Lots More on Solving the Mystery of the Big Market Selloff

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1:08bloomberg audio studios podcasts radio news hi how are you great to see you again how's life nice to see you what's up good to see you thank you guys for having me no thank you for coming thanks for anything going on this week big week holy moly yeah you know we've been feeling stuff seeing stuff for a while but you 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. I got back Sunday. I was like, I got to start this right now. I did a deadlift. One, two, three. Hegemony. Hegemony. Okay, go. Hegemony. Barges. This is an after-school special, except...

1:52I'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 squid ink pasta? 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 Odd Lots 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.

2:26And we really do have the perfect guest. So when you say that stuff was already getting a little hairy, 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. Skew is this relative measure of kind of demand for downside versus demand for upside. which is something that we can come back to later. But without a doubt, when you began to see SKU relentlessly stay bid, when you began to see the volatility of volatility stay so bid, even as stocks were trying to stabilize after some of the recent death by paper cut of geopolitical and 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.

3:31But, you know, it told you that there was this, you know, grab into tails. And 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, SKU 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 my view is this, skew really on a longer horizon, like decades type horizon, to me is representative of what's the actual risk-taking, risk-appetite backdrop, meaning it's heavily related to central bank policy.

4:20So, for instance, in the kind of QE era where the Fed was trying to incentivize a wealth effect, right? They wanted you to be leveraged long assets because that's economically virtuous, right? Consumption, paper wealth effect, all those things. You were leveraged long risk assets skew as steep because you had something to hedge. But after the events that created that 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 chain disruption, into the stimulus, plus the tectonic stimulus, which had never been tried before, in addition to the unprecedented quantitative easing, you finally had this escape velocity inflation event, which then forced the Fed behind the ball.

5:18And 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 is an at-the-money put, right? It's a hedge there. You were able to sleep at night, collect 3%, 4%, 5 % at times.

5:56The 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, vol 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.

6:33The 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 vol selling, right? So down days were opportunities to sell vol. And at the core of everything that has kind of happened over the last week in particular, last few days really, has been about that kind of come to Jesus moment for the short vol trade of the past two years. So, you know, you had this dynamic where flat skew was a feature of quantitative tightening.

7:12And 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 vol correlation. So we are speaking with Charlie McGilligot. 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.

7:52Yes. Yes. You can have this one. Volma Fedyen. And the Volma is AI. So it's volatility, AI, Fed, and yen. Wow. That's good. That really rolls off the tongue. Yeah, I know. It's meta is what it is. It's going to be useful in some. 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 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.

8:32So 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.

9:15You need low volatility to be able to accumulate those positions, 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-dovish 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 market expectations. They ultimately are targeting half the bond buying and they'd already cut off the ETF purchases.

9:57That 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 kajillion strategies out there. And yes, carry had been popular. Carry 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 vol 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.

10:42I say this all the time. This is often used with regards to these deleveraging events. It's oftentimes used when discussing systematic strategy, vol events. But volatility is the exposure toggle in modern market structure. And that being the case, sustained periods of low volatility, where I would say that 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 vol narrative as the market was forced into a soft landing consensus last year. People were perpetually trying to pull forward the hard landing recession and end of 22, start of 23.

11:35You had the Civ B 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 vol backdrop was really facilitating this massive growth in the short vol stuff that's been out there and the AUM growth. And it's not just short vol premium income ETFs, of course.

12:15It's VRP. It's dispersion strategies. It's correlation, short correlation trades. It's QIS 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 vol supply. And here's kind of the kicker to me. With regards to that soft landing outcome, which was consensual, we had had a kind of assigned a zero delta of a hard landing. But we had been saying for quite a long time, 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 less than a month span, we've seen six of the last seven major U.S.

13:00labor 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 vol 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 vol buildup in history, does have a stopping out. And that's where we are.

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15:05Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S.-listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. 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.

15:38And 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 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. 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.

16:16We've been conditioned to see these opportunities to monetize downside hedges or say VIX upside convexity or S &P downside in the span of hours. When you have these, whatever the macro catalyst is, 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 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 or across multiple strategies that we referenced earlier, a lot of people ended the day Friday thinking that they could be short vol and maybe short delta or short the market, but also too short vol coming out of that trade because the vol moves were so magnificent, so outlier.

17:15The issue then became that they got their fingers blown off on the Monday reopen. So you can lose money trying to do that based on prior back test on these outlier vol squeezes. It's when Asia crashed overnight, and that in and of itself is another conversation, another 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 bid for tails and Vivex went absolutely bonkers. Oh, yeah. Volatility of volatility. That was the one to watch. Yeah. As far as just a read on demand for tails, it was over for those people. So the second day in a row, and now you have a pattern here where 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.

18:11And by the way, this vol squeeze, this vol outperformance on a beta adjusted look was unlike anything we'd seen. I'm telling you, like past COVID extremes at a point, past Volmageddon or LTCM, you know, some of these metrics were unbelievable, whether it was VIX relative to S &P, whether it was Vol Vol relative to VIX, whether it was SKU relative to at the money implied vols, all these different metrics, 100th percentile. This was a vol 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 talking about risk management on the show.

18:58From a risk management perspective and your VAR, that it is going to be incredibly difficult to get that reflexive, say, systematic buyer back in the market right now, or that discretionary macro trader who's running the back test. And the backtester saying after these types of vol overreactions, you've got to be long the 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 up ways. You're not going to be able to allocate any risk into this trade of any size that's going to make a difference.

19:34So 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 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?

20:18I mean, and I then too think back to like the financial crisis where it was one large hedge fund kind of liquidating their converts book that really started like a knock on calamity leading 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 Nikkei, the short yen, obviously the carry component have been great trend trades with high sharps for a reason. There's a fundamental economic story. You got the third arrow achieved. You've got wage renegotiation. Now corporates have pricing power.

20:59Consumers 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 US exceptionalism trade is dominated for a decade, and Europe is eternally tied into China, and Europe is eternally cyclical, and 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.

21:38So 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 de-risking, particularly amongst a lot of overseas leveraged pod multi-strat investors that have been there, you shoot first, you ask questions later, it's skinny exits and the deleveraging and getting out of a place that is that type of illiquid, liquidity constrained. it was just a magnitudes move, but it was all the stuff that had the highest sharps. It was Topix banks, right? It was all those things that are going to be most sensitive to escaping negative interest rates.

22:15And you crowded into them and you crowd out of them. And the magnitude of those moves now, as you're seeing both down and back up, speaks to how much leverage was in that trade. And that was just a particularly sloppy unwind.

22:33Thank you.

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23:38Complete disclosures available at public.com slash disclosures. So, have you heard the story about the prescription plan with savings automatically built in? It's where a family of any size can feel confident the cost of their medication won't hold them back. Go to cmk.co slash stories to learn how CVS Caremark helps members save just by being members. That's cmk.co slash s-t-o-r-i-e-s. So as you said, people have had their fingers burnt multiple times now, and we think there might be some shortfall exposure still left in the market. What are these sort of, I guess, either pain points that you're looking at that would accelerate the downside or the sort of things you need for a durable recovery.

24:28As 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 coming into today and how if we'd be able to hold on to the rally last night was at the end of the US cash equity session yesterday, day, it was an ugly close from a vol perspective. Vol went out bid, skew went out bid. Vol of vol was super firm, super sticky. There was no pullback despite, 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 just about four and a half billion bucks at Delta.

25:13And it rallied us like 20 handles. But vol was still stressy. That to me is indicative of the fact that they're 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.

25:59But as the equity market rally became so unstable over the course of the past year, VIX upside, so VIX calls was, or call spreads, but that's not a true hedge, that's a separate conversation, was kind of the most popular tail hedge out there. VIX is inherently convex. It's the square root of variance. So it's going to move off the line. It's going to outperform into 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 fills back in. People keep reloading on it because this trade has been quite cheap.

26:37Once this short vol trade really began to implode, what you started seeing, and we did recently have another reload last week of a dealer getting short, 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 vol correlation, meaning as the market's going lower, vol is going higher again, they have to go out and short futures. So that to me, when we saw the market staying stressy into the close, I know that people are still buried in some of those trades and are not out.

27:19I think a lot of people were finally getting the shoulder tap in the last 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 that 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?