Confirming JPMorgan’s “worst case scenario” that forced de-levering in vol-based strategies would lead to retail ETF outflows and create a vicious cycle downwards, Morgan Stanley’s Christopher Metli warns that today’s moves lower are likely not being driven by systematic supply – this appears to be more discretionary selling.
Risk-Parity funds are seeing some of the biggest losses in history…
But, as we previously detailed, JPMorgan offered hope that this vicious circle of de-leveraging could be stalled – and had been in the past – by dip-buyers from greater-fool retail inflows.
In the past, just as we have seen this year, these risk-parity-correlation tantrums have been cushioned by equity market inflows, and we note that, in particular, YTD equity ETF flows have surpassed the $100bn mark, a record high pace.
If these equity ETF flows, which JPMorgan believes are largely driven by retail investors, start reversing, not only would the equity market retrench, but the resultant rise in bond-equity correlation would likely induce de-risking by risk parity funds and balanced mutual funds, magnifying the eventual equity market sell-off.
Which could be a problem…
As ETF outflows are surging…
And as Morgan Stanley’s Christopher Metli – who previously explained what happens when VIX goes bananas – notes, today’s moves lower are likely not being driven by systematic supply – this appears to be more discretionary selling.
Systematic supply from vol target strategies is largely out of the way now, while consensus trades are getting hit: NDX is underperforming SPX, momentum is down 1%, and the Passive Factor is up, indicating actively held names are underperforming names better held by passive funds.
So why now, even though the systematic supply is largely out of the way?
Well as noted in previous comments, consensus was that this was a dip to be bought and that vol should be sold. While systematic funds delevered this week, there has been less discretionary supply and end users have bought very little protection.
This makes the market still fragile to negative shocks – in aggregate less fragile than coming into the week for sure, but still at risk.
The shock today has been higher real rates on expectations of more Fed tightening to come. After ignoring the original driver of this whole episode earlier in the week, investors have finally returned to the fact that the Fed is going to have to react to a stronger economy. 10y real rates today hit the highest since 2015 indicating tighter financial conditions, and breakevens are down slightly.
In some sense, Metli points out, these ups and downs are a normal reaction to the shock and pain of the Monday selloff, and as noted in previous comments the market usually remains choppy after these events. A focus on rates and the upcoming CPI report on Tuesday, plus dealers remaining short gamma, likely means the market remains choppy for the next few days.
But Metli does offer some silver-lining hope – just as JPMorgan’s Kolanovic did on Tuesday, another -4% SPX move is unlikely given lower systematic supply and less VIX ETP gamma, and the point of max pain is very likely behind us.
Choppy means +/- 1 to 2% moves for a few days followed by a gradual moderation in volatility as the market digests a more hawkish Fed.
…unless the bond market becomes truly unhinged, he adds.
Finally, Metli notes that right now, the options market does not fully price in a higher volatility environment for longer, and the inverted curve means forward volatility is relatively inexpensive.
June VIX futures are only in the 35th 10-year percentile, while even further out volatility between June and Dec of 2018 is only in the ~10th 10-year percentile – good value versus a VIX that is in the 90th percentile.
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