"Friday 'Shock' Larger Than Brexit For Quants": BofA Expects $52 Billion In Near-Term Selling Pressure

It all started with a note by JPM's Marko Kolanovic last Wednesday, in which he warned that the period of market calm is ending, and volatility was about to surge, which in a reflexive fashion would lead to accelerated selling by quant, systematic and risk-parity funds as a result of near-record leverage. While a driver of the recent market stability the "relatively stable macro data and a seasonal decline in trading activity" he explained that "a significant driver of the volatility collapse was derivatives hedging effects, also known as pinning", as well as the near all-time high leverage for Volatility Targeting and Risk Parity strategies. "This is all about to change as a number of important catalysts materialize this month (ECB, BOJ, Fed meetings), seasonals push market volatility higher, and leverage in systematic strategies and option positioning provide fuel for volatility."
*) For those who missed his must-read note, which predicted the Friday plunge with uncanny precision, this is what he said: As market volatility plummeted, investors added to option protection and moved (struck) it closer to current price level. The market would need to move only 1-2% lower for option hedging to push volatility higher (as opposed to suppressing it, which was the case past 2 months). Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure. Our estimate of equity exposure for these strategies is shown in Figure 1...

Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility. In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October. Figure 2 above shows that equity volatility tends to increase by ~20-30% in September and October (September also tends to be the worst performing month, with an average -1% return). This seasonality is also present after removing prominent outliers (e.g. 2001, 2008, 2011, and 2015). When it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of ~$100bn, which could push the market lower.
*) So, following Friday's broad-based deleveraging across all quant, and certainly risk-party funds, the topic of forced selling has dominated sellside research, with BofA releasing a report overnight according to which "multi-asset vol controlled portfolios that use a systematic approach similar to our models may be subject to $12bn in global equity selling pressure in the coming days ahead. Likewise, we estimate about $40bn in global equity selling pressure via CTAs in the near term. Between the two, we could see ~$52bn in near-term selling pressure, half of which may be through US markets. Global equity selling pressure via CTAs could also increase as European and Asian markets had closed before a large portion of the move lower in US equities on Friday."

Even more interesting is BofA's comparison of what happened today with the post-Brexit selloff: according to BofA Friday was worse, as the notional volume traded in S&P500 E-mini futures alone was $516bn. "While the current selling pressure we estimate from quant funds is only ~10% of the volume traded, the key question is if this is just the beginning of more volatility that ultimately puts more selling pressure on the market. In comparison with past shocks, during Brexit our models estimated ~$50bn of selling but only from CTAs and over a ten-day period in August-2015, ~$115bn from CTAs and ~70bn from multiasset risk-parity like funds. Importantly, in a fragile market with low conviction, the risk is that negative price action alone drives further selling." So far this is precisely what is going on.

*) Here is the full note by BofA's Chintan Kotecha and team, which if correct, means even more pain for stocks in the coming days.
# Record lull in volatility finally breaks as shock risk runs high; Through Thursday Sep 8th, the S&P500 recorded its longest stretch (42 trading days) in history (since 1928) of trading within a range of 1.77%. Friday, this lull was broken as the S&P fell 2.45%, its largest daily move since Brexit. However, unlike the Brexit selloff, Treasuries also fell, causing a greater jump in multi-asset portfolio volatility. As we have highlighted, markets remain vulnerable to a shock as the recent low vol has pushed up leverage and long positioning across a range of investment strategies.
# Low vol + rising equity = elevated leverage & positioning; In our weekly report two weeks ago, we noted the degree to which low volatility and rising equities could potentially be increasing leverage and long positioning from certain quantitative based funds. Specifically, our models showed leverage levels across multiasset & other portfolios that target fixed volatility may have been at their max limits. As well, our bottom-up CTA model suggested that positioning in global equities via trend following managed futures funds could be at its highest levels since 2015. For both classes of funds, the theoretical risk of deleveraging can be highest when vol spikes up from low levels and when assets had been trending higher, much like environment prior to Friday. In addition, BofAML US quant strategy has recently noted that a number of long-only and hedge fund positioning metrics are back to 2015 or higher levels.
# Declining equity/bond diversification leading to higher vol; Three-month correlation between the S&P500 and 10-Year US Treasury bond prices set its YTD low on the Monday post-Brexit at -0.66. As a result, risk parity-style portfolios likely fared well through Brexit as sharp moves lower in global equities were diversified by the strong performance in bonds. In the almost three months since then, the correlation of daily moves between the two increased to -0.08 and over the last month alone, the correlation has turned positive to 0.27. Increasing correlation implies less diversification for risk parity-style portfolios and could be a precursor to higher vol.
# Friday's shock alone likely larger than Brexit for quant funds. As a result of Friday’s decline, we estimate multi-asset vol controlled portfolios that use a systematic approach similar to our models may be subject to $12bn in global equity selling pressure in the coming days ahead. Likewise, we estimate about $40bn in global equity selling pressure via CTAs in the near term. Between the two, we could see ~$52bn in near-term selling pressure, half of which may be through US markets. Global equity selling pressure via CTAs could also increase as European and Asian markets had closed before a large portion of the move lower in US equities on Friday...

While not dominant driver of flows; still key to watch. For perspective, on Friday, the notional volume traded in S&P500 E-mini futures alone was $516bn. While the current selling pressure we estimate from quant funds is only ~10% of the volume traded, the key question is if this is just the beginning of more volatility that ultimately puts more selling pressure on the market. In comparison with past shocks, during Brexit our models estimated ~$50bn of selling but only from CTAs and over a ten-day period in August-2015, ~$115bn from CTAs and ~70bn from multiasset risk-parity like funds. Importantly, in a fragile market with low conviction, the risk is that negative price action alone drives further selling...

Things To Ponder

Selloff gathers pace as stimulus pullback fears deepen (Reuters)

Clinton's bout of pneumonia raises worries for Democrats (Reuters)

Google's Self-Driving Car Project Is Losing Out to Rivals (BBG)

OPEC sees more oil supply from rivals, implying larger 2017 surplus (Reuters)

Oil falls as U.S. drills more (Reuters)

"Global Market Rout"; Bond Selloff Snowballs Into Stock Liquidations On "Stimulus Pullback" Fears

While there is not much to add to our previous market wrap from earlier this morning, now that traders in the US are arriving at their desks, the selloff appears to be accelerating and as Bloomberg notes, "a selloff in fixed income is starting to snowball into a global market rout"driven by what Reuters dubbed "growing concerns that global central banks' commitment to the post-crisis orthodoxy of super-low interest rates and asset purchase programs may be waning." It appears Kuroda broke markets once again, the reason being the central bank insistence to steepen yield curves to avoid suffocating banks and pension funds, while keeping the broader easing theme on hold even as it means trillions in longer-dated bonds now find themselves in limbo as frontrunning central bank purchases is no longer possible. So what do traders do?
Why they sell of course. As Bloomberg also adds, "shares in Europe and Asia dropped the most since the aftermath of the U.K. Brexit vote in June, and U.S. stock-index futures fell as concern spread that central banks are preparing to wean markets off unprecedented stimulus. Treasuries extended their slide into a fourth day as the U.S. prepared to sell three- and 10-year notes, and the yield on benchmark German bunds reached the highest since Britain’s decision to exit the European Union was confirmed. Oil sank toward $45 a barrel as nickel tumbled the most in four weeks. The yen advanced and the won slid. Samsung Electronics Co. tumbled after airlines and regulators warned against the use of its Note 7 smartphones." Come to think of it, it really is starting to look like a bloodbath, especially considering the dominant color in the following market summary table...

 
Last week we first warned that the incipient selloff in long-dated bonds, which the market had ignored for months, would spill over into all global markets and products, and sure enough that is precisely what is taking today, continuing Friday's sell off. Starting with a tumble in longer-dated government bonds, "financial markets have been jolted out of a period of calm by an uptick in concern over the outlook for central bank policies. Lael Brainard, a member of the Federal Reserve’s board of governors, speaks Monday in Chicago, days after Fed Bank of Boston President Eric Rosengren said the economy could overheat." Not helping risk sentiment, the ECB last week played down the prospect of further stimulus and Bank of England Governor Mark Carney said the chances of a U.K. recession had fallen. With the the Bank of Japan set to unveil the results of a comprehensive policy review at its its Sept. 20-21 meeting, traders are on tenterhooks especially after a Friday Reuters report that the BOJ is now actively considering steepening the JGB yield curve. “It was only a matter of time for this selloff,” said Bankhaus Lampe, Germany. “We had seen post Brexit a really notable rebound in markets even if fundamentals hadn’t improved accordingly. I expect some more downside going forward. There’s also the risk of the Fed meeting coming up.” As a result, the MSCI All-Country World Index of shares fell for a third day, dropping 0.8 percent in early Europe trading. All major western-European stock markets dropped as the Stoxx Europe 600 Index lost 1.7 percent. The VStoxx Index tracking euro-area equity volatility headed for its biggest jump since January, signaling a return of instability after an extended period of stable prices. Miners posted the worst performance of the 19 industry groups on the Stoxx 600 today as commodity prices retreated.
Energy companies slid as oil extended declines after U.S. producers increased drilling. Linde AG tumbled 8.4 percent after saying it terminated talks for a combination with Praxair Inc. EON SE slid 15 percent after spinning off its Uniper SE unit. RWE AG fell 3.1 percent after confirming plans for an initial public offering of Innogy SE shares in the fourth quarter. SVG Capital Plc jumped 15 percent after HarbourVest Global Private Equity Ltd. offered to buy it for about 1 billion pounds ($1.3 billion) in cash. Emerging Markets allowed no safe haven today, and the MSCI Emerging Markets Index slid 2.3%, the most since the June 24 Brexit vote. The gauge has tumbled 4.2% in two days, poised for a one-month low. The Hang Seng China Enterprises Index of mainland companies listed in Hong Kong sank 4 percent, the most in seven months, and South Korea’s Kospi lost 2.3 percent.
Samsung plunged 7 percent after U.S. regulators joined the company in cautioning users to power down their Note 7s and refrain from charging them. Aviation authorities and airlines have called on passengers to stop using the gadgets during flights. The company announced a recall of millions of big-screen smartphones on Sept. 2 after about three dozen of them were found to have batteries that caught fire or exploded. S&P 500 Index futures slipped 0.7%, and were aggressively propped up by the key support level of 2,100. Crude oil was down 1.7%, flirting with $45, after Friday's Baker Hughes report that U.S. active rigs rose once again, while bets on falling prices also increased. OPEC’s monthly market report due at 6:45am ET. But the asset class currently in the driver's seat remain bonds, where the selloff at the long end continues. Germany’s 10-year yield climbed four basis points, or 0.04 percentage point, to 0.05 percent, and touched the highest level since June 24. Spanish bonds with a similar maturity dropped a fourth day, pushing the yield to the most in seven weeks.
Yields on 10Y Treasuries rose two basis points to 1.69 percent, before sales of a combined $44 billion of three- and 10-year notes. The three-year noes being sold later on Monday yielded 0.95 percent, an increase of 10 basis points compared with the previous auction on Aug. 9. Brainard, seen as a leading opponent of rate increases for much of the past year, is the last scheduled Fed speaker before the self-imposed blackout period running up to the Sept. 20-21 policy meeting. Any hawkish shift in her rhetoric may stoke volatility in financial markets, which on Friday put the probability of a hike in borrowing costs this month at 30 percent. Ten-year yields in Australia surged nine basis points to 2.05 percent, after gaining 10 basis points on Friday, and that for New Zealand debt with a similar due date jumped 11 basis points to 2.47 percent. Japanese government bonds with maturities of less than a decade advanced and longer-dated securities declined. The moves follow a Reuters report on Friday that said the Bank of Japan was studying options to steepen the nation’s yield curve. The cost of insuring corporate debt against default jumped the most since late June. The Markit iTraxx Europe Index of credit-default swaps on highly rated companies climbed four basis points to 72 basis points. A measure of swaps on junk-rated corporate issuers rose 16 basis points to 332 basis points. Both gauges are at the highest in about two months.
◦S&P 500 futures down 0.6% to 2104
*) Global Headline News;
◦Global Stocks Sink With Bonds, Commodities as Fed Angst Builds: Fed’s Brainard is among officials due to speak on Monday
◦Linde, Praxair Agree to Terminate Discussions on Merger: Deal would’ve created world’s biggest industrial gas supplier
◦HP Inc. Buying Samsung’s Printer Business for $1.05b: HP seeking to become a bigger player in copiers and printers
◦North Korea Seen Ready to Conduct New Nuclear Test at ‘Any Time’: ‘High’ probability next detonation could come this year
◦Clinton, Suffering From Pneumonia, Cancels Trip to California: Incident fuels speculation about Clinton’s health
◦Perrigo Targeted by Activist Starboard With New 4.6% Stake: Activist critical of missteps since drugmaker rebuffed Mylan
◦Starbucks New Tea Line Chases China’s $9.5b Tea Market: Launches tea products in Asia-Pacific after U.S. growth
# Looking at regional markets, we start in Asia where stocks traded negative across the board following Friday's US sell-off, where all 3 major indices slumped over 2% following hawkish Fed rhetoric and weakness in commodities. ASX 200 (-2.2%) printed fresh 2-month lows, weighed on by commodity weakness in which WTI crude futures declined over 3%, while a firmer JPY dampened hopes of a rebound in Nikkei 225 (-1.7%). KOSPI (-2.3%) fell below 2,000 amid continued geopolitical concerns and losses in Samsung Electronics. Shanghai Comp (-1.9%) and Hang Seng (-XX%) conformed to the widespread negative tone in the region, with the latter suffering from an increase in Hong Kong money market rates after the 3-month HI BOR gained the most since February amid speculation that the PBoC could be intervening in the CNH to prevent CNY depreciation ahead of the first Special Drawing Rights (SDR) operation at the start of next month. 10yr JGBs fluctuated with early support seen as the downbeat tone across equity markets increased demand for safety, however, prices then reversed aggressively in late trade following the BoJ's buying operations which was for a relatively reserved amount.
*) Top Asian News;
◦Traders Most Bearish on Yuan in Four Months as Loan Rates Surge: Bonds extend drop as 10-year yield rises to 7-week high
◦China Proposes Tighter Bond Market Leverage Rules After Defaults: An investor’s repo holdings can’t exceed 70% of bond holdings
◦Bond Rout in Japan Will Pass, Says Analyst Who Picked Rally: Falling liquidity exposes market to spike in yields, Sano says
◦Ex-SAC Trader Said to Shut Hedge Fund Backed by Alibaba Founders: Pinyin is led by Bazarian, who worked at SAC for 10 years
◦Samsung Drops After Warnings to Stop Using Note 7 Phones: Global aviation authorities warn against use while on planes
# Friday's selloff in the US remains at the forefront of traders' minds today, with the downside filtering through to Europe, with all major European indices in the red (Euro Stoxx: -2.3%). In terms of a sector breakdown, all sectors reside in negative territory, with financials and materials among the worst performers. E.on (-12.5%) remain the worst performer, given that today sees the first day of trade for Uniper, combined with reports of higher liabilities for nuclear waste storage. Also of note, Linde (-8%) are among the worst performers after their merger with Praxair fell through. Fixed income markets have also continued their decline, with Bund yields soaring further into positive territory, with the US weighed on by a significant quantity of supply, in the form of USD 24b1n 3yr notes and USD 20b1n 10yr note auctions.
*) Top European News;
◦Deutsche Bank CEO Says Asset Management Is ‘Essential Part’; Cryan tells staff not to become distracted by ‘speculation’
◦Basel Capital Revamp Endorsed Without Assurance Sought by Europe: Basel aims to finish capital framework revision this yr
◦HarbourVest Offers to Buy SVG Capital for About $1.3b: SVG shareholders will receive 650p in cash for each share they hold
◦Carney to Assess Post-Brexit Strength as BOE Rate Seen Unchanged: BOE will announce policy decision on Thursday
◦EON Loosens Grip on Old Power Plants as Uniper Starts Trading: Uniper starts trading at EU10.015/share in Frankfurt
◦AB Foods Drops as Primark’s Summer Slowdown Prompts Selloff: Primark’s same-store sales declined about 2% in 4Q
◦Schaeuble Goes Global to Crack Financial Transaction Tax Dilemma: Austria’s Schelling says decision needed in October
◦Volkswagen Eyes Bond Sale as Carmaker Seeks to Move Past Scandal: Has ‘pretty good handle’ on scandal’s financial risk
# In FX, the Bloomberg Dollar Spot Index fluctuated near a one-week high before Brainard’s speech, with regional Fed chiefs for Atlanta and Minneapolis also lined up to speak on Monday. The yen appreciated 0.6 percent versus the greenback. There’s “growing caution over a rate hike as the day of the Fed’s decision draws closer,” said Masashi Murata, a currency strategist at Brown Brothers Harriman & Co. in Tokyo. “Markets had been too confident that a hike wouldn’t happen. But global economies are not in a critical phase, so there’s a limit to selling on risk aversion. Money will eventually seek yields and underpin high-yielding currencies.” The won slumped 1.4 percent, the worst performance among major currencies, after Yonhap News reported that U.S. and South Korean intelligence authorities see a high chance that North Korea will conduct an additional nuclear weapons test after holding one on Friday. The MSCI Emerging Markets Currency Index slid 0.4 percent, leaving it down 1.3 percent over two days.
# In commodities, the Bloomberg Commodity Index fell 0.6 percent, after sliding 1.3 percent on Friday. Crude oil sank 1.6 percent to $45.14 a barrel in New York after American producers increased drilling, adding to a glut. U.S. rigs targeting crude rose to the highest since February, according to data from Baker Hughes Inc. Nickel slid 3.4 percent in London, dropping for the first time in eight days, while tin tumbled by the most since May. Gold rose 0.1 percent, after retreating 1.6 percent over the last three sessions. Iron ore fell in China to the lowest since June amid speculation the nation’s policy makers will tighten property curbs and so cool demand for steel. Steps should be taken to restrain bubble-like expansion in the housing market, Ma Jun, chief economist of the PBOC’s research bureau, said in an interview with China Business News. Wheat in Chicago fell 0.7 percent to about $4 a bushel, approaching a decade-low of $3.8675 reached on Aug. 31. Money managers have their biggest-ever bet on price declines and a global stockpile estimate by the U.S. Department of Agriculture is forecast to still be at a record high after the figure is updated on Monday.
# On today's calendar, with the FOMC blackout period taking effect from Tuesday the Fedspeak is frontloaded to today. Lockhart will speak at 1.05pm BST, Kashkari at 6pm BST and perhaps most significantly the uber dovish Brainard is scheduled to speak at 1.15pm Chicago time.
*) Bulletin Headline Summary from RanSquawk and Bloomberg;
◦Friday's selloff in the US remains at the forefront of traders' minds today, with the downside filtering through to Europe ◦Commodity currencies vs the JPY have been the primary target for risk sellers, and this has eventually weighed on USD/JPY which is now eyeing another test below 102.00
◦Looking ahead, highlights include comments from Fed's Lockhart and Brainard
◦Treasuries slightly lower in overnight in overnight trading with global equities drop amid concern that central banks are preparing to wean markets off unprecedented stimulus. Week’s auctions begin with two events at 1pm ET with $24b 3Y notes, WI 0.945%; sold at 0.85% in August and $20b 10Y notes (re-opening), WI 1.675%; last sold at 1.503% in August, 72.2% awarded to indirect bidders was among highest on record;
◦Fed’s Brainard will begin speaking at 1:15pm ET in Chicago
◦The plunge in euro-area government bonds that has driven German yields to their highest level since the U.K.’s Brexit vote is unlikely to escalate into a full-blown rout, according to Charles Diebel, head of rates at Aviva Investors
◦The U.S. government should consider fiscal and regulatory reforms to boost economic growth because the scope for low interest rates alone to do so is limited, said Federal Reserve Bank of Minneapolis President Neel Kashkari
◦ABN Amro Group will cut as many as 1,375 jobs through 2020 as the Dutch lender begins to implement a 200 million euro ($225 million) cost-cutting plan announced last month
◦Money managers increased wagers on falling oil prices by the most in three months as a meeting between Russia and Saudi Arabia ended without specific measures to support prices
◦Oil extended declines following the biggest drop in more than a month after U.S. producers increased drilling as the market contends with an overhang of crude and fuel inventories
◦The central bank governors overseeing the Basel Committee on Banking Supervision backed the “broad direction” of the regulator’s bank capital-rule revamp, while stopping short of providing assurances sought by Europe on the overhaul’s impact
◦China should take steps to restrain bubble-like expansion in housing markets and tame excessive financial inflows into property, according to Ma Jun, chief economist of the People’s Bank of China’s research bureau
◦China has proposed measures to tighten leverage rules in the onshore bond market, highlighting concern that investors’ borrowings are overextended after a series of defaults
◦Democratic presidential nominee Hillary Clinton canceled a two-day trip to California after her campaign disclosed Sunday that she’s suffering from pneumonia. The cancellation followed Clinton’s abrupt departure from a Sept. 11 commemoration....

CBS; August Bankruptcies Lowest In Eight Years

The number of bankruptcies in the Netherlands last month hit its lowest point in eight years, according to national statistics office, the CBS nieuws. In August, 282 companies failed, which was 88 fewer than in July and the lowest monthly total since October 2008. Bankruptcies have shown a pattern of general decline since a peak in May 2013, and the first eight months of 2016 had almost a fifth fewer than the same period last year. Most companies that went out of business in August, the CBS said on Friday, were traders and financial services....

Temperature Records Set To Tumble As Heatwave Hits Holland

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