- Friday was one of the most dramatic days in the US rates space in recent history. Even veteran traders were taken aback.
- Meanwhile, dollar-funding markets are tightening and credit spreads are widening.
- In equities, market participants are being whipsawed. I'll explain why.
- It's not all bad news. But then again, it never is.
"Panic moved up a few notches from already extremely high levels,” Tony Farren at Mischler Financial Group remarked on Friday. "I thought last Friday was the blow off top and then a few times this week before today but now it's beyond belief," he went on to marvel.
That's the kind of commentary that was coming from the pros on the last day of the week, particularly during the US morning, when a bond rally with almost no precedent was unfurling.
Although most serious traders watched the beginnings of it unfold in Asia on Thursday evening, anyone who somehow wasn't aware of the situation woke up to read about a series of limit-up, circuit-breaker halts in Ultras amid a combination of acute fears about the coronavirus, a generalized risk-off trade and an apparent convexity event.
“For those who don’t trade bonds on a regular basis, it’s difficult for me to convey the true ‘epic-ness’ of this move," my good friend Kevin Muir, a 25-year market veteran who used to run equity derivatives at RBC Dominion, remarked, in a Friday morning note.
And I could go on. Duration had gone "offer-less," so to speak, and liquidity had apparently collapsed. At one point Friday, 30-year yields fell nearly 34bps.
The following visual is from Bloomberg's Cameron Crise, and I use it not simply for the "eye candy" value (anyone can create the actual chart), but rather for the accompanying quote from Crise, who made a simple, yet crucial point. After reminding everyone that Friday's move lower was the largest since 2008, Crise noted that prior to the crisis, "you have to go back to the ’87 crash to see a move that big [and] in neither case was the starting point 1.54%."
That latter bit is obviously key. 30-year yields fell nearly 34bps from already record low levels.
As Muir went on to emphasize, it's really not possible to communicate to everyday people how astonishing this was. "I have seen comments from veteran traders [saying] they have never seen an overnight move of this magnitude," he wrote, hours before the open on Wall Street.
"People don't appreciate the magnitude of this move," he told me in a chat. "The Fed has lost control."
Note that the move pushed the 30-year yield below the upper-end of the Fed's target range even after this week's emergency, inter-meeting cut. Have a look:
Commenting briefly on the overnight move in rates, Nomura's Charlie McElligott wrote Friday morning that it "obviously has the look of a convexity event [with] forced hedging/buying at the highs from mortgage investors, insurance companies and [anyone] who's short options."
But, he went on to say that the manic moves in rates were also "a simple function of OIS markets now pricing-in a full additional 50bps rate cut on March 18th from the Fed."
Friday morning smacked of panic. Perhaps the most unnerving visual is the chart below, which shows FRA/OIS widening pretty much in a straight line.
That's indicative of interbank stress, and to the extent there's such a thing as "good" stress, that ain't it - to speak colloquially.
When you start seeing dollar-funding pressures materialize, that's when you've got a problem. Cross-currency basis widened out too. TD's Priya Misra suggested this week's oversubscribed repos could have been "the canary in the coal mine."
Just before the Fed cut on Tuesday, both the scheduled term repo and that day's overnight operation were oversubscribed. It was the first oversubscribed O/N op since October. The next day's O/N op was oversubscribed too, and both term ops this week were three times oversubscribed.
On Tuesday evening, the incomparable Zoltan Pozsar released a 17-page note on possible dollar-funding pressures associated with the COVID-19 outbreak.
If you know anything about Pozsar, you know there should be a picture of him in the dictionary next to the entries for "rigorous" and "trenchant." In the note, he argues that the Fed should "combine rate cuts with open liquidity lines that include a pledge to use the swap lines, an uncapped repo facility and QE if necessary," to prevent interbank stress ultimately stemming from the economic fallout associated with the containment measures adopted globally to halt the spread of the virus.
In credit, Friday was very problematic. Investment grade funds saw the largest outflow since May of last year though Wednesday, according to Lipper.
Between plunging crude prices (OPEC+ is now effectively dead after the ill-fated betrothal between Riyadh and Moscow ended in tears in Vienna) and warnings coming in from the travel industry, stress is showing up in both high grade and high yield. CDX IG spreads widened sharply (and I do mean sharply) into the weekend.
Suffice to say the mismatch between the total outstanding stock of corporate bonds and dealer (i.e., the street) inventories could be an issue in the event credit cracks further.
In equities this week, investors witnessed what it's like to be caught in "the two-way slingshot of vol. dealer hedging flows," Nomura's McElligott wrote Thursday. Hopefully, you noticed that the swings in stocks this week were not just "exaggerated" - they were flat-out wild.
Let me put this in the simplest possible terms: Any explanation you read purporting to explain what you see in that top pane (and the bottom pane too, for that matter) that doesn't reference gamma squeezes, systematic flows, a lack of liquidity provision and/or a dearth of market depth, can be dismissed out of hand.
On Wednesday, I went to great lengths to emphasize that while the COVID-19 panic is quite obviously the proximate cause of the market's consternation, this wild, careening around is a function of the liquidity-flows-volatility feedback loop that includes dealer gamma hedging, vol.-targeter de-leveraging, CTAs and an absurdly thin market. Here's McElligott:
Equities investors right now are suffering under the two-way slingshot of vol dealer hedging flows: our latest SPX / SPY consolidated options-implied gamma analysis shows that dealer positioning dynamics remain deeply in negative gamma territory, and will stay that way as long as spot remains below the ~3225-3250 area in S&P futures
As such, every directional move sees exacerbation / momentum overshoots, as say, dealers get 'longer' the lower stocks travel and thus hedge by selling delta in hole—OR, dealers get 'shorter' the higher stocks go and thus hedge buy buying delta at the highs.
This all stands in stark contrast from where we were two weeks ago, where a 90th+ %ile long $gamma in SPX options (as vol was sold to dealers at the money for standard yield enhancement purposes) kept markets so extraordinarily 'placid' and in relatively tight intraday ranges, as dealer hedging flows would generically 'buy dips' and 'sell rips' and thus helped to 'insulate' the market into a 'Minsky-trap'.
This dynamic whereby every directional move is turbocharged is highly pernicious when it collides with maxed-out exposure from vol.-targeting strategies and CTA trend.
The attendant volatility (i.e., the volatility which occurs around wild swings) saps liquidity – and in exponential fashion. The worse market depth gets (i.e., the thinner the market is), the bigger impact a given flow (buy or sell) will have. Price swings are thus magnified even further. That raises the odds that previously unthinkable levels on spot will be breached, triggering CTA de-leveraging. If volatility remains elevated, trailing realized gets pulled higher, which activates de-leveraging from the vol.-targeting universe.
That is what you've been seeing.
I discussed it at great length in "We’re All Momentum Traders Now," but I also provided a handy, annotated visual summary on Twitter, which I'll screengrab for readers here (because I know how much everyone loves a Cliff's Notes version):
That's what's amplifying the moves in equities. It isn't disputable.
So, where to from here? Well, stating the obvious, nobody really knows because the "COVID-19 tape bomb" risk is ever-present. As I put it in a predawn note Friday, "fear is in the driver’s seat with a death grip on the steering wheel and is mashing the pedal to the proverbial metal."
But, on the bullish side for US equities, Joe Biden is (for now anyway) in the driver's seat with a death grip on the steering wheel and is driving quickly towards the Democratic nomination.
In the near-term, that's a good thing for stocks. At the risk of oversimplifying, there's probably not a material downside risk for markets in a hypothetical Trump vs. Biden general election. Obviously, nobody is going to sell their entire portfolio if Joe Biden becomes president. And Trump is market-friendly on most days (and I don't think I need to elaborate on what I mean by "on most days").
“A centrist democratic president would likely be neutral to net positive for the market… based on our estimate that the benefit of reduced macro volatility (trade wars, market volatility, uncertainty for businesses/capex, etc.) likely more than offsets the potential increase of corporate and individual tax rates,” JPMorgan’s Marko Kolanovic wrote Wednesday, in a short note reiterating points he discussed at greater length in December.
What I would caution readers about, though, is that while stocks ended a wild week slightly higher, there was nothing "normal" about the price action. And Friday's dramatics in rates, credit and (especially) dollar-funding markets are perhaps more worrisome than any stock selloff.
That's not a prediction as much as it is me imploring folks to keep an eye on credit spreads and especially on things like FRA/OIS and cross-currency basis.
If you see that stuff continue to widen out, that's when you should be concerned.
I would actually be a buyer of equities in a kind of generic sense right now, where "generic" just means if my horizon were at least a decade. But trust me when I tell you that if you wake up one morning to a bunch of headlines on Bloomberg about seizures in the interbank market, you might as well just turn off the TV and go for a nice, long walk on the beach.
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