48 Hours

You needn’t have worried, apparently.

US equities effectively relegated Monday’s fairly dramatic swoon to the dustbin of history in a matter of 48 short hours.

I’m compelled to quote myself. Or, actually, “compelled” isn’t the right word. I don’t need an excuse to quote myself. I’d do it regardless.

There’s no surer sign of narcissism than someone who quotes themselves habitually. The saving grace is that I pair an obsessive commitment to self-awareness with my narcissistic personality disorder. It’s an odd combination of traits, but if you’re unwilling to abandon deeply rooted arrogance, being committed to conscientiousness is a helpful offset. (If only I’d realized that prior to alienating the rest of humanity and burning every bridge I ever built. But it’s fine. I don’t like leaving the island anyway.)

When it comes to the market’s Pavlovian response to any and all selloffs, I’m fond of excerpting my previous missives explaining how “BTD” metamorphosed from a derisive meme about retail bagholders into a viable (indeed, a nearly infallible) trading “strategy.” To wit:

Investors became acutely aware of their own role in shaping the evolution of monetary policy — they learned that beyond a certain threshold, central banks would verbally intervene to reassure markets. Once investors knew to expect intervention (verbal or otherwise) at, say, 10% down on a major benchmark over a short window, it made little sense to wait on equities to fall 10%. If you know it’s coming down 10%, you buy down 7%. But if you suspect the next guy (or gal) has made the same calculation, you won’t wait around for him (or her) to buy down 7%. Rather, you’ll buy when stocks are down 5%. Everyone is front-running everyone else in an effort to front-run central banks. Before long, the entire exercise becomes so recursive and self-referential, that even the most minuscule of drops are immediately bought.

That’s where we are. And it was on full display this week.

As the simple figure (below) shows, market participants’ conditioning is strong. Old habits die hard, especially when they’re rewarded time and again. The frustrating part for anyone chagrined at such things is that indulging the habit helps ensure the behavior is rewarded. If enough people buy the dip, stocks recover, thus “validating” the strategy.

I often joke that eventually, we’ll be buying prospective dips. That’s a kind of brain-teaser. Mull it over for a minute and you’ll see what I mean.

When you consider the vol “smashes” (to use the Street’s highly scientific nomenclature) that often accompany rallies, and the extent to which positions are adjusted according to volatility, you can fully appreciate how ingrained this psychology invariably becomes. If the dip-buying is accompanied by vol compression, systematic exposure is toggled higher, creating another bid for risk. And around we go, until the Jenga tower becomes unstable again.

“To the point on the behavior since the systematic selling triggers turned, if one looks back to last Friday’s trade, that late +1% squeeze into the close off the lows to pare the loss in SPX to something far less sinister (at least from a mechanical $ deleveraging perspective for Vol Control), followed by [Tuesday’s] grinding one-way trade higher has again dictated a monster compression of Vol thereafter, because there simply hasn’t been any follow-through to the selloff,” Nomura’s Charlie McElligott said.

Small-caps outperformed handily on Wednesday. The Russell topped big-cap tech for a second day and was higher on the week by nearly 4%.

Note that small-caps had fallen into correction territory. If you assumed the reflation trade was dead, you might have figured an outright bear market for the Russell was the next logical stop. Now, at least some manifestations of reflation appear resurrected, even as news around the spread of the Delta variant and “breakthrough” cases gets more inauspicious by the day.

In rates, yields were cheaper Wednesday, providing a bit of respite from the relentless flattener. The 10-year was back near 1.30%. A tailing 20-year sale meant bonds held losses, but it wasn’t the proximate cause. The risk-on mood in equities weighed and more generally, there’s a sense that positioning “just has” to be cleaner by now, leaving less dry kindling to fuel the well-documented squeeze. More simply: If yields are going to keep falling, they’ll need a macro catalyst.

“The roughly 10bps round trip in the 10-year yield reinforces the notion that the bullish price action will need further fundamental justification to proceed,” BMO’s Ian Lyngen and Ben Jeffery remarked. “This is unlikely to come before next week’s Fed meeting and any hints the recent Delta variant repricing has altered the FOMC’s stance,” they added, expressing doubt that “the mounting headwinds will be sufficient to derail the market’s collective tapering expectations” even if “pushing off the liftoff rate-hike timing is certainly consistent with a longer path out of the pandemic and, frankly, already priced in at this stage.”

Meanwhile, Bloomberg reported that Jerome Powell “enjoys broad support for his renomination among top White House advisers.” Continuity is usually a good thing, while the opposite (i.e., the perception of chaos) is usually bad. Just ask Turkey. The same linked article cited a pair of sources in noting that “White House officials have not yet spoken to Biden about a potential Powell renomination or replacement.”

Of course, we all know who’s really going to make the decision. Asked last week whether she’d recommend Powell for a second term, Janet Yellen told CNBC “That’s a discussion I’m going to have with the president.” She could have just as easily reversed the wording: “That’s a discussion the president is going to be having with me.”