Having correctly predicted the broader market dump last week, and – more importantly – accurately defining the key CTA selloff levels much to the embarrassment of some of his peers who keep making wrong calls and, unable to make an accurate forecast for month instead chose to blame “fake news”, Nomura’s Charlie McElligott is out with an unexpected warning this morning, just as speculation of broad based capitulation is finally gripping markets.
Observing the weakening global growth signals, which as we noted earlier dragged both Europe and Asia lower, in his latest note McEllgiott warns that despite the fading inflation impulse and slowing global growth due to “restrictive financial conditions,” which has further depressed risk-taking sentiment across trading desks on Monday morning, he sees near-term macro and positioning catalysts “for a powerful blast of Equities upside” for the following reasons:
- The recent overshoot in US Rates has been more about positioning stop-outs and performance destruction (especially with the unfortunate proximity to funds’ year-end) than a “pure” read on the “end-of-cycle” US economy alone (despite clearly weakening global growth and fading inflation impulse)
- In addition, large long-end buying (in turn, bull-flattening the curve) is acting to EASE U.S. financial conditions as a near-term catalyst for Equities
- Additionally, the obvious “dovish pivot” from Fed removes the “policy error” left-tail from market
- The potential for the crowded “Long Dollar” trade to “tip over” with on the end of policy normalization and data weakness will help feed higher “inflation expectations” as a POSITIVE macro factor sensitivity for SPX
- Finally, there is an enhanced-risk of positioning squeeze in Equities as the performance purge across fundamental and systematic strategies has seen them slash net exposures, while our CTA model shows nearly consensual “Max Shorts” across global Equities now…but SPX within reach of again tactically pivoting from “Max -100% Short” to again “+21% Long” ~ 2668
Furthermore, the proximity to the year-end “shut-down,” which means active/fundamental hands are largely “tied” and not in position to chase into an upside Equities trade this calendar year, the “chop” is not yet done according to McElligott. But, as the Nomura quant adds, there is scope for something developing thereafter, counterbalanced by the peak of the China slowdown in 1Q/2Q19 and it’s “drag” on global growth and inflation.
Commenting further on the first bullet point, McElligott points out the dramatic repricing in rate hike odds seen last week, when Eurodollar futures volumes exploded to a record high, and notes that rates capitulation is “maxing”—EDZ8-Z9 now only pricing 10.25bps of hikes next yr / Mar 19 hike probability is now just 25% likely, while EDZ9-Z0 now shows -13.5bps of FED EASING in 2020.”
And yet, the cross-asset quant asks if this is all truly about an “end-of-cycle” view? Here are McElligotts counters what has rapidly become conventional wisdom, noting that instead of reflecting fundamentals, the move is merely a technical “push”, and explains why as follows:
- My belief is that while we are absolutely repricing due to lower growth- and inflation- expectations on account of rapidly deteriorating US financial conditions (in-line with my long-held “Two Speed Year” thesis), it is the unwind of enormous legacy “Bearish Rates” positions which is the larger catalyst behind this “overshoot” and is now perhaps sending a FALSE SIGNAL to Equities, over-stating the scale of the “imminent” recession risk
- Recent flow-driven “bull-flattening” in US curves and the knock-on into front-end inversions (with many U.S. Rates front-end curves at 90%+ R Sq to US 5s30s)—which has then perpetuated the risk-negative “growth-scare” / “end-of-cycle” overshoot as global data has clearly deteriorated—instead acts to offset and “ease” recently tighter US financial conditions, especially with the move occurring in the most economically sensitive long-end bucket
Arguably his strongest argument, one also made last week by Jeff Gundlach, is that there were simply “MASSIVE shorts” in the front-end which facilitated this beyond-epic trade unwind, i.e. a much discussed position (and one of many similar structures in the market) accumulated across the first half of 2018 where somebody was long approx. 900k long-dated red and green Eurodollar options Put ratios, “which has embedded enormous gamma-risk in the market and thus exacerbated the insanity of the short-squeeze (and corresponded talk of ‘stop-outs’ through buyside fixed-income pods in recent weeks).“
Finally, when evaluating yield curve signals, it’s not just the violent squeeze on the short end, but also rising organic demand for the long end: this according to McElligott was due to larger entities (as per the “Others & Non-Reportables” category of long-end futures OI data) now again buying the long-end.
To this point, our Nomura QIS Risk Parity model shows as estimating MASSIVE buying in DM Sovereign Bonds totaling +$42B MoM and looking almost entirely concentrated in JGBs and USTs
And while McElligott also comments on the limited upside in the USD, what we find most interesting – and his competitors most controversial – is the latest CTA positioning. According to McElligott CTA positioning, much of it exhausted to the upside, confirms similar USD length “which could also boost risk assets / inflation expectations on potential deleveraging.”
CTA Position Estimates
Further to potentially bullish CTA positioning, Nomura notes that “as a bullish (risk) “tell” and against this legacy “Max Long” Dollar position in the market (vs broad G10), we are beginning to see Commodities positioning pivoting back towards “Neutral” vs broad “Shorts” just one-month ago—this is another signal of potential upside for inflation expectations, especially as “trade-war thaw” begins to seep into US Aggs as China flips the switch and resumes purchases of US ags and energy, where a gradual daily improvement on continued “tangible” improvement with China buying can boost generalized risk-sentiment further.”
CTA Position Estimates
The biggest risk for bears, however, is that CTAs, having flipped “max short” may now be squeezed higher, as a result of a rate selloff/reversal (into higher yields):
Our Nomura QIS CTA model now show “Max Short” positioning re-established across nearly all global Equities futures it tracks, with -100% Short positions in SPX, Russell, Eurostoxx 50, Nikkei 225, DAX, FTSE100, CAC40, Hang Seng, Hang Seng CH, ASX 200 and KOSPI 200 (NASDAQ the last remaining U.S. Equities “Long” but at a very scaled-down +21% long / 3.1% overall portfolio size, while Bovespa actually remains “Max Long”)
Indeed, as the following table shows, the equity positioning in the bank’s trend model is now almost entirely “Max Short” across the world (except the stubbornly green Bovespa):
CTA Position Estimates
As such, using the S&P as chief equities proxy, McElligott would see CTA Trend begin to cover and “flip” LONG again at 2667—with potential estimated notional on the cover from “-100% Max Short” to go back a “+21% Long” position (based off of Friday’s closing spot level—which, as he reminds, these estimated levels are not static).
In short, S&P CTA are currently -100% “max short”, but would be buying over 2,667.54 to get to -39.5% – a buying volume of $45BN – and another $45BN at 2,667.8 to get to 21% long, with the model estimating “Max Long” accumulatve above 2,771.6.
It’s not just trend-followers who are positioned for a bullish reversal: so are trading desks, with McEllgiott calculating that the SPX/SPY net Delta is now -$451B (and front-month -$306B of that as hedges are held and “kicked in”) but notional bias is to the upside.” That said, offsetting this upward bias, we are also back to negative Gamma, with the move per 1% move + or – now -$9B and across strikes bias to downside.
Finally, the key S&P levels that matter for “Greeks” are the 2600 strike with $4.4B gamma and 2650 with $4.3B gamma, “although that 2500 strike is ‘creeping’ with $3.0B of gamma.”
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In parting, McElligott does a post-mortem of the Friday equity flush, noting that it was consistent with that of “risk management” -dictated behavior (especially due to the proximity to year-end), with funds showing zero tolerance for further drawdown: by the end of the day, Equities Long-Short and Market-Neutral performance looks to have made fresh YTD lows.
However, contrary to some erroneous report in the financial press, Friday’s exposure reduction wasn’t about a broad “gross-down”, and instead it was about taking down your “nets” (long exposure less short), with popular longs being “hate sold” while at the same time seeing shorts pressed hard in a clearly more defensive posture as funds look to “shut it down” through the end of the year.
In short, another day in which the “max pain” was to the downside (sorry JPMorgan quants).
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