When Your Risk-Free Asset Turns On You

Investors were once again “treated” to a rates-inspired tech selloff Tuesday, a fairly regular occurrence.

The amount of duration embedded in the market is enormous, but because “everyday” investors don’t generally understand the concept, sharp pullbacks in secular growth darlings (e.g., mega-cap tech) seem to come out of nowhere, leaving some (too many) folks perplexed.

To reiterate: These moves and the accompanying factor volatility are almost completely explainable by reference to what’s happening in rates. The surge in crude gave the whole thing an extra kicker early this week, turbocharging the value/cyclical outperformance that would have transpired anyway given the bear steepener.

Read more: Oil And Bonds!

“This UST / Rates beatdown is ‘knocking-on’ and causing factor rebalancing pain inside US Equities for crowded ‘duration proxy’ Tech / Secular Growth longs, versus big rallies in ‘economically sensitive’ Cyclical Values, which for many have gone underweighted / short again,” Nomura’s Charlie McElligott said Tuesday morning.

The dynamic isn’t difficult to visualize, that’s for sure. Pick a proxy, any proxy (figure below).

As long as yields keep rising, that dynamic will likely persist. The problem, as ever, is that outperformance doesn’t necessarily entail making money. So, you’re better shielded in value shares and cyclicals, but not immune.

Hedging may be exacerbating moves in Treasurys. Morgan Stanley called the belly “particularly vulnerable, given the convergence of Fed hawkishness and mortgage durations.” The bank recommended a short in 10-year notes and five-year TIPS.

“TY has fallen for six consecutive sessions, while overall fresh local lows across UST futs through large OI strikes / new highs in yields typically means dealer ‘short gamma’ hedging, as well as the increased risk of incremental convexity sellers adding to pressure,” McElligott said.

“The threat of convexity hedging has exacerbated moves as rate hike premium continues to filter into the curve after last week’s FOMC,” Bloomberg’s Edward Bolingbroke remarked, weighing in.

Note that it’s not correct to say the move in yields comes “despite” the selloff in stocks. The key point (and this brings us full circle) is that the selloff in stocks was the direct result of what was happening in rates.

This recalls number eight from a list of “25 Sayings On Vol And Risk” published here over the summer. “For different reasons, if interest rates either fall or rise very quickly, the outcome is bad for risk assets,” Macro Risk Advisors’ Dean Curnutt said in July, adding that,

In the first, a shock has compelled a flight to safety and a duration rally. In the second, like the 2013 Taper Tantrum, the risk-free asset is itself the sponsor of the event, forcing equity markets to reconsider assumptions used to discount cash flows and sometimes creating a VaR shock.

The latter dynamic is what market participants experienced on Monday and, more dramatically, on Tuesday. Incidentally, it’s also why folks are increasingly prone to looking elsewhere when it comes to hedging equity portfolios. If you can’t rely on bonds, you have to find something else, and that search is probably contributing to the supply/demand imbalance in the vol complex.

Note that this is all exacerbated materially by the weight of the mega-tech names at the index level (figure below).

That, in turn, has ramifications for hedging (in equities), and thereby for what mechanical flows are pushing and pulling on spot throughout a given session.

“Being that Tech / Secular Growth is such a substantial part of S&P weighting, the consolidated SPX / SPY options positioning data is now showing an increasingly grim profile too with this move in spot,” McElligott said.

On Monday, dealers were “clinging ‘moderately long / neutral’ Gamma, but as of today, we are now in a slight ‘short Gamma vs spot’ territory,” he added.