Central Bank interventions at the faintest hint of market duress then facilitated enormous popularity of VRP / momentum / trend / carry –strategies, both active and passive / systematic, deployed with low-cost leverage (thanks to the aforementioned “financial repression”), and one where risk is managed by “normal distribution” / linear VaR, creating now what is a broad market structure with deeply embedded “Negative Convexity” / “Short Gamma,” via Vol Control / Target Vol / VaR risk management, Risk Parity / CTA Trend strategies and Options Dealer Desk “Gamma” hedging as examples of primary inputs.

In a world of constant “Short Vol” regime based-upon low nominal interest rates / flat curves—which meant that strats of “Duration Sensitives + Risk” posted the best (linear- and backward looking) Sharpe Ratios, these trending legacy positions “worked” and the feedback loop then fed that further, with more $ allocated / exposure added through leverage.

But when the macro regime changes to something which risks a reversal in interest rates (gasp!—bear steepening) and lower-visibility on the future path of interest rates at the very least—i.e. this current “tail” scenario of an inflation overshoot from base-effect + pent-up demand release via renormalization + supply-chain bottle-necks, all hyper stimulated from fiscal policy—you’re now combustible for brief but violent deleveraging & momentum shocks.