What a difference five weeks makes.
The one-two-three punch of a conciliatory nod to the term premium in last month’s Treasury refunding (i.e., smaller-than-expected coupon increases), softer US macro data (e.g., the last jobs report and CPI) and Chris Waller’s sea change moment (i.e., de facto confirmation that the Fed will consider insurance cuts in the first half of 2024 assuming inflation continues to recede) prompted an astounding about-face across assets last month.
When the dust settled, “everything rally, 2023 edition” stood as one of the most uniformly fortuitous turns in recent memory.
“I’d call it a ‘rolling capitulation’ out of the ‘old regime’ macro trend trades due to narrative-shift catalysts aligning,” Nomura’s Charlie McElligott said Friday. “It should go without saying that much of the market’s flow story [in] recent weeks has been driven by the systematic space.”
It’s important that market participants understand the extent to which those flows can be decisive. Indelicately: Some top-down fundamental equity strategists lounging in research departments around the Street tend to ignore systematics on the tacit excuse it’s not their purview. That’s a bad idea.
“The past month’s estimated notional flows out of the CTA trend / managed futures space perfectly replicated this legacy positioning unwind theme,” McElligott wrote, calling bonds and STIRS a “one-way buy-to-cover.” On Nomura’s estimates, that buy flow exceeded $100 billion in bonds and nearly $40 billion in STIRS.
Of course, that’s meaningful for equities: The proximate cause of stocks’ consternation from August through October was bearish/hawkish rates. Charlie called the squeeze for equity index futures shorts “brutal.” CTAs flipped back to “outright long,” he said, estimating the buying at nearly $56 billion over the past month.
At the same time, the relentless grind lower for realized vol triggered some $46 billion in mechanical equity buying from vol-control cohorts over just the past two weeks, again according to Nomura’s estimates.
You could argue (I suppose) that impressive as those notionals sound, estimating systematic flows isn’t an exact science and is anyway far less important than getting the big-picture fundamental narrative right. The problem with that is twofold.
First, too many top-down equity strategists harbor an excessively (and ironically) narrow view of what counts as the “big-picture fundamental narrative.” There’s more to it than plugging in an estimate for index-level aggregate EPS and filling in all the other blanks with the economics team’s year-ahead macro predictions (which’ll all be wrong) and a 10-year yield forecast (which’ll be wrong too).
Second, the risk of getting caught woefully offside seems to be growing as time goes on. Late last month, for example, a couple of big-name bears on the research side cited a humdrum list of familiar talking points in suggesting a Santa rally was unlikely. (“Look at you now!” to quote Al Pacino’s most famous character.)
McElligott, by contrast, said the following on October 30:
If this “more bills, less coupon” Treasury [refunding] scenario were to play out, the setup is then rationally for a tactical duration rally / dollar lower dynamic, which would likely lead to an equities relief rally, as [financial conditions] ease. The concern here is that we have exhausted selling, both systematic and fundamental, while downside hedges are deep in the money and hence at risk of being taken-down and monetized, which could set off some ‘reversal flow.’ That’s the vicious feedback loop for a rally. Funds both active and systematic [could] become the dreaded ‘buyers higher‘ and have to add back exposure the more we rally.
With hindsight, that October 30 note (particularly if read in its entirety) looks almost comically prescient.
For what it’s worth (which was theoretically a lot to anyone who took the time to internalize the message), I wrote the following in these pages on the same day:
So, where to from here? Well, anytime you get a positioning purge or even just a broad-based de-risking, any subsequent rally hurts because everyone’s underexposed. Positioning could be cut further, the bond selloff could escalate, the data could turn decisively such that bad news is too bad to be “good” and on and on. You know the left-tail risks. But, as we’re reminded whenever there’s a melt-up, right-tail risk is often underappreciated.
Two days later, one of the most spectacular “everything” rallies in recent memory (i.e., an epic right-tail event) commenced.