“Vol tends to collapse under its own weight,” Nomura’s Charlie McElligott wrote Tuesday, as US equities attempted to stabilize following a rocky start to payrolls week.
For months, well-documented imbalances in the vol complex manifested in extreme readings on various manifestations of “crash” which, when juxtaposed with a steady grind lower in realized vol, created an uncomfortable optic.
And it wasn’t just about optics. Subdued realized vol and associated mechanical exposure adds created a top-heavy dynamic in the vol control universe. As realized was pulled higher amid what counts as “tumult” in equities these days, a meaningful portion of that exposure was “cleansed” (to employ the euphemism), likely contributing to the selloff on down days and perhaps capping gains when stocks attempted a rebound.
On Tuesday, McElligott documented what he described as “‘real signs’ of constructive developments in equities,” where that means the above-mentioned extremes have come off the proverbial boil and otherwise shown signs of wanting to normalize.
Equity vol and skew “are now unable to outperform even in a substantial ‘spot-down’ environment like Monday,” he wrote, noting that S&P vol was flat and skew softened, even as the index logged another >1% daily decline.
Why does this matter? Well, it’s the same story detailed late last week in “How Equities Can Rally After September’s Selloff.” We need to reactivate the virtuous loop and it starts with an inability for vol to stay elevated.
“It’s going to be increasingly difficult for really high Vol and Skew to stay ‘up here’ without sustained selling and continued large daily changes being implied by VIX,” Charlie went on to say, adding that assuming spot doesn’t keep careening around, hither and thither, vol can reset lower. That reset, McElligott reminded folks, “has the tendency to ‘sling-shot’ the spot market recovery via a virtuous feedback loop [as] downside hedges are monetized [and] vanna support [is induced] as iVol softens and downside puts move further OTM.”
At the same time, the recent positioning cleanse means less demand for downside hedges, which helps alleviate some of that pervasive vol complex tension.
On Monday, I reiterated the absolute necessity of taking account of mechanical flows when attempting to make sense of price action. McElligott on Tuesday flagged persistent risks from accelerant flows, with dealer hedging chief among them.
“After [Monday’s] selloff in spot, the negative $Gamma and negative $Delta ranks are off the charts across major index- and ETF- options, which will make for ‘jumpy’ overshoot flows in either direction, lower or higher,” he said. (Have a look at the figures, below.)
One more time: You have be cognizant of the potential for these “amplifier” flows (i.e., selling begets selling or vice versa) to create exaggerated moves in spot which the financial media then attempts to explain after the fact by reference to incremental news flow that more often than not doesn’t “match up” with the scope of a given move.
Big-cap US tech is a sitting duck (for lack of a better way to describe the situation) in the event we can’t get back above the neutral line and the rates selloff decides to get disorderly.
“With [that] much negative Gamma [and] Dealers short a ton of downside there, [it] could get weird if the UST selloff were to further extend on say a big NFP print, or continued ‘right tail’ behavior in the Energy / tradable inflation complex,” Charlie added.
Remember, the recent selloff in rates was led by reals, which is highly undesirable for richly-valued equities but also just for risk assets in general (because higher reals and a stronger dollar exert a tightening impulse). But with calls for triple-digit crude now becoming more “norm” than “exception,” and with the global energy crisis risk now “realizing” right in front of us, inflation expectations could take the baton.
Meanwhile, CTA selling is a factor now too, or at least on Nomura’s models. “The QIS model estimated selling across a number of legacy ‘+100% long’ signals in equities positions,” Charlie said, noting that those flows come on the heels of the vol-control de-allocation discussed above (and ad nauseam here over the past two weeks).
But through it all, there are faint glimmers at the end of the tunnel. For example, consistent with (admittedly nascent) normalization in the vol complex, McElligott flagged “very modest signs of life” in upside expressions and structures.
One key takeaway for Charlie is that the (somewhat frightening) overhang from rates notwithstanding, “it sure feels like risk has tactically pivoted to the upside in equities.” He added a caveat: “For now.”
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