Nomura’s Charlie McElligott wasn’t surprised.
“Who woulda thunk it?!”, he asked, rhetorically, as risk assets shuddered amid Evergrande contagion fears.
The implied “I told you so” from McElligott was more about his persistent warnings on a post-OpEx “window for movement” than it was about China risk. Throw in the possibility that the long shadow of the September Fed meeting could keep the vol-sellers at bay until the dot plot event risk passes, and you had a recipe for an accident.
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“The post-options expiration ‘gamma unclench’ and ‘vol expansion window’ allows for movement in US Equities via a vol market which has been pricing outright ‘crash’ metrics for months in conjunction with significant de-risking flow potential from negative convexity vol-sensitives into this week’s FOMC event-risk,” Charlie wrote Monday, noting that this comes “during a poor weekly seasonal slice for global Equities” and now has “a macro scare catalyst” kicker in the Evergrande drama.
Markets are now operating without the gamma insulation that can serve as another source of effective dip-buying. Spot was through the dreaded negative gamma “flip” level on Monday morning, McElligott said.
One potential stumbling block over the next three sessions is that vol-sellers may wait out the new dots and Jerome Powell’s presser, as opposed to indulging the instinctual temptation to immediately reengage. That’s a problem.
“Now, you’re in that very tricky spot where what has been historically low realized vols reset closer to what has been outright ‘crashy’ implied vols, risk[ing] the mechanical de-allocating / de-grossing flows,” Charlie went on to say.
For that to play out, the messiness (for lack of a less colloquial term) would need to persist long enough to pull up trailing realized, thereby putting loaded vol control exposure in play, where “in play” means at risk of being mechanically deleveraged.
“Vol Control becomes a marginal seller now on ~50bps daily change days unless we see daily ‘unch’ in SPX sustained over the forward one-week period,” McElligott wrote Monday.
Again, this hinges on the magnitude of daily swings, which is why the post-OpEx “unclench” is even more important than usual. With vol control having accumulated equity exposure during a prolonged period of low realized vol (figure below), large swings in spot could dictate what Charlie described as a “shock de-accumulation.” The loss of the gamma “pin” makes large swings more likely.
There are a lot of “ifs” involved, so instead of presenting this as something to panic about, it’s probably better (from the perspective of “regular” market participants anyway) to present it as a thought experiment, albeit a somewhat unnerving one, given that even the most dedicated, disciplined buy-and-holder, can’t totally ignore a harrowing drawdown.
“IF today’s current -1.5 to -2.0% holds,” it could entail somewhere between $15 billion to $40 billion of selling from vol control in the “coming days,” McElligott said, on the way to warning that if, for example, 1.5% daily changes in US equities were to be sustained for a week, the de-allocation could be nearly $75 billion.
That figure would rise in the event daily changes were even more pronounced. “2.5% daily changes for one week would be -$137.1 billion of de-allocation,” Charlie wrote.
I should reiterate: None of that is guaranteed. It’s all contingent, the situation is fluid and it comes in an environment where retail investors are predisposed to buying every dip. There’s still some $4.5 trillion in sideline cash sitting idle in money market funds.
To be clear: McElligott didn’t posit any doomsday scenarios. In fact, he went on to walk through a series of “constructive” points.
But the main takeaway on Monday was just that markets really do need to get through the next several sessions without tipping the Jenga tower or otherwise letting the mechanical deleveraging genie out of the bottle.
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