On Friday, RBC’s Charlie McElligott sent out a great summary of how “Markets Are Paralyzed With Uncertainty” as the “Spook Story” of spiking yield curves appears to have arrived seemingly out of nowhere, bringing with it the fear that an inflationary impulse may finally be coming, leading to the worst S&P selloff since Brexit.
Today, he provides a just a useful “big picture” update on a market that has been VaR shocked, and is urgenly waiting for more information from the aforementioned Lael Brainard speech due just after 1pm Eastern. As he puts it, “the standard (and now at least semi-annual) VaR-shock episode kinda / sorta continues, as mechanical deleveraging from the systematic quant community continues in equities and fixed-income markets, largely off of the recent reversal in the long –end of global rates and their curves—thus, we’re simply experiencing a re-positioning shift.“
The RBC strategist further notes that, as expected, “a few diff open-end risk-parity strategies I watch saw 3SD moves Friday, which is totally reasonable considering their holdings and leverage (one particular risk-parity fund’s holding list is a “who’s who” of beatdowns: long US 10Y note, Gilt fut, midterm euro-OAT, S&P eminis, gold futs, jpn 10y bond, euro-BTP future, Euro-Bund buture, Aust 10Y bond fut. Look at the comedy below which is the panic exodus from you EU fixed-income proxy mega-long, German Bund future.”
As an example of the dramatic unwind in flows, he points out the 5 sigma move in German 10Y bunds, which over the past 3 sessions have seen the largest move in at least 10 years.
That said, while futures dropped as low at 2,100 overnight, they were supported by the critical psychological support level, and have sharply rebounded since then in what has been a largely one-way morning session. As McElligott notes, “the pace of the declines has slowed meaningfully (or even outright reversed) from Friday’s “freefall,” but as we’ve experience during prior “forced selling” episodes, there are typically multiple days of said deleveraging flows involved in order to appropriately rebalance exposures. The other angle worth mentioning too is that per Friday’s flows and convos so far today, the fundamental active community did very little ‘moving’ to chase themselves into knots, which is a ‘good look’ being that Spooz have already bounced 25 handles off the earlier panic lows, which I’d say is a pure function of seeing negligible ‘follow-through’ / further selling in US rates today (although curves still steepening).”
Then there have been the Fed speakers:
“Thus far, Fed speakers (Lockhart and Kashkari) are seemingly voicing some reticence on a September hike (pretty dovish Q&A with Lockhart), with ALL eyes as Brainard (dove) later at 1:15pm EST, as the conspiracy theory is that she was to be rolled-out to make an assessment that September could be an appropriate time for a hike, which would stand in stark contrast with her outlook and history—and thus would theoretically close the probability gap that block the Fed’s desire to hike (FFF and OIS implying “just” a 26% likelihood of Sep hike) if they so choose.”
And for those – like Goldman – seeking a continuation of Friday’s selloff, here is a word of caution from the RBC cross-asset expert: “My purely speculative view–after years of seeing the Fed operate within this “reflexivity conundrum”–is that the markets have already spoken (meaning already financially tightened enough) to a point where the Fed ONCE AGAIN has to back away from their “hiking threat.” Back to “none and done,” which will likely merit a pretty violent rally in risk and reversal in rates.“
In other words, as we said earlier today, following Friday’s sharp selloff, the Fed’s best laid rate hike plans may have just crashed and burned spectacularly, and what stocks are now pricing in is the latest Yellen relent in a “none and done” world. This means that if contrary to expectations, Brainard offers no tightening bias in her speech, stocks may will explode to the upside, and wipe out most if not all of Friday’s losses, once again slamming momentum chasers who had been expecting the start of a sharp leg lower in stocks as a result of the Friday shift in sentiment.
Meanwhile, selloff or not, rally or re-drift lower, the RBC trader gives some delightful examples of just how broken the markets have truly become:
A lot of goofiness has “gotten us” to this point in modern markets—a place where now at least semi-annually we suffer-through one of these approximately three-to-five day long “unwind spasms.” The current terrible brew is largely based-upon some mix of the following:
- The growth of risk-parity, vol targeting and CTA (trend-following) strategies and their AUM (either RP or systematic funds occupy SIX of the top nine slots as world’s largest hedge fund managers, with those six funds alone managing $386.4B between them. Estimates of aggregate AUM in risk-parity funds alone sits ~$400B, as we see today an incredibly / ironically-timed headline noting that the world’s largest RP manager’s newest hybrid fund has taken-in $22.5 since last year / $11B in ‘16. [ZH: Bridgewater]
- The aforementioned systematic universe—as well as an expansive list of ‘fundamental” funds with “risk mitigating overlays”—utilize measures of market volatility to allocate the inherent leverage component contained within each (controlling sizing and asset allocation). So when you get an inflection in volatility off of that “more frequently occurring than modeled” left tail, you get a drunken-sailor re-allocation / re-positioning with very heavy-handed trading….against the underlying managed world that has only “slowed down” their trading / turnover, as you’ve essentially been “paying away performance” to over-trade markets…ESPECIALLY during a “macro drawdown” period.
- Synthetically repressed cross-asset volatility–as central banks currently are buying nearly $2T of assets annually, outsizing major developed mkt bond issuance en masse. in turn, this crushes real rates & rate volatility /credit spreads & credit volatility, which then feeds into extraordinarily low equities vol (both as a macro factor input for equities, in addition to the “debt for buyback” virtuous cycle as low rates incentivize corp mgmt teams to bring debt in order to fund stock repurchasesàcreating an EPS uplift through shrinking the float of shares).
- Thus, “Max positioning length” has been accumulated in both fixed-income and equities from many strategies on account of said historically-low trailing volatility. This too has affected the traditional active community via concepts like “TINA” (“there is no alternative”), which has made even fundamental managers turn “trend followers” as “stocks and bonds just keep going up.”
- This “stocks and bonds just keep going up” dynamic = historically rich valuations by almost any metric, while cross-asset valuation metrics like the “equity risk premium” become completely bastardized due to the yield compression seen in fixed-income markets over the past years of central bank NIRP and QE / bond buying policy. Bonds are simply in another planet…again, how do you contextualize bond valuation in a world where central banks buy bonds with negative yields?
- Within equities, the valuation perversion becomes especially acute in the irony of all ironies—stocks and sectors that have historically “low volatility,” i.e. bond proxies like dividend yield plays / utes / telcos / staples / REITs. As such (and as chronicled since start of the year in “RBC Big Picture”), we’ve seen retail pile-into these “low vol” / “anti-beta” / “quality” products (11 of the top 30 ETF inflows YTD in “low vol” / divy yield / defensive sectors, totaling ~$29B of new AUM YTD btwn them), which are all based on the same “yield compression” environment. So this ‘easy access’ to the smart beta “bond proxy / low vol” theme only further richens the valuation of the underlying equities.
At this poit McElligott is happy to highlight who – and how – has gotten us into this predicament, in case it remains unclear to anyone:
The Central Bank volatility suppression then too has created massive convexity in the system—as yield has become so difficult to find across asset classes (read: financial repression), shorting front-month volatility has become a popular source of alpha. This is clearly exhibited by the tremendous scale of VIX ETNs which allow “vol tourists” easy-access to a vehicle to piggyback said recently winning strategy of “shorting vol.” And it’s not just VIX ETNs…but what about the previously discussed pension fund “vol selling” fad to generate income? Nice.
CFTC DATA FROM FRIDAY SHOWS LARGEST NET SHORT POSITION IN VIX…EVER:
CONVEXITY AS AN EQUITIES SIGNAL
McElligott then laments the artificial world, or universe, created by central bankers, “a universe too where the entire buyside is managed from the same generic risk management models, especially as hedge funds have become 2/3’s institutionalized from an AUM perspective. VaR models are the real MVPs nowadays, because they have most everybody hitting “liquidate” at the same time.“
What has helped “light the match?” The slightest hint that the post-crisis QE / monetary policy regime could be changed—namely 1) speculation that the BoJ could potentially look to steepen the JGB curve (kicked-off by BoJ’s Sakurai two Friday’s ago) 2) the ECB pausing on the widely-anticipated extension of their own bond buying last week, and 3) a Fed which is seeming trying to “force-through” a September hike.
In addition, an ill-timed swan-dive in US (e.g. ISM & NFP misses) and global economic data trajectory (Citi Econ Surprise Index for G10 economies currently negative for the first time since June) has added to the “policy error” fears, exposing the positioning-imbalance.
Finally, an equally unfortunately-timed “maximum supply” environment in US fixed-income market since returning from Labor Day weekend, with potential of upwards of $200B of paper coming this week alone btwn UST bills, coupons and IG. Let’s see how today’s avalanche of supply gets digested before we make any rage calls on the direct of rates from here.
His conclusion:
Sooooooooooooo, there’s that. “That” is our reality: robots dictating to 30 yr olds who’ve never seen anything but ZIRP / NIRP thanks to central bankers who (through political pressure) are completely unwilling to see markets do what they are supposed to do—discover price. Thus, leveraged-carry strategies which for 99% of the year make money in this CB monpol bizarro world then see multiple years-worth of coupon smoked into nothing as what should be idiosyncratic “butterfly flapping its wings” events spills-over, correlations go to 1, and books are purged.
Or, as we added sarcastically, “HEALTHY, VIBRANT MARKETS.”
Alas, in this world “healthy, vibrant markets” may never again come back at least until central banks lose control, which however won’t happen today, and certainly not after the speech of 4-time Clinton donor, Lael Brainard, so unless there is indeed a major surprise forthcoming, prepare for what may be the latest Fed relents, one which leads to a “violent rally in risk and reversal in rates.“
And with that, we sit back and await Lael Brainard’s speech in just two hours.
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