If US equities felt melt-up-ish to you midway through Monday’s bond market holiday, it wasn’t your imagination.
Recall that investors added downside hedges recently amid a bevy of ostensible left-tail risks, leaving the right-tail under-owned.
What does that mean, in layman’s terms? Well, it means that in the event the left-tail isn’t realized, the conditions are in place for a melt-up.
Downside hedges and/or long vol expressions are dead weight for the buyside in a “spot up, vol down” bullish tape. As that equity downside / VIX upside moves further out of the money, dealers can unwind their own hedges on the protection they’re short to clients. “It’s another iteration of the same message,” Nomura’s Charlie McElligott said Monday. “We push through risk events and downside hedges then bleed out, which means dealers buy back delta, helping implied (and realized) vol leak out premium.”
The figure on the left, below, shows you “what happens when the market’s over-hedged,” as Charlie put it. Specifically, the table shows forward returns for equities after skew and one-month ATM implied steepen / widen. The message: Stocks rally on the dynamics mentioned above (in the absence of shocks sufficient to help the left-tail realize / manifest).
The figure on the right shows you the real-time “under-capture,” as it were, which McElligott noted is actually even worse than those beta studies indicate given the aforementioned dead-weight downside some of these discretionary funds are sitting with.
What do you do if that’s you — i.e., if you’re under-capturing? You grab and chase. “Just get me in,” so to speak. Between that, the hedge unwinds and the read-across for systematics of an in-trend market and subsiding vol, you get that palpable, familiar “lift,” helped along, as is so often the case, by new records for Nvidia.
At the same time, the leveraged ETF space and the ever-expanding premium income product universe are piling on from a flows perspective, with the former doing its EOD re-balance thing, and the latter experiencing what, by now, is a familiar stop-in dynamic as spot moves up through the short strikes on those funds’ rolling calls.
The leveraged ETF EOD rebalances are coming on record AUM (charts on the left, above) and the market’s learned to front-run the call roll on the overwriter fund resets (figure on the right).
Charlie summed it up: “Modern market structure phenomena are amplifying the escape velocity of the move and setting the table for more buying / demand flow going forward.”
