Shocktober’s Not Over – McElligott Sees More “Rolling Minsky Moments” As “Pseudo-Stability” Unravels

Just before last week’s interest-rate driven market selloff entered its most acute phase, we cited CTA positioning data from Nomura showing that systematic funds had not yet begun the painful process of deleveraging as certain “triggers” had not yet been met. But shortly after this commentary from Nomura’s cross-asset strategist Charlie McElligott had been distributed to Nomura’s clients, the selling pressure intensified, busting through trigger levels in a way that only exacerbated what became the most intense selloff in SPX since February (and the biggest for NDX since Brexit).

With markets creeping higher again after Wednesday’s furious selloff, McElligott chimed in with an update to Nomura’s positioning models that incorporated this latest break. As of Wednesday’s close, McElligott acknowledged that the Nomura Quant Strategies CTA model was indicating that these systematic sellers had reduced down to “43% Long” from “100% Max Long” 1 week ago, resulting in an estimated $88BN in one day selling on the one day move from “97% Long”, the positioning at the start of Wednesday’s session, all the way down to “43% Long.”

Leverage

With his audience clamoring for more guidance about what, exactly, triggered the market wreck of this past week, McElligott made a brief appearance Thursday afternoon on the MacroVoices podcast, where he got “philosophical” during an interview with Erik Townsend and Patrick Ceresna, arguing that this week’s equities driven selloff actually had a deeper “macro origin.”

Again, if I’m really stepping back and talking almost more philosophically, it’s the bigger picture here is that a higher real interest rate environment is resetting term premiums. And, with that, the cost of leverage, cross-asset correlations, asset price valuation – all of these constructs built into the post-crisis quantitative easing era are now ripe to tip over.

And we’re seeing these rolling Minsky moments as the pseudo-stability of lower interest rates, flatter curves, and suppressed volatility breeds instability through the leverage. And the leverage that’s had to have been deployed on strategies over the past few years as yield was chased. And that’s what we’re coming out of right now.

As McElligott explains, the market tantrum that was apparently triggered by the return of the bear steepener trade in long-term rates during the preceding week, is ultimately a factor of the “pseudostability” that has characterized market flows during the post-GFC era. As a result, investors can expect these “rolling Minsky moments” – instances where selloffs rapidly intensify as both systemic and discretionary bids evaporate – to become increasingly common.

Charlie

Fortunately for discretionary managers struggling to meet their P&L targets, this systematic selling has mostly subsided for now, as the market rebound (which really continued on Friday) moved these funds further away from the next big deleveraging target.

So, with that 2,719 level that you spoke about, was the next deleveraging point per our projections in the S&P for the futures to close below that level. It’s not a one touch, but to close below that level would see our current S&P position break down from what went into the day as a 43% long. And, as of one week ago, that was 100% max long. If we were to have closed below 2,719 today, that would have then taken us down to just 9% net long. And would have triggered an additional selling of $57 billion S&P futures.

As an aside, McElligott explained that selling, for now, has been concentrated in the CTA universe, as risk party funds – that other favorite market scapegoat – are typically much slower to move, and thus will take more time to react to the breakdown in the equity-bond correlation.

So our model looks at windows from two weeks, to one month, to three month, to six month, to one year. And we see the different transitions and the different signals generated across those buckets for various asset classes. But when the bond equities correlation breaks down, as it is currently right now, people will jump to the risk parity side of the equation, which, per our construct, is a much slower moving vehicle.

Ours, particularly, uses a two-year window. So there is a little bit of false attribution in my mind currently within the institutional marketplace as far as trying to pin responsibility on the risk parity community, when, in my mind, the much more powerful short-term force in the market are CTAs.

Of course, any discussion of how options traders react to these vertiginous downdrafts like what happened last week would be remiss if it ignored the role played by gamma-hedging options dealers. And while JPM’s Marko Kolanovic, who failed to predict last week’s blowup, said that this type of hedging played an outsize role in the selloff, McElligott warned that dealers could crash the market if SPX were to hold below 2,750, which would leave dealers dangerously out of position.

We saw an enormous jump day over day with the S&P futures options and SPY ETF options cumulative, both delta and gamma, on the day. So SPX net delta moves down $460 billion. That’s a 0.1 percentile move since 2013. The day prior, that net delta was negative $55 billion. So just impossible, almost nine times growth over the course of the day with regards to how much delta was kicked off for sale from the options community yesterday in just SPX and SPY.

And what that means from the delta side of things is that – and this is as of yesterday’s numbers – but S&P gamma is now at $24 billion per 1% move plus or minus. And those big strikes there are 2,800 and 2,750. And I think, judging by today’s spasms where it looked like we were going to break out, and then it looked like we were going to break down, and it looked like we were going to break out, and then it looked like we were going to break down, those levels kept us pretty well pinned.

But the danger here is that, on a close below that pretty heavy open interest line of 2,750, the more we start slipping below, the further out of position the short gamma is. And the more it slips, the more you have to sell to stay hedged. And that’s always the danger of the options market.

Looking ahead, the most pressing question on every investors’ mind is whether this week’s selloff was merely another dip to buy, or the beginning of the long-awaited shift away from the QE paradigm into a pre-recessionary QT mode. For what it’s worth, McElligott is optimistic that the market could hold up a little while longer, as discretionary managers have taken the opportunity to shrink their positions over the past few weeks, sapping demand for hedges and allowing them more leeway to get back in at a better price. 

Meanwhile, the two-week blackout period for corporate buybacks is almost over. Just as it did during the Feb. 5 blowup, the evaporation of the corporate bid often contributes to more price instability. And while some corporations have managed to circumvent these rules via ASRs, once the corporate buyer returns in earnest, McElligott expects they will provide an added bulwark against the type of market chaos witnessed last week.

I want to be as black-and-white on this as possible, and totally clear. If there was going to be a period of pullback with this tape, it was going to come in this two-week window where we are at peak buyback blackout. And that is absolutely where we are right now. The vast majority of S&P sub-industry levels are at effectively 100% blackout as of this week. Now, 10B5-1 plans allow corporates to buy outside of the blackouts, but with a number of limiting factors there. The bottom line: There still is a reduction in net corporate flow.

That is a critical facilitator allowing this risk-off trade to really proliferate. And, just like February 5, this move was precipitated for macro purposes. This isn’t purely a sentiment trade. This certainly is negligibly about trade wars.

However, another looming risk is the evaporation in demand for long bonds, which sent long-term rates moving higher earlier this month. As McElligott noted, much of this selling could be attributed to a mysterious foreign trader, which begs the question: Has the PBOC stepped up liquidations of its Treasury positioning (to be sure, the yuan has continued to weaken, which suggests that any selling by China has likely been relatively muted)? And if so, is China deliberately trying to crash the US equity market?

Now, the market can go two ways. If people are really getting nervous with regards to another October volatility shock, and if people start taking chips off the table, because these stocks that have been most affected – all these momentum longs, all these gross tech stocks – if that starts bleeding into retail, then, yes, this could very well perpetuate. I do think the other angle here is that there has been a massive seller of the US long-bond contract in the market the past few weeks. And there are a number of folks fearing that it could be somebody – an entity overseas – that would really cause the fixed income world to further wobble.

If we see the long end continue to sell off and the curve continue to bear-steepen, I think all bets are off and equities could absolutely continue trading lower. I personally believe that we are seeing de-risking now. And the de-risking is actually seeing money flow back into Treasuries.

In McElligott’s view, traders trying to mitigate their exposure to equity risk should revive the bid for long-dated Treasurys. But if yields continue moving higher, all bets are off…

Listen to the interview with McElligott below. It begins at the 59 minute mark:

The podcast targeting pro finance and sophisticated investors, hosted by Hedge Fund Manager Erik Townsend

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