First thing on Monday, before the market cracked with equities puking and the Dow tumbling almost 1000 points before closing down 767, its biggest drop of 2019, we warned that a selling avalanche was imminent for one reason: "extreme negative gamma" positioning among traders, which explained in simple English meant that too many traders were positioned on the same side of the trade, and were forced to liquidate long positions as the market slumped, accelerating the drop to the downside.
So looking at yesterday's miraculous rebound in the markets, which saw the Dow soar almost 600 points higher from its sharply lower open in an almost straight line, can one argue that the same catalyst that slammed the market lower was also responsible for the surge higher.
Why yes, one can.
According to the latest note from Nomura's quant guru, Charlie McElligott, whose "Greek" observations correctly predicted the Monday flush as CTAs took out key thresholds to the downside and were forced into a mechanistic selling deluge, yesterday’s overshoot “stop-in” across US Rates/USTs was not just about the usual narratives (“CB policy error,” “currency wars / race to the bottom,” a “trade war spurring a recession” scare and/or 4 overnight “surprise” rate cuts—add the Philippines to the “new cuts” list today) although these certainly did not help, "it was also another reminder of the power that options market “Gamma” hold over the underlying assets, in standard “tail wags the dog” fashion…where this same “Short Gamma” dynamic is having very significant impacts across ALL macro cross-asset right now and exacerbating the violence of moves."
Ah yes, gamma - the most powerful force in the market, that moves prices violently in either direction when nothing else makes sense.
In Wednesday's case, the endless amount of upside buying in US Rates- & UST- options as “end-of-cycle” hedges over the past year had "simply gotten Dealer vol desks (and a number of systematic Rate Vol selling strategies in earlier versions of the 2019 “Bond / Rates Rally”) short a lot of Gamma via this incessant Receiving “force-in” (with Convexity hedgers also part of the feedback loop as they mechanically “have to” chase new multi-year levels)…and all into an environment ripe with almost endless macro catalysts for a “right tail” move in Rates (most notably the CB “dovish pivot” due to the global growth slowdown / disinflation / trade war escalation) which has added a mechanical “pile-on” to the vapor moves."
Furthermore, as we noted previously, when drawing a comparison between this August trade MTD and December ’18, the Nomura strategist reminds us that we are also dealing with significant market illiquidity (August VIX seasonality is “a thing” for a reason)...
... tight $USD funding (draining of Reserves + UST / Bill supply = EFF > IOER dynamic since March..
... widening FRAOIS with 3m back at levels last seen in….Dec ’18) and Dealer VaR-constraints (many at-or-nearing at risk limits and thus little tolerance for pain either with their own hedging needs or ability to further facilitate client flows)
Which bring us to "BOOM" (McElligott's words, not ours), "that’s how you get this incredible mix of “stop-in” panic / capitulation / grabby price-action seen yesterday morning, again piling-onto the endless stream of catalysts (Trade War, global data slowdown, dovish CB pivots, Brexit, Hormuz, Hong Kong etc) for the insane fixed-income rally (i.e. 5d cumulative move in Dec ED$ was the largest since Sep ’11; block ED$ upside buyers playing for 50bps cuts ahead of Sep mtg; the renewed & substantial interest in long-dated ED$ Par Calls, playing for NEGATIVE US interest rates btwn Sep ‘20 / Jun ’21; or even just the violent acceleration of curve bull-flattening, with 3m10y at lows since ‘07).
But wait, there's more - as McElligott adds, the game is potentially near-term inflecting in Rates as
- yesterday’s weak UST 10Y auction (indigestion after recent price-action: who is the incremental buyer “up here”?),
- bouncing Equities (via systematic fund covering of recently laid-out shorts & gradual monetization of downside hedges in stocks from discretionary),
- Chinese efforts to stabilize the Yuan all helped to turn the tide off of the extremes and
- Fed dove Evans reiterating the “mid-cycle adjustment” theme previously-iterated by Powell and Bullard—have all helped drive a meaningful reversal in the Rates trade off of yesterday’s peak
Fast forward to the close of trading on Wednesday when the Nomura quant notes that widespread observance of the technical Hammer "reversal signals" across the US Rates market; Fast forward to today when Treasuries remain well off the highs, with the ED$ strip weakening -5 to -6.5 ticks across the board— "and all ahead of today’s largest Duration Treasury auction on record, which COULD further bleed prices in Rates/USTs."
So what happens next?
There are two answers. If only listens to Nomura's Japanese quant team, led by Masanari Takada, what comes next is nothing short of a Lehman-like shock crash, as we detailed on Tuesday. As we discussed in the prior article, Takada reads the current trend in sentiment as suggestive of both deterioration in supply-demand for equities and a sharp downward break in fundamentals, but above all, "the pattern in US stock market sentiment has come to even more closely resemble the picture of sentiment on the eve of the 2008 Lehman Brothers collapse that marked the onset of the global financial crisis."
At the same time, for Nomura's US-based quant team, that of - well - Charlie McElligott, the next catalyst is more technical, and as he states this morning, "from here for the direction of global risk assets will be the resolution of the “stand-off” I reference yesterday in the Equities volatility complex, with a seemingly “binary” outcome being signaled by VIX / VVIX."
Meanwhile, the challenge facing Dealers is to place & hedge the massive “50 Cent” VIX OTM upside Calls trading over the past ~2m, is keeping the vol complex “wound tight,” with some vol desks short convexity/gamma and keeping SPX downside skew so acute per the Nomura quant (still extreme despite the bounce off the lows with 1m at 92nd %ile since 1996, as both the put-wing / “crash” being so “bid” and almost zero demand for upside):
Implied distribution of S&P 500Index options show the shift toward downside/"crash outcomes and away from upside:
So for the TL/DR crowd what does all of this mean. Well, one of two things: we either resume crashing, or we surge (obviously), to wit from McElligott:
My belief that much of the “downside flow risks” remain “in-play” (1. CTA model remains +63% Long in SPX, but with deleveraging levels not far below market and absolutely within reach per this realized vol environment 2. Our analysis continues to indicate “extreme short” $Gamma position for Dealers at 8th %ile for SPX / SPY since 2013, so any triggering of systematic downside deleveraging flows (say from a rogue “Trade War” tweet) could then be exacerbated by this Dealer desk hedging)…
But I also believe that the longer the trade situation goes “quiet” (and by the looks, both China and US are trying to again assuage markets at this current juncture ahead of Sep scheduled mtg), you are likely to see increased likelihood of a slow-bleed in Vols, as “longs” will look to monetize the recent moves—which then could ease the dealer “negative convexity / short gamma” pain which at this moment is keeping S&P downside / VIX upside “sticky” and ultimately reverse—and helping spring-board stocks higher thereafter
In summary, unlike Nomura's Japanese quant, McElligott is far more optimistic, and his take is that "absent fresh shocks in the next two weeks ahead of expiration (with downside tails still looking like potential for an SPX 2750 –type move), there is real potential to see US Rates/USTs fade from the overshoot extremes made yday, while Equities then too continuing to stabilize—which in-turn likely drives further upside in Stocks, via the “virtuous” second-order benefits of volatility re-pricing gradually lower, as downside hedges turn worthless and “crash” gets sold."