Odd Lots - Lots More on Solving the Mystery of the Big Market Selloff

Episode Date: August 6, 2024

The S&P 500 has plunged more than 5% over the past couple of trading days. The Nasdaq 100 is down 7%. The Nikkei fell an astonishing 13% on Monday and then triggered a circuitbreaker as it climbed up 10% on Tuesday. Meanwhile, measures of equity market volatility like the VIX have soared to their highest levels since the pandemic crisis of 2020. So what’s behind all these dramatic moves? There’s a long list of culprits, with market participants blaming everything from the Federal Reserve being behind the curve, to the deteriorating labor market and softer-than-expected payrolls data on Friday, as well as the unwinding of the yen carry trade, the bursting of the AI bubble, and the reversal of short-volatility trades. In this emergency episode of Lots More, we speak to Charlie McElligott, cross-asset macro strategist at Nomura, about what caused the selloff and how long it might last.Read More: $6.4 Trillion Stock Wipeout Has Traders Fearing ‘Great Unwind’ Is Just StartingRisky Borrowers Discover Doors Are Closing in Bond, Loan MarketsOnly Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at  bloomberg.com/subscriptions/oddlots See omnystudio.com/listener for privacy information.

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Nice to see you. It's up. Good to see you. Good. Thank you guys for having me. No, thank you for coming here. Thank you. Anything going on this week?

Big week. Holy moly. Yeah. You know, we've been feeling stuff, seeing stuff for a while. But, you know, by end of last week, it was like, this is getting pretty hectic. And I had to drive like eight hours each way up to New Hampshire. Oh.

I got back Sunday. I was like, I got to start this right now. I did a deadlift. One, two, three. Hedge. Hedemini. Okay, good. Barges.

This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best with impostin? These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple of years, the AI will do a really good job of making the oddlots podcast. And people will say, I don't really need to listen to. Joe and Tracy anymore.

We do have... Cha-ching. The perfect guest. Welcome to lots more where we catch up with friends about what's going on right now. Because even when odd lots is over, there's always lots more.

And we really do have the perfect guest. So when you say that stuff was already getting a little hairy last... Like, what were those early signs? Was it just Wednesday during the Fed decision? Or what were you starting to see? Well, there's different time horizons.

for sure. And I think one of the things that we absolutely have to discuss is the signal from skew, right? Skew is this, you know, relative measure of kind of demand for downside versus demand for upside, which is, you know, it's something that we can come back to later. But without a doubt, when you began to see skew relentlessly stay bid, when you began to see the volatility of volatility, stay so bid, even as stocks were, you know, trying to kind of stabilize after some of the recent death by paper cut of geopolitical and kind of earnings disappointments. So, you know, obviously the growth dynamic is a big part of this, too, as far as, you know, the labor data finally catching down.

But, you know, it told you that there was this, you know, grab into tails. and, you know, a big part of the messaging that I've been giving since March-April period was that we had been living in this really interesting world where in the end of April, SCU was extremely, extremely, historically, all-time kind of flat levels, meaning that it was really representative of two things. Extremely low demand for downside and extremely high demand for upside. Downside protection. Right.

All right, just for listeners to make sure. Right. And kind of when you look at the forwards, and in my view is this, skew really on a longer horizon, like decades-type horizon, to me is representative of, you know, what's the actual risk-taking risk-appetite backdrop, meaning it's heavily related to central bank policy. So, for instance, in the kind of QE era, where, you know, the Fed was trying to incentivize a wealth effect, right? They wanted you to be leveraged long assets. and in that because that's economically, you know, virtuous, right? Consumption, you know, paper wealth effect, all those things. You were leveraged long risk assets, skew is steep because you had something to hedge. But after the events that created that, you know, idiosyncratic stacking of stuff from the Fed's inflation rethink in 2019, the flexible average inflation targeting, the tariffs impact into COVID, into the supply,

into the supply chain disruption, into the stimulus, plus, you know, the tectonic stimulus, which had never been tried before, in addition to the, you know, unprecedented quantitative easing, you finally had this escape velocity inflation event, which then forced the Fed behind the ball, and it forced them to have to tighten in a place that we've never seen before. And QT, right, as opposed to QE, they needed to create a negative wealth effect because they could only impact demand-side inflation. And with demand-side inflation being the only lever that they could pull, they had to create a negative wealth effect. And in that environment, skew went extremely flat. You didn't own underlying. They were telling you to get out of risk assets. They were telling you

to park in cash. Cash isn't at the money put, right? It's a hedge there. You were able to sleep at night, collect three, four, five percent at times. The only tail that you were afraid of was no left tail, was no crash downside event, it was about missing the right tail. It was about missing the rally. The up crash. The up crash. So the last two years, you know, kind of prior to the last six months, let's say, the last two years, we were in this super bizarre place to a lot of people, counterintuitive, with positive spot, meaning kind of underlying market, Vol correlation. You know, VAL was going higher as the market was rallying because people didn't have the exposure on. We're being forced to chase, right? Data was beginning to soften. Inflation was starting to come off.

The Fed was kind of opening the door to the end of the tightening cycle. And you were under positioned. So you're grabbing into calls. And that same positive spot vol correlation on sell-offs meant that vol would grind lower because you were in this really virtuous backdrop for VAL selling. Right? So down days were opportunities to sell VAL. And at the core of everything that has kind of happened over the last week in particular, the last few days really, has been about that kind of come to Jesus moment for the short vault trade of the past two years. So, you know, you had this dynamic where flat skew was a feature of quantitative tightening, and at the March kind of extremes, we started beginning to see skew steepen again pretty impulsively,

and that was the signal that, you know, we were going to resume back to this prior world, of a negative spot-val correlation. So we are speaking with Charlie McGilligate. He is, of course, the cross-asset macro strategist at Nomura, and the guy we like to call when we need to start talking about Greek letters and things like Delta hedging and all of that. Charlie, what are we calling the sell-off? I came up with an idea that I'm quite proud of.

Give it to me. I mean, it sounds like fodder for my subject line. Yes, yes. You can have this one. Valma Fedian. And the Valma is AI. So it's volatility, AI, Fed, and yen. Wow.

That's good. That really rolls off the tongue tracing. It's meta. It's going to be useful. You got to use that as your title. Multivariate. Yeah. I mean, look, there's, you know, we spoke about, you know, the macro catalyst that kind of

set off this event, you know, and a lot of people, I think, you know, way off the mark with regards to, oh, it's, you know, it's, it's yen carry. unwind or, oh, you know. Yeah. Wait, talk more about that because I see lots of people saying it's the yen carry unwind. So the idea that people were borrowing in yen at a low interest rate and then investing that in risk assets. But if that was happening on a scale which would cause the market moves that we've seen

in the past couple of days, I would have thought that you would see more of an impact in stuff like credit, right, like IG or high yield. And that hasn't really happened. Because my impression was always like a lot of targets of the carry trade were actually in credit. Right. I mean, very simplistically, the carry trade, if anything at best, is simply representative of risk appetite. And when carry trades are popular and thus crowded and leveraged, it speaks to a backdrop of low volatility.

You need low volatility to be able to accumulate those positions, you know, short this to buy this higher yielder. And, you know, without question, as far as the butterfly flapping its wings event, the Bank of Japan allowing people to be structurally short the yen for decades because of their just consistency with regards to this, you know, perma-doveish posture, then switching in pretty short time horizon into something more hawkish than expectations, particularly that last meeting, where they, you know, they raised by more than kind of. of market expectations. They ultimately were targeting half the bond buying and they'd already cut off the ETF purchases. That was absolutely not helpful for the carry trade. But for the carry trade, as far as our industry goes, it is one piece of the puzzle as far as the cajillion strategies out there. And yes, carry had been popular. Carrie had been crowded to build into those trades. You need low volatility. A lot of those trades then look like trend trades. A lot of

those trades are overlapping and concentric with CTAs, but it in and of itself was not the issue. Yeah, I was going to say it often feels like, because we did a recent episode on the correlation trade, and we've talked about the low-val trade. It often feels like these are all the same trades and the carry trade being another one, the momentum trade being another one, the same trade in different flavors. I say this all the time. This is often used with regards to these de-lars. leveraging events. It's oftentimes used when discussing, you know, systematic strategy,

you know, vol events. But, you know, volatility is the exposure toggle in modern market structure. And that being the case, sustained periods of low volatility, where I would say that, you know, the big shift, the bigger shift from a macro catalyst to me that occurred over the past few weeks, was back to this idea that we had been consensually and comfortably in a low-val narrative as the market was forced into a soft landing consensus last year, right? People were perpetually trying to pull forward the hard landing recession and end of 22, start of 23. You had the SIVB crisis. That was going to be the credit crunch that pushed us over the edge. fighting, fighting, fighting for the recession that never came, ultimately we kind of got stopped

into this really comfortable backdrop. Soft landing, Fed would still be supportive. Treasury did a little work around the edges to ease financial conditions and lighten the load of the Treasury sell-off and the long-end rate volatility in the fall. And that low-val backdrop was really facilitating this massive growth in the short-val stuff that's been out there. and the AUM growth, and it's not just short-val premium income ETFs, of course, it's VRP, it's dispersion strategies, it's, you know, correlation, short correlation trades, it's QIS, you know, at banks, their proliferation, especially being used by multi-strategy hedge funds, which are big users of those products.

All of that stuff created the short-val supply, and here's kind of the kicker to me. With regards to that soft landing outcome, which was consensual, we had had kind of assigned a zero delta of a hard landing. But we had been saying for quite a long time, the market had been fixated, this economy goes as far as the consumer goes. And the consumer is a function of the employment data. And when in, you know, less than a month span, we've seen six of the last seven major U.S. labor releases at magnitude, downside surprises, you kind of got the whites of the eyes of this trade where, well, holy moly, like maybe that's not a zero delta, maybe that's a 20 delta on the hard landing.

And that completely ruptures as a macro catalyst, the comfort in the delta on that short ball trade, the comfort in that soft landing trade. And that, to me, if anything, if you want to point to one thing, was what lit the match to then take advantage of the larger structural short vol supply that, like every other short of all buildup in history does have a stopping out and that's where we are. A lot of short daily news podcasts focus on just one story. But right now, you probably need more. On Up First from NPR, we bring you three of the world's top headlines every day in under 15 minutes.

Because no one's story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR. I do think it's kind of funny that one of the things that's happened in recent days is the yield curve has uninverted. And the yield curve, of course, was the thing that last year when everyone was focused on recession, they were so focused on the yield curve inversion. And now it's like, oh, it's uninverted. But actually, we're all worried about the hard landing now. Anyway, how much short vol exposure do you think is still out there? Or have the past couple of days seen a cleaning of the house, so to speak?

So great, you know, that's the trillion-dollar question. I think a lot of folks after that Friday freak out, and this is, again, this is part of the issue here, we've been conditioned on a multi-year decade type of look back. We've been conditioned to see these opportunities to monetize downside hedges or, say, VIX upside convexity, you know, or S&P downside, in the span of hours. when you have these whatever the macro catalyst is, you know, we slide from dealers from a long gamma spot to a short gamma spot. It triggers systematic, synthetic short gamma. You get these accelerant flows and you have these wipeouts.

You have like a couple of hours max to monetize those hedges before reflexive vol sellers reappear, before the dip buyers reappear. And I think the hard lesson here was due to the magnitude of how much short vol there were across, you know, multiple strategies that we referenced earlier. A lot of people ended the day Friday thinking that they could be short VAL and maybe short Delta, you know, or short the market, but also too short of all coming

out of that trade because the VAL moves were so magnificent, you know, so outlier. The issue then became that they got their fingers blown off on the Monday reopen. So, you know, you can lose money trying to do. that based on prior, you know, back test on these vol squeezes and these outlier vall squeezes. It's when Asia crashed overnight and that in and of itself is another conversation, another, you know, probably a separate recording for us. But when Asia crashed overnight and those people woke up and vol was where it was and

you saw more, you know, more bid for tails and VIVX went absolutely bonkers. Oh, yeah, volatility of volatility. Volatility. Volatility, yeah. You know, as far as just a read on demand. man for tails. It was over for those people. So the second day in a row. And now you have a pattern here where, you know, fool me once, shame on you, fool me twice, shame on me. Where you've gotten your fingers blown off two days in a row trying to play this trade. And by the way, this vol squeeze,

this vol out performance on a beta adjusted look was unlike anything we'd seen. I'm telling you, like past COVID extremes at a point, past Valmageddon or LTCM, you know, some of these metrics were unbelievable, whether it was VIX relative to S&P, whether it was Volval relative to VIX, whether it was skew relative to at the money implied vols, all these different metrics, 100th percentile. This was a VAL event. This was not a stocks event. And that occurred.

You're now dealing with an environment. from a risk management perspective, and I know you just had some really good content, you know, talking about risk management on the show. From a risk management perspective and your var, that it is going to be incredibly difficult to get that, you know, reflexive, say, systematic buyer back in the market right now or that discretionary macro trader who's running the back test. And the back test are saying after these types of vol overreactions, you've got to be longer market and short vol. But the problem is you're blowing out your risk budget now on down days. We snap back overnight in Japan. You're blowing out your risk budget upways. You're not going to be able to allocate any risk into this trade of any size that's going to make a difference. So we're still on very thin ice and the market is still priced for a lot of crash. I'm glad you brought it back to the sort of simple macro, which is just that, look, you know, suddenly people realized on Friday maybe that soft land between Powell on Wednesday and the, you know,

the employment report on Friday, maybe that soft landing scenario that everyone, the consensus had emerged. Maybe it's no done deal. You said it could be a separate recording. Can you give us like the 30 second version of that Sunday night Asia crash and what you thought was going on there or what was on your mind then? We've seen so many times after a Friday sell-off, Asia just act poorly, right? I mean, and I, you know, I then, too, think back to, like, the financial crisis where, you know, it was one large hedge fund kind of liquidating their converts book that really started like a knock on calamity leading, you know, around the Lehman event.

You know, this, I think, too, was then further amplified, let's look at Japan specifically. The Japan trade has been a great trade. The Long Neke, the short yen, obviously the carry component have been great trend trades with high sharp. for a reason. You know, there's a fundamental economic story. You know, you got the third arrow achieved. You've got, you know, wage renegotiation. Now corporates have pricing power. Consumers can digest it, all this stuff. They escaped deflation. Great story. It was crowded and it's illiquid, and it doesn't trade very well. And in a world where the U.S. exceptionalism trade is dominated for a decade, and Europe is eternally tied into China, and Europe is eternally cyclical, and that

they don't buy back their stocks and they don't have any secular growth tech and all those things, a lot of global equities managers were looking for opportunities to diversify out and play Japan. And that meant real money in Japan. And that meant hedge funds started chasing in Japan. That meant retail, certainly domestically, in Japan playing the stock market boom. So you just had a lot of hot money, a lot of fast money, a lot of slow money in a place that doesn't trade very well. And when you got that first derisking, particularly, I'm a lot of. amongst a lot of overseas, leveraged pod, multi-strat investors that have been there, you shoot first,

ask questions later. It's skinny exits and the deleveraging and getting out of a place that is that type of liquid. Liquidity constrained. It was, you know, just a magnitudes move. But it was all the stuff that had the highest sharps. It was topics banks, right? It was all those things that are going to be most sensitive to, you know, escaping negative interest rates. And, you know, you crowd it into them and you crowd out of them.

And the magnitude of those moves now, as you're seeing both down and back up, you know, speaks to how much leverage was in that trade. And that was just a particularly sloppy unwind. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini.

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That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. So, as you said, people have had their fingers burnt multiple times now, and we think there might be some short-vall exposure still left in the market. What are these sort of, I guess, either pain points that you're looking at? at that would accelerate the downside or the sort of things you need for a durable recovery. As you said, I guess it's going to take some time for those windows of volatility events and the var spikes to fade into the distance. But is there anything there that you're watching?

So the thing to me where I was still uncomfortable, for instance, in the micro term, about, you know, coming into today and how if we'd be able to hold on to the rally last night, It was at the end of the U.S. cash equity session yesterday, it was an ugly close from a VAL perspective. VAL went out bid, skew went out bid. VAL VAL was super firm, super sticky. There was no pullback despite, you know, for instance, in the last couple of minutes of the day, there was a large hedge on wine, large put spread on wine that bought, you know,

just about four and a half billion bucks a delta. And it rallied us like 20 handles. But like, VAL was still stressy. that to me is indicative of the fact that there's still, and I think it's a dealer problem, I think it's a market maker problem, that there is still a lot of embedded kind of short gamma in the VIX complex, and there still is a lot of short skew out there, maybe in like the dealer or the S&P positioning. And that VIX complex is really interesting, guys, because I feel like maybe we talked about this when I was on the show once before, but on a kind of pre-Dodd-Frank

view versus where we are now from speaking with VIX dealers, VIX options dealers around the street, you maybe have 10%, 20% max of the risk-taking capacity that you used to have. But as the equity market rally became so unstable over the course of the past year, Vicks' upsides, so Vicks calls was, or, you know, call spreads, but that's not a true hedge. That's a separate conversation, were kind of the most popular tail hedge out there. You know, VIX is inherently convex. It's a square root of variance, so it's going to move off the line. It's going to outperform into, you know, kind of a crashy type situation.

There was a massive amount of short VIX calls for dealers over the course of the past year. We've had a couple events. We get squeezy and then it, you know, fills back in. People keep reloading on it because this trade has been quite cheap. Once this short vault trade really began to implode, what you started seeing, and we did recently have another reload last week of a dealer getting short, you know, really big size in VIX calls. When VVIX starts expanding like that, you know that they are stressed and scrambling to cover what is effectively their short gamma. And they have to go out and they have

to buy VIX Delta, which is buying VIX futures. Or they have to go out in this case because we're now negative spot volk correlation, meaning as the market's going lower, VAL is going higher again, they have to go out and, you know, short futures. So that's a lot. And in this case, because we're now negative spot vault correlation, I mean, because that to me, when we saw the market staying stressing into the close, I know that people are still, you know, buried in some of those trades and are not out. I think a lot of people were finally getting the shoulder tap in the last, you know, 30 minutes yesterday saying, this hasn't pulled back. We haven't been able to cover this. We got to cover and cover out some of this risk. So that, to me, was indicative. On the go forward to the point you raised with regards to

when do things stabilize. I want to see this current flow, which is just hedge unwind, hedge monetization, which is going to help stabilize the market in periods. I want to see that turn more into a willingness for the vol sellers to reemerge out of their bunkers. That's a big if right now, right? Are you able to be short vol? Are you able to be short gamma?

Are you able to be short skew? Or you be able to short crash, you know, systematically in light of the vol events of the last few days and whether or not you can get approval or the risk budget to put that trade on. But there still has been massive asset growth across the VRP complex, across the premium income ETS, across the dispersion books, across QIS products that are exploiting zero DTE options, no overnight risk. Those still have to trade. Those still have to sell VAL. Those still have to short Vega, and I think that they are going to slowly reappear, and as they begin to slowly reappear, and that's going to take time, dealers start getting longer gamma again.

Range compression begins to set back in, trailing realized vol windows begin to roll back over ever so incrementally. But the trick is this, you know, vol control, which is kind of a euphemism, a generic for anything from, you know, target volatility funds to various annuity, to some of these balanced funds that shift out of equities into, you know, cash or bonds during a a vol-event. Well, we view them as the primary source of much of this de-leveraging over the last week. Again, volatility is your exposure toggle. We got it.

We think they've sold almost over the past two weeks, $130 billion of equities. Because of that realized vol issue that we're talking about, where, you know, still with the front VIX future right now, as I was walking in here, was kind of, you know, 28 or so, you're still, you know, pricing in something close to 1.8% daily moves in the S&P. You know, it's going to take a month of 50 basis point moves to get half of that buying back. Even just two weeks of 50 BIPs moves a day, which is a magnitude smaller versus where we are right now and we're still price for stress is barely going to create any buying right now. So you need a sustained period of calm.

you don't need rallies. You just need, you know, VAL tends to mean revert. At some point, you've got to keep feeding volatility with big moves or else it tends to mean revert lower. And that's when the VAL sellers reappear. And that's when dealers get long gamma. And that's when markets begin to compress again. And that's when, you know, we can see some kind of resumption of, say, more constructive behavior. Joe, you know what's cool. On the terminal, you can chart target VAL equity exposure. And you can see it peaking in sort of June and then obviously falling very precipitously in recent days. So that's kind of cool. Charlie, we have to keep this fairly short because it's an emergency episode. We want to get it out quickly. But I have one very important question for you,

which is I have someone visiting me in the next week or so in New York. Where should I take them for stake? Oh, good question. I figure you're the guy to ask. We ask you about Vol and meat, basically. You know, what's so funny is that I get, you know, I'm a home steak guy. Like I have a half cow share. So I get, you know, these parts delivered to me from upstate. So it's like something Tracy would have. Oh, I love bone marrow. Oh, my God.

I have nothing better. Oh, it's so good bone marrow on. And the bone marrow on the steak then, right? It's like eating a life force. I love it. I drink it, the bone broth, all that stuff. So I honestly am somewhat averse to restaurant. Steakhouse is oftentimes cooking with vegetable oil, seed oils, all that stuff.

I've always been like a big brawny New York City steakhouse type of a guy. So like a very generic Smith and Wolley type of a place. Oh, yeah. It's just, you want to get lunch today? Yeah, actually, I'd be totally up for it. Actually, my lunch plans just fell through. So I actually have some time. We could talk through some stuff.

Let's get steak for lunch. Yeah, let's do that. Okay. Lots more is produced by Carmen Rodriguez and Dashel Bennett with help from Moses on I'm in Kail Brooks. Our sound engineer is Blake Maples. Sage Bauman is the head of Bloomberg podcasts. Please rate, review, and subscribe to odd lots and lots more on your favorite podcast platforms.

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