Scary Stories

Thank god for the flattener.

Monday’s action in rates breathed life into what might have otherwise been a somewhat tedious session for macro watchers, who can’t make it through the day without a narrative to latch onto.

In that regard, the bear flattening impulse was a godsend. It opens the door to “policy mistake” banter and, relatedly, creates a “growth scare” optic. The US 5s30s tightened inside 85bps, the flattest since April 2020 (figure below).

We’ve seen this movie before. Back in June, the Fed’s hawkish lean collided with the onset of the Delta wave in Western economies to create a similar optic. This time, though, it’s primarily about tightening and the eventual read-through for growth as momentum wanes (i.e., policymakers exacerbating a slowdown), whereas in June, some feared an imminent, outright downturn tied to new virus containment efforts.

The evolution of the BOE’s (now overtly) hawkish lean alongside hot inflation data out of New Zealand were the catalysts Monday. China’s underwhelming growth numbers didn’t help.

There’s a perception of policy panic, and that’s feeding concerns about a possible overcorrection — an about-face that finds central banks prioritizing the inflation fight versus prioritizing growth and maximum employment, which was the mantra a scant six months ago.

As for equities, I outlined the risks in “‘Bad-flation’.” The good news is, positioning is cleaner. I’ve been over this before, but just to recapitulate, September’s swoon helped uncock extremely loaded systematic exposure. Now, with realized vol back on the wane, purged exposure can be rebuilt.

“As rVol softens, systematic strategies are able to mechanically re-allocate on a lagged-basis, while simultaneously, the reversal in spot sees CTA Trend forced to cover nascent shorts and begin to re-lever long exposures,” Nomura’s Charlie McElligott said Monday. The simple figure (below) is just 10-day realized with Charlie’s annotations.

Nomura’s models suggest the market is back trading in long gamma territory vis-à-vis dealer hedging, meaning stocks should be at least somewhat insulated from large swings, barring an exogenous shock or other catalyst that sends spot careening through key strikes and triggers.

“As implied resets lower, [it] incentivizes hedge monetization and the resumption of short vol flows which creates Delta to buy and gets dealers back into market stabilizing ‘long Gamma’ (and ‘long Delta’) position, as options are again sold from Overwriters / Strangle Sellers etc,” McElligott went on to say.

Ultimately, the conditions are in place for the virtuous feedback loops to reestablish themselves in equities. Again, assuming no shock-down catalysts.

Do note, in the context of the renewed obsession with “policy mistakes” and “growth scares,” that narratives can be self-fulfilling. In extreme cases, they can morph into macro shocks.