Nomura’s Charlie McElligott sees the chances of a meaningful bounce in US stocks (on month-end pension rebalancing flows as well as some sentiment-shifters overnight), but warns that should we fall just a little lower, CTAs will be triggered to “delever” and markets will flush 10-15% lower from here…
McElligott first looks at the state of play…
UST yield curves have now pivoted toward a clear “bull-steepening” on the week, as Fed action SOONER and LARGER is now “assumed” by market into this Coronavirus / Sanders “growth-scare” (an April cut is now 70% and June is 1.2 cuts), following the largest cumulative 3d deterioration of US financial conditions since the Dec ’18 Fed QT panic.
Remember that during the “end-of-cycle slowdown” careening into “outright recession” panic of last year (thanks to the escalation of “trade war” fear), the Fed’s own research told us that despite a potential re-approach of the zero bound that when they DO cut into a recession fear, it will be BIG and FAST.
And the grab for the safety of “Duration” into this global growth scare saw both Asian and European “real money” investors continue to buy government bonds overnight, and even at these “rich” levels – which perversely drives greater risk of 1) accelerated convexity hedging and 2) buying from portfolios which continue getting “shorter” their Duration targets into month-end.
All of this said – and similar in-stance to my comments on VIX futures “stalling-out” overnight below – we are too seeing STIRs unable to rally further here this morning and in-fact, lower, with EDZ0 hitting resistance back at its peak last made Sep 4th, 2019 at the culmination of last Summer’s own “growth scare,” with selling / profit-taking in bullish plays in the options-space / selling outright ED$- and FF- futures in the European session.
Now too we see TY outright “down on the day” and accelerating lower alongside Bunds, following German Finance Minister Scholz’ stating that they plan on temporarily suspending the debt brake on local governments as the German economic slowdown strain grows.
S&P futures at one point were DOWN 70 from overnight highs before thereafter bouncing ~50 handles from the overnight lows on bursts of hedge monetizations (covering dynamically in Spooz shorts, but also as investors sell S&P weekly Puts back to Dealers—who are thus now “long” said Puts—which then forces Dealers to buy S&P futures, in-turn shock-absorbing the market), as well as risk-relief from both the German “austerity easing” news noted above (although “apparently” UNRELATED to Coronavirus is the claim), as well as the Chinese “mini-QE” announced for virus-hit SMEs.
Vol too is stalling-out finally (UX1 down on day after the earlier Spooz puke through 3100) despite the extreme VIX futures curve inversion (tells you that a good chunk of the systematic “roll down” or “short vol” flow is covered which should gradually see front-VIX future fade lower thereafter), which like almost any other “extreme fear / selloff” back-test tells you to “buy the dip” in stocks / “sell the rip” in vol
But what happens next? McElligott suggests two possibilities – short-term bounce or medium-term trounce…
Although I typically “fade” the pension month-end rebalancing stuff as “noise not signal,” I do believe that there is increased potential for this “Equities bot, USTs sold” rebalancing-flow over the next few days, simply in-light of the scale of the Feb moves / extreme MTD “performance spread” of SPX total return vs Agg total return (just 10th percentile since 2004—the more “extreme” it gets, the more “signal” there tends to be)
Nonetheless, there remain a number of headwinds to the stickiness of this “local” US Equities bounce which keep us “chopping,” largely due to the mechanical “lagging” deleveraging from the “vol trigger” / systematic community but also the incremental seller that is currently the massive Asset Manager “legacy long” in S&P futures:
Spot S&P remains deeply into “Short Gamma” territory, which despite the significantly smaller overall $Gamma (%ile rank), is a real flow that will continue to dictate that market makers by-and-large will be “selling into sell-offs” – PARTICULARLY as there remain some large downside tails which Dealers are SHORT but are increasingly becoming “real” / “in-play”
Similarly is the previously unthinkable possibility that the ridiculously “in-trend” positions for CTAs in S&P 500 futures are now “live” for deleveraging as well (after we noted that the Russell was going-to and DID in fact “crack” yesterday, in-line with our model) – just last Thursday, the deleveraging trigger per our Nomura QIS CTA model in the S&P 500 position was ~8.5% away from spot, and now as a snapshot in time (ref futs 3127 vs today’s “trigger” at ~3139), we would expect to see CTA deleveraging today on a close in Spooz below said 3139 level—which would see the legacy “ 100%” signal drop to just “ 15%” with very significant notional$ in S&P futures for sale (as the trade has been so “in-trend” for a year now on the Fed-pivot induced “vol suppression” environment, which meant more leverage deployed into this “winner”)
The issue is that the 3m lookback window now has “loading” (vs previously “just” 6m and 1y windows), and due to the extent of the extreme price deterioration in the past half-week, meaning that this window’s signal is likely to flip “short” tomorrow
Source: Nomura / QIS
As noted in recent days, our “Vol Targeting” implied rebalancing model has estimated selling of nearly $70B of S&P in the past 1w period, with the %ile “gross allocation” from 91st % allocation to 1m ago to today’s just 18th %ile gross notional exposure since 2010—this selling continues to passively execute in the market in coming days in standard “lagging” fashion on account of the “drag-up” in trailing realized vol above “trigger” levels.
And finally, the 100th %ile / $190B of Asset Manager “net $ long” in SPX futures certainly looks to be “the” incremental “sell-flow” after what had effectively been a year of continuous buying – we will know more when the CFTC data comes out Friday (bc it will capture both Mon and Tue of this week), but per our “ES Trade Imbalance” monitor for lot sizes 100-500 in futures, Tuesday was a “one-way” SALE flow for what we consider as the proxy for this participant-type
And finally, McElligott details where the ‘avalanche’ sell pivots are (once again highlighting that 3139 ‘deleveraging’ swing point in the S&P)
And as far as sensitivity to movements across asset classes:
So, BTFD for a short-term bounce but be ready to flush the pension-rebalancing flows stall and lows are revisited.