A Global "Tightening Tantrum" Has Begun; RBC Urges 'Seek Protection', VIX To Double

RBC's head of US cross-asset strategy, Charlie McElligott, notes that a look through markets shows "nervy" price-action everywhere with the exception of developed-market equities (shocking, I know) into this accelerating "financial tightening" theme.

The story of the past week in global markets was the jump in US real yields (per ever-increasing Fed hiking-path probabilities, i.e. June now ~50%) and the trickle-down impact it has had across the asset-spectrum.  Nominal rates gapped higher through their multi-month range on the mega ADP print (although there was profit-taking from shorts following Friday’s NFP relative to very high whisper expectations) while breakevens cracked to the downside, as WTI and Brent collapsed to new 2017 lows.

Specifically focusing on the crude move, CFTC open-interest data (per RBC’s Kristen Arey) is telling us that it is “new shorts coming in to drive the pressure in oil, not long capitulation (yet)”--i.e. the STILL historically elevated long leaves crude at serious risk of further downdraft then, as the negative PNL in the trade from ‘late-comers’ mounts and forces itchy trigger fingers liquidating losers.  With crude having been ‘trendless’ for so long, this is one-to-watch as well with regards to those new shorts which are very likely CTA / systematic funds, where these leveraged momentum models could really inflect damage as they look to press this ‘positioning asymmetry.’

The ‘knock-on’ I’d then too be concerned about would be the impact that crude is having on the risk-parity community, which has already been under meaning performance duress MTD due to the ‘double-whammy’ sell-off with crude and ‘risk free’ developed-market government bonds.  I’ve mentioned a number of times over the past few months that a sizeable component of the crude length has likely been RP funds, as crude provides liquid exposure to a collective ‘higher inflation expectation’ (alongside less liquid TIPS).  A crude sell-off escalation via the trend-following community turning short and ‘pressing’ is likely to exacerbate recent RP performance challenges and could induce mechanical rebalancing, or worse, VaR deleveraging unwinds from these funds across their asset buckets.  Equities could certainly bear some of the brunt, due to the recent historically low volatility profile of the benchmark indices—especially into an economic scenario bucket of ‘higher growth, higher inflation’—as it is highly probable that the equities component is near ‘max long’ and thus a probable source of deleveraging.







As we’ve been highlighting since mid-December (when Mark Orsley and I constructed our list “What Could Derail the Reflation Trade?”):

1) the idea of gap-higher real rates as an expression of “Fed being viewed as behind the curve” was a chief concern, as the narrative would then rapidly shift to the market worrying whether we are “tightening faster than the economy is growing.”  Mind-you, 3m LIBOR is already ‘going there,’ currently at 8 year highs and nearly doubling YoY.  Add-in the trajectory of +++ Eurozone data and thus...


2) the speculation last week that the ECB could potentially be forced to hike rates prior to the tapering of QE (something Peter Schaffrik has been mentioning recently, with Mark noting last week that the Euribor Dec 17/18 curve is already pricing-in two hikes in ’18) alongside...


3) the Bloomberg story yesterday noting that the BoJ’s current pace of  asset-purchases has it running 18% under its official target and it’s fair to say that we are experiencing a bit of a global “Tightening Tantrum.”

As such, the nascent signs of cross-asset distress seen the prior week in EM equities accelerated further this past week, with commodities at the root of the weakness (WTI -9.8% as the headliner, but across base / precious metals as well).  The outsized weight of the energy- and materials- spaces within the High Yield credit universe saw HY CDX widen 27bps / HYG -2.2% since the start of March (‘fed’ by big issuance uptick as well which created some cash ‘softness’ alongside ETF redemptions), while the interest rate move also spilled-over into hyper-crowded and previously “untouchable” US investment grade credit, with ‘duration’ hit accordingly alongside the endless stream of supply finally creating indigestion ($45B of new paper last wk making an astounding $327B year-to-date, as corporate treasuries rush to fund in debt markets ahead of higher rate landscape), driving spreads wider.

The negative ripples were also felt in key ‘reflation’ proxies within the equities-space (cyclicals like energy / materials / banks, small caps, high beta and ‘value’ factor).  MLPs (total return index -3.0% last wk), high divy yielders (-1.3% last wk), REITs (-4.5% last wk) and ‘leveraged credit’ equity plays (-5.9% last wk) were all hit too off the back of the move higher in rates and the gap-lower in crude as well hit these ‘high yielding’ bond-proxies.  From a sector- / performance- perspective, the overweight within the equity hedge fund universe to tech, healthcare and consumer discretionary sectors is helping to mitigate the losses from overweights in the energy and materials sectors YTD—energy especially, now -8.0% YTD within the SPX, while Russell 2k energy sector is -15.1% YTD and at lows as the XLE broke its 200dma meaningfully for the first time since April ‘16.  This same ‘energy overweight’ is hurting ‘value’ MF’s funds of course too, which were last year’s highest-flyers…not to mention the $7.3B of inflows into ‘value’ smart beta ETFs YTD.



Despite all of this cross-asset “agitation” however, broad index-level equities to the casual observer remain optically “strong like bull,” riding the wave of the YTD inflow of +$82B into the asset class through last week (actually surpassing bond fund flows YTD as well).  We have been noting this since the start of the year in the form of the daily NYSE market-on-close buy imbalances from institutional, index and ETF rebalancing flows adding massive equities-exposure at the highest volume ‘print’ of the day to the tune of +$21.B notional buying in aggregate on said MOC’s in 2017.  This speaks to an investor universe that is increasing equities exposure into the new normal of “higher rates” as they readjust from 8+ years of “slow growth / slow inflation” narrative.

Equities futures positioning data from Kristen Arey is telling us an interesting story though, as e-mini S&Ps saw a net $4.8B of short covering last week to keep SPX ‘propped’ higher, with leveraged funds net buyers of $10B on the week (against asset manager selling).  And due to the richness of calendar trades into expiry this week, shorts continue to be expensive to hold, incentivizing further covering.  Away from S&Ps though, we’re seeing a different story, with $3.5B of net selling in Nasdaq and Russell futures last week, as NDX saw profit-taking, while Russell longs have been liquidated now by specs, with the small cap benchmark index essentially flat YTD, disappointing those late to the trade.


So with all of this said, we have seen a very notable dynamic developing within the S&P 500 per the Quant Insight macro factor PCA model thus far in March.

The incredibly-stable macro regime of the past year-and-a-half {the feedback loop we’ve pounded into your brains: 1) inflation expectations, 2) credit spreads, 3) equity vol} expressed by both the standard (83d rolling) and long-term (250d rolling) models is now seeing their respective R^2’s drop precipitously.

What does that mean in English?  The macro factor models are losing their ability to ‘explain’ the index moves.  Currently both models’ R^2’s are now at 43% and 57%, respectively, from highs near 90%.  Although the historical data set is not deep, you can see in the charts above (specifically featuring the long-term model) that the prior two instances where the R^2 dropped through the 65% “trigger” in the long-term 250d rolling model, we have seen a concurrent DOUBLING + in VIX through the trough and return through 65% “confidence” period, as the macro regime evolves and ultimately “firms.”


The equities inflow story continues to be robust (as do jobs and survey / ‘soft’ data), but I believe there is a heightened risk of an equities drawdown occurring alongside:

1) further fiscal policy implementation delays (taxes and infrastructure an ’18 story best-case with ACA, immigration, SCOTUS, wiretapping and Russian messes),


2) the current crude sell-off “knock-on” effect” across assets (potential for VaR episode) and


3) tightening of financial conditions will likely too see that inflow euphoria abate in coming months, as it is also likely the economic surprise ‘beats’ mean-revert lower as well.

So, McElligott concludes rather ominously:

I will again join the chorus of sellside “Cassandra’s” pushing protection trades / hedges: SPY April 233/225 PS (costs 1.10, gives 7:1 leverage) and UXA April 17/21 CS vs 13P for even money.


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