Nomura Warns, Emerging Market “Butterflies Are Flapping Their Wings”

While The Fed has shifted from QE to QT and a policy of broad “financial conditions tightening” has been driving the “rolling volatility events” of 2018 – with the potential for a “hawkish hike” next week causing more agitation – Nomura’s Charlie Mcelligott notes that currently the most acute stress is seen in illiquid EM (long- and carry- unwind), with the daisy-chain moving from Argentina and Turkey to Brazil yesterday and now, more “indiscriminately” across the spectrum “spilling over” into a mini-equities quant unwind.

As discussed numerous times previously by Mcelligott, a multi-year low in UST  term-premium reversed and broke higher in the days immediately following the first-passage of US tax reform back in early Dec ’17 – as the market determined that “visibility” on the path of interest rates was effectively “shocked lower” meaning interest rate volatility HIGHER going-forward – as we added massive fiscal stimulus into an already “hot” economy so late in the cycle.

As interest rates were the vehicle by-which the Fed dictated the post-crisis response (ZIRP and LSAP / QE) in order to drive financial asset inflation and create a “wealth effect,” disruption to the former “rates suppression” regime would inevitably lead to higher cross-asset volatilities… and that it did.

Within the next two weeks / by mid-Dec ‘17 , S&P 500 12m fwd EPS peaked and rolled; cryptocurrencies peaked and were hammered thereafter; from mid-January to start February, we saw the MOVE index of swaption implied interest rate vol nearly double in less than a month; thereafter, we experienced the leveraged “short vol” ETN termination event of Feb 5th; and more recently, we’ve seen “liquidity events” across the Credit and Fixed-Income spectrum, from liquidation spasms in BTPs last week (Italy just paid more than Greece to borrow 183 day bills, btw) to even “the most liquid security in the world,” as experienced by USTs last Tuesday and again yesterday (“Flash Rallies”).

[ZH: And yesterday’s chaos in Treasuries suggests the liquidity is very much missing…

“What happened yesterday was alarming, and further underscores for me how ephemeral the nominal liquidity is becoming…” — RJ O’Brien’s John Brady, on Thursday’s treasury squeeze.]

However, the “constant” has been Emerging Market stress.  EM “vol events” are a “fact of nature” in Fed tightening cycles.  One month ago it was Argentina, then Turkey (both ongoing)…most recently yesterday, the failed interventions in Brazil escalated the already precarious state-of-affairs within the country, while this morning it seems the EM selling has become more indiscriminate, with ZAR, INR, PLN, RUB, KRW, MXN, HUF showing the “bleed.”  This is classic carry-trade unwind, with massive inflows over the prior multi-year “suppressed vol” regime finding very “skinny exits” on the way out.

But as some might look at these cross-asset events as “idiosyncratic,” therein lies the risk.  Yesterday within the relatively “liquid” U.S. equities space, we saw enormous pain under the hood on widespread reversals across recent thematic trends, factor behavior and popular positioning. 

Is it possible that some of this “butterfly flapping its wings” distress in formerly ultra-crowded Emerging Markets could be “spilling-over”—say at a Multi-Strat fund—into  more liquid strategies like Equities Quant?  Without question the stress is nowhere close to the level seen during the most-famous example of this occurring back in Aug ’07, but the “tremors” and flow-through are definitely reminiscent.  

We saw large multiple SD / Z-Score reversals in Momentum-, Value-, Growth-, Quality-, Beta-, Up / Down EPS Revision-, R&D / EV-, R&D / Sales-, Cash / Assets- and Commodities- factors across U.S. Equities yesterday.  The simplest expression of this was the multi-year high flyer “Tech” sector as the worst performer in the S&P, while “Energy” was best; “Semis” and “Software” were hit, crowded shorts in “Consumer” and “Media” and bond-proxy “Defensives” squeezed; “Biotech” and “Medtech” were hit hard, while “Generics” and “HC REITS” were higher; Energy “pairs” screamed “unwind” etc.  

So even though the SPX tape was ‘unch,’ the violence being felt on the buyside was powerful.


BOTTOM LINE—it looked like a quant “gross-down” event, potentially “triggered” by the EM stress “spill-over.”

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