One week ago, Jeff Gundlach urged his twitter followers to take profit on his “top trade of 2019” he had put on just one month earlier at the Ira Sohn conference, buying rate vol, when the trade (in the form of a put-call straddle on TLT) had returned 22%.
In retrospect, Gundlach may have just scratched the tip of the iceberg, to mix metaphors, because after a drop, rate vol in the form of the MOVE index has once again spiked to multi-year highs even as equity vol remains surprisingly subdued (with oil vol somewhere in the middle).
One reason for this may be a seismic shift taking place under the rate surface, as one or more dealers and/or clients, are unwinding a giant Eurodollar swaption, which has sent short-term vol into the stratosphere and is sending out painful shockwaves not only across the entire curve but various other asset classes too.
In his comment on today’s key market moves, Nomura’s derivative expert Charlie McElligott, says that today’s main event is not whether oil will go up (or down) on the ongoing tensions in the Straits of Hormuz, or even how stocks will gyrate as the Fed’s rate cut intentions are repriced following conflicting overnight economic data (– from China, + from the US), but whether there will be “further follow-through of this ongoing “stress event” in USD Rate Vol space, as the “upper left” – in the vol grid shown below – is “evidencing tremendous pain for Dealers who are hedging their short ATM positions “and exacerbating this outrageous front-end squeeze (as well as stop-outs from systematic “short vol” strategies because the entire surface is now “bid”).“
The extremely painful repricing of the end of the Fed’s tightening cycle, which has only accelerated in recent weeks, is shown in the vol cube below.
As McElligott explains, the chart above shows how USD Rate Vol dealers, who are long wings and short ATM, are seemingly “being LIT ON FIRE, along with systematic “Short Vol” strategies to a lesser extent, as the whole surface is “bid” i.e. 30Y tails” in the vol cube above by the “stunning” moves in the “upper left” of the USD Swaption / Vol grid, as “Short Gamma” / “Negative Convexity” strikes again.
The resulting gamma as “someone” remains painfully trapped and unable to unwind a negatively convex trade – think short squeeze that only get more painful as more dealers cover – is also further exacerbating the “grab” of Eurodollar futures, as a result of what McElligott calls “seemingly “perpetual” short-dated upside expressions trading (huge Z9 calls trading for October expiry past few sessions, with more call spreads, call flies and call condors active overnight across front-end ED$) and preliminary Open Interest data showing fresh longs in the front-end of the strip (U9 +25k; Z9 +34.5k; H0 +23K; M0 +36k)“
So as we wait to see if one or more dealer desks, or macro funds, suddenly get the Volkswagen treatment and unleash hell in the swaption space, here are some observations on yesterday’s torrid move in stocks, where according to the Nomura experts, “equities price-action looked “gross-down”-esque in pure “Momentum Unwind” fashion (1Y Price Momentum -2.0% on session, 4th worst day of year and a -2SD move vs past 1Y), as despite another large rally in Rates / USTs we saw Defensives / Low Vol (now purely “Momentum Longs”) hit LOWER against Value / Cyclicals (“Momentum Shorts”) squeezing higher (Materials +1.7%, Energy +1.3%, Industrials +0.6% vs SPX +0.4%)” as shown below.
And while the rate vol turmoil has yet to spread to equities, yesterday saw the 6th worst drawdown in McElligott’s US Equities model L/S HF portfolio of 2019, with performance-pain being exemplified by the standard “Value / Momentum” factor ratio signal (+2.7% on the day, as it represents “the opposite of crowding”—look at the QTD / YTD returns).
What about the surge in gold?
Whether aided and abetted by recent bullish commentary from Stanley Druckenmiller, Paul Tudor Jones, or Jeff Gundalch, the ongoing gold breakout is “the ultimate “Short USD” expression into mounting Dollar pessimism across Macro, as there is no central bank on the “other side” who can pivot “more dovish” to offset the Fed’s coming easing cycle” according to the Nomura strategist.
And as Real yields are collapsing as the data- and inflation- slows, “along with the mounting potential for an “activist” Fed (go big or go home)”, this all sets the table for this conditioned “commencement of Fed easing cycle”/”QE-trade” winner, in this case gold, which as PTJ said earlier this week, is his favorite trade for the next 12-24 months.
Meanwhile, with all these various cross-asset tensions stretching their respective rubberbands, McElligott concludes by noting that “the most crowded trades in the world” – “receiving in Rates, long ED$ / USTs / Duration, long Steepeners” – keep on working…. Although should the Fed shock the market next week by leaning hawkish and unwinding the market’s expectation for 2 or more rate cuts in 2019, watch out below as the “most crowded trade in the world” suddenly implodes.
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Author: Tyler Durden