Now that inverse VIX ETFs have effectively blown up, suffering “termination events” like XIV earlier today, one of the forming bullish market narratives is that there will be no incremental “squeezed” buying of VIX from this key vol-selling group. Of course, there is a perfectly obvious flipside to that which few have pointed out, namely that holders of the inverse ETPs lost $3.4bn as the products went bankrupt, which removes a steady source of volatility supply over the last year.
But a bigger question is whether the vol selling is indeed over, and according to a just released analysts from Bank of America the answer is a resounding no. In a note from BofA’s Benjamin Bowler, the derivatives expert writes that the ETP driven vol explosion which we described in painful detail previously, is just the beginning.
While BofA’s model implements position changes in response to a given day’s moves on the close the same day, in reality, both risk parity and CTA strategies operate over varying horizons. In any case, the bank’s derivatives team expects actual rules-based risk parity and CTA strategies to implement significant allocation changes within a few days.
So, with BofA assuming $200bn in rules-based risk parity strategies and $250bn in model-driven CTAs, then its models estimate $140bn of global equity unwinds as a result of Friday’s moves and another $60bn as a result of Monday’s moves.
There are two ways to read that number: over the same two days global equity index futures volumes across the largest markets was approximately $1.6 trillion. So if BofA were to assume the entirety of equity unwinds were completed, then it would equate to approximately 12% of the volume over the last two days.
However, it is certain that the move is nowhere near done and BofA expects that if risk parity and CTAs are still unwinding equities in the coming days, then it will be against a continued rise in volumes due to higher volatility.
As a reminder, earlier in the day we presented calculations from Morgan Stanley‘s quant team, according to whom annuity funds will now need to sell between $30 and $35 bn of equities on Tuesday, and a similar amount Wednesday while Risk Parity could provide an additional $10 to $20bn in equity and bond supply this week.
Further, regarding risk parity BofA’s models estimate that funds are on average around 1.3x leveraged with an about 30% allocation to equities. Assuming about $200bn in unlevered AUM, that gives nearly $75bn remaining exposure to equities. Since risk parity typically does not go short, remaining equity selling pressure – once the current $200BN is offloaded – should be less than what some estimate, the question however is how easily digested that initial sale will be.
There is some good news: According to BofA’s models, CTA equity long positions are in the process of unwinding or are completely sold, with only $75BN left in global equitie4s.
While CTAs have the potential to continue selling via turning short, we believe the risk to that is low as CTAs often use moving average crosses to determine long and short positions. While specific parametrizations can vary tremendously across CTAs, in our opinion an important combination worth monitoring is both the 1M vs. 3M and 1M vs. 10M moving average crosses. Given the strong rally in equities over the last year and longer, the 1M moving average still remains well above the 10M and we do not believe shorts build up until we see that set cross.
However, speaking of CTAs, there is another potential major risk factor: a sudden spike lower in Treasury yields. Recall our article from January 24 “Momentum Traders Wreak Havoc For 2Y Treasurys, Could Unleash Sharp Bond Liquidation” in which we explained that some of the biggest marginal buyers, and sellers, of 2Y notes are CTAs.
Well, according to BofA’s latest analysis, the rally yesterday in bond futures “is causing our model CTA portfolio to cover its short US bond futures position in order to limit losses. Given the recent significant trend lower in bond prices prior to Monday’s reversal, our model’s short position was quite high. Should actual CTAs also start unwinding their short US bond futures positions, then we may see a squeeze in the coming days.“
Which brings us to BofA’s final observation: according to the quant strategists, if today’s dip is bought and we reach a local high, “CTAs could accumulate equity longs.”
Given that moving averages still point to positive trending equities, we believe CTAs could actually reinitiate longs should we see a snap back in the next one to two weeks. This incremental buying pressure could help propel any reversal in the markets and is worth monitoring.
In other words, if only central banks provide just enough support to stocks today, we may all simply forget that on “Black Monday 2017” we saw the biggest volatility freakout in history and the algos will be back to buying the dip, as they always have been, in no time as nobody learns any lessons once again.