‘Rolling Minsky Moments’ And ‘Pseudo-Stability’: Revisiting The Avalanche

“We’re seeing these rolling Minsky moments as the pseudo-stability of lower interest rates, flatter curves, and suppressed volatility breeds instability through the leverage that’s had to be deployed on strategies over the past few years as yield was chased”, he continued. 

Later in the chat, MacroVoices Co-Host Patrick Ceresna asked McElligott to elaborate on the role systematic strats play in accelerating declines. Specifically, Ceresna asked Charlie about the Thursday note excerpted in the second linked post above. Here’s what McElligott said:

I know that various negative convexity strategies which have proliferated in the prior quantitative easing era – those lower yields, flatter curves, suppressed volatility – have led to the growth in systematic trend, risk control, risk parity, vol targeting, annuities, leveraged VIX ETNs. That’s all part of the market structure that we deal with.

And, to my prior point, as we transition from QE to QT (quantitative tightening), we are now going to be forced to see structural unwinds of some of these forces.

So, the systematic community and the role that they play in the market, the highest impact of unemotional selling in the most violent fashion typically occurs through the CTA universe, the trend universe.

One, because it’s so structurally leveraged. And, most importantly, it’s a shorter-term vehicle, shorter term sign.

On Thursday afternoon and also on Friday, several analysts were keen to note that while the CTA de-risking had likely run its course, vol.-targeting strategies would probably continue to sell in the days ahead. As you’re probably aware, the vol.-targeting crowd is slower moving. This group includes risk parity, a strategy that leans heavily on leveraged bond positions and depends, at least in part, on the preservation of a negative stock-bond return correlation (positive equity-rates correlation). Do recall that a flip in the sign of that correlation was one of the key worries headed into this week.

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Stock-Bond Correlation Breaks, Presaging Locust Plague, Pestilence, Famine

The positive equity-rates correlation that’s been a fixture of markets since 2000 has disappeared and as you can see from the following visual, it’s a rare thing that the sign flips negative:

Corr

(Bloomberg)  

That sign flip prompted some folks to speculate that risk parity exacerbated the unwind, and while that could end up being the case in the event vol.-targeting strats start to de-risk next week, McElligott reminds you that due to the slower-moving character of those strategies, it’s not correct to blame them for last week. To wit: 

But when the bond equities correlation breaks down, as it is currently right now, people will jump to the risk parity side of the equation, which, per our construct, is a much slower moving vehicle. Ours, particularly, uses a two-year window. So there is a little bit of false attribution in my mind currently within the institutional marketplace as far as trying to pin responsibility on the risk parity community, when, in my mind, the much more powerful short-term force in the market are CTAs.

On Friday afternoon, JPMorgan’s Marko Kolanovic noted that “the biggest selling pressure [on Wednesday] was from option gamma hedging.” He went on to postulate that as long as the S&P held gains on Friday, “it could result in a squeeze higher by end of the day from gamma hedging flows.”There was indeed a squeeze higher into the close on Friday.

In the MacroVoices interview, Ceresna asks McElligott to elaborate a bit on how those flows impacted the market on Wednesday and what he (Charlie) sees going forward. Here are some excerpts from that exchange:

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Disclosure: None of what I write here is to be construed as advice to buy or sell any kind of asset. It is merely my personal and not my professional opinion. Any asset can go to zero.

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