ED HARRISON: Hi. I'm Ed Harrison, your host for Investment Ideas. Following on Recession Watch, we're going to be talking to Charlie McElligott who is a Managing Director at Nomura for Cross-Asset Macro Strategy. He's going to be talking to us about the near term volatility that we're seeing in the market and what it means in terms of this binary path that we're going on between recession or potentially just a mid-cycle slowdown. We're also going to talk to him, because this is Investment Ideas, about what he sees over the medium term as well- say, the 24-month time horizon. What is the non-consensus view that he has going forward? Hope you enjoy it.
Charlie, it's good to see you back here again. A lot of things have changed. And we're going to talk about what you earlier told me was the most underappreciated call that you could make over the medium term. But actually, I want to go and talk a little bit more about what's going on now with regard to volatility. That's why people are talking a lot right now about the volatility that we've seen in the market. And you're someone who's really well positioned to talk about that from a non-retail investor perspective. Talk to me first about, in terms of market structure, where we are like who your clients are and what they're doing in the market.
CHARLIE MCELLIGOTT: Sure. So sitting on Nomura's equity derivatives desk as a desk strategist, not a publishing research analyst, gives me an interesting perspective with regards to a much more tactical view, a much more tactical framework exposure to the flows of our trading client. It's both as an advisor of our risk management as well as the larger consultancy role for our clients. These are institutional players, but certainly, particularly heavy within the hedge fund community, but also too with hedging programs for real money, for insurance companies, for pension companies. So you get a really interesting look under the hood with the moving parts.
And then I work very closely, because it's the toggle that central banks have pulled on with our rates business, we have a fantastic rates business, both linear and in vol. And there too, we get exposure to the macro hedge fund community, similar overlap with our equity derivatives desk, but also to the asset liability manager. And the asset liability managers from the perspective of what happened this past one-month-plus, with that duration grab that we saw play a major role in that.
ED HARRISON: And so you're talking not just a hedge fund, but long only asset managers, long/short funds, the whole gamut, but it's skewed towards the institutional side.
CHARLIE MCELLIGOTT: Yes, yes. Entirely institutional.
ED HARRISON: In August, which where we are right now, we saw a huge tick up in the VIX and volatility in equity indexes, the VVIX, the volatility of the VIX, what's going on with that?
CHARLIE MCELLIGOTT: Over the course of July, we started seeing a very notable behavior in the VIX complex, and not just the UX, the futures but also too with Vol of Vol with VVIX with SKEW, just generically speaking, say the richness of downside to upside from a percentile perspective over last X number of years. And my view, towards the end of July- I really picked up late in July. My view in the end of July, as we're entering August was that don't be caught short gamma in August just like this theme.
ED HARRISON: And by the way, for retail investors, gamma is?
CHARLIE MCELLIGOTT: To make it as layman as possible, I think the idea is that hedging an options dealer is selling optionality, whether it's higher or lower in an asset. And you are short options. The idea being that- if you're short gamma and the market's crashing, perversely, you have to sell more, the lower goes, and vice versa, you have to buy more, the higher it goes.
ED HARRISON: So it's not a linear relationship, there's a curvature to the relationship.
CHARLIE MCELLIGOTT: Right. So this is the same, short gamma is the same concept is negative convexity in the bond space, which again, when I said don't be short gamma into August, you saw the exact same phenomenon even though different players, different catalysts within the rate space, which was this negative convexity type move, which was the same driver of this volatility move in August. And more specifically, with regards to, well, what drove that signal in Vol of Vol? What drove that signal in the VIX complex that the market was telling us we're either going to crash up or crash down. In this case, we did both.
And I believe it was particularly due- before we had, what I'll get to which was the macro catalyst to set it off. But in this particular case, there was one outsized flow in the market from an entity who runs a hedging program that bought and grossly outsized the amount of volatility supply in the VIX calling. So meaning a low probability crash type of a move which would have showed up in the VIX complex, we're seeing the VIX in that 20- at this time, we were 11, 12, 13 VIX up in the upper teens into the mid-20s.
ED HARRISON: Where we've already gone.
CHARLIE MCELLIGOTT: Where we have since traveled to temporarily for a period of time.
ED HARRISON: And by the way, as you say that, I have a smirk on my face, because there's a name that this fund or this group has gotten in the market. Well, they're called-
CHARLIE MCELLIGOTT: They're colloquially known as 50 Cents. Because so many of these trades, this was a long time hedging program in the market, 2017 into the start of 2018 before the VIX event and the leverage VIX ETN event in February known as 50 Cent because they were buying these cheap lottery tickets on these crashes. They determined that it was an effective use of hedging for this crash scenario for their long only portfolio. The thing is that back in the 2017 halcyon days of short volatility, target managers retiring because they're trading short volatility in their retail portfolios.
There was this massive supply of short volatility, particularly within the leveraged VIX ETNs which had daily rebalance at the end of the day. And we knew that if there was a risk catalyst, and ended up being there was a macro catalyst in the form of an inflation overheat scare where we added the fiscal stimulus to an already above trend economic cycle. And that was the macro catalyst for the interest rate selloff, the debt metastasize itself in this huge move in VIX on February 5th, 2018. After that event, and after that hedge paid off, they're no longer was that supply of short volatility in the market.
ED HARRISON: Because people got burnt on that.
CHARLIE MCELLIGOTT: People got burnt by that. And those leverage VIX ETNs went away, it's an extinction event. So that short vol supply was no longer in the market. You couldn't put those trades on because you would never squeeze in VIX to that extent. So they went away. Lo and behold, circa July this year, 50 Cent showed back up. And that's why over the course of July, we started seeing VIX in particularly Vol of Vol and SKEW makes such a move. So like 95th percentile in one month SKEW meaning again, just like think about it as richness of what people are willing to pay for downside versus upside protection.
And that was ultimately this trigger for the- once you got the macro catalyst at the form in end of July by Donald Trump's tariff tweet, unexpected off the grid, people thought we were going the right way. Boom, you gap down and you have this short gamma event in the VIX space, short gamma event in the S&P space so S&P downside and it was also this stimulus for this negative convexity event in the fixed income space. Now, you have convexity is short gamma in the equities terminology.
ED HARRISON: But now you were saying that August and actually also September are month one and two in terms of watch out. Traditionally, in terms of gamma. Explain why you think that's the case?
CHARLIE MCELLIGOTT: August is the, on a monthly basis, like the largest monthly positive return for VIX since its inception in 1989. September is the number two, so that seasonality matters. What is that seasonality picking up? I think it's picking up the illiquidity profile of both of those months, frankly, with regards to managers, PMs, CIOs, traders, both buy side and sell side being off desk. It's certainly been exacerbated in the post-crisis period with regards to regulatory restrictions, with regards to trading desk risk budgets and risk limits, VAR tightening both buy side and sell side, which is just a vicious cycle, less liquidity, smaller depth of book, more price impact.
So that was also part of the calculus as far as "Don't be short gamma into August". Then once we had the macro shock down, then you bring out dealer short gamma dynamics, then you bring out buy side negative convexity dynamics in the rate side, then you bring out synthetic short gamma events with, say, this systematic community, and you see these extreme moves that to a fundamental retail investor, you might take a step back and just say, wow, you're really pricing in the end of days here. And that's the danger where it's not necessarily an illusion, the catalyst was the right catalyst. But with regards to the extent and the magnitude of the price extremes, that's why we got to where we got to.
Ironically, if you take it back to the 50 Cent stuff though, so you talk about this Vol of Vol told us we were going to crash down. So anytime Vol of Vol, VVX is over 90-95-
ED HARRISON: It's like at 110.
CHARLIE MCELLIGOTT: Yeah, it's 110. It's pretty sticky right now. My Spidey senses is up, as my vol trader Tom Eason says VVIX never lies. And we started seeing that downside fear trade really accelerate. There's ugly global growth data piling on to the tariff fears, this idea that the tariffs are going to drive the end of cycle trade into an outright recession.
But what ended up happening- and I think this is part of our larger message by the end of this discussion, was that we never quite got there. So those upside strikes, the calling in VIX, we never quite crashed out. Because in pure- in what we've learned to be Donald Trump behavior, the equities market vigilantes swung back and he spooked them. So over the course of that week and a half ago period or week ago period, you got that CEO conference call with the banks' heads. You got that dinner with Tim Cook, where Tim Cook emphasized the negative implications of the tariffs. And then lo and behold, you got the tariff extension.
So once you didn't get those strikes to trigger, all of a sudden, dealers are looking around days from the expiry, days from VIX settlement long so much crash and that liquidity dynamic affects dealers, too. We have to go find other dealers to find VIX upside trades or to find S&P downside trades or they have to go out and short S&P futures themselves. Now, all these trades need to start getting unwound. Lo and behold, the low print of the VIX was- and we made this call and we're going to trade higher meaningfully so into the VIX expiration because all these dealers have to puke their crash protection.
All those VIX, all those short futures, all the short S&P futures covered. All of that VIX upside had to be puked in the market. VIX ended up trading down to almost like a 14-handle at some point. That was the low point VIX. And now here we are, again, agitating off the back of this latest tariff retaliation scourge.
ED HARRISON: I want to get into September but you mentioned something that I found interesting. It's this it almost seems like get rinsed and repeat type of activity. Because you look back, yet you talked about the February 2018 VIX spike, we had in October, December, then May, we had another one. And then finally in August. It seems like every single time we had this spike, then on the other side, you have the people coming back into the market. What's the dynamic for that? I was talking to you before and you were talking about Donald Trump as being basically an option, he's creating optionality.
CHARLIE MCELLIGOTT: Yes. Donald Trump is a human option. In a world constructed in the post-crisis period where central banks' unwritten mandate is to control financial conditions, suppress volatility, whether it's rate cuts, asset purchases, forward guidance- and the growth of strategies profiting in shorting volatility and the risk adjusted returns, that those strategies have returned, and as the asset growth band in those strategies and the larger role they play in daily markets, for him to be this optionality-introducer into a market that short optionality makes total sense. It's completely rational.
So if you're talking about what rhymes, here's a perfect example. You have macro catalyst shutdown, Trump tariff tweets in end of July. You could even say this latest escalation tirade on Friday, you end up typically dealers, options desks, such as ourselves or our other competitors, in this post-crisis regime, because people have found it profitable to sell volatility in a grinding higher equities market, we're actually getting long gamma, because the former buyers of hedges, the former buyers of tails, the biggest players out there, real money, asset managers, pensions are now sellers of volatility. Yield enhancement strategies, overriding strategies. There's plenty of systematic strategies. VIX rolldown just playing that shape of the VIX curve, that are these sellers of volatility.
What ends up happening is that in a shock down market, though, in a world where a lot of people have taken for granted the way that central banks step in and smooth, there is all of a sudden this grab into protection, and then dealers get short gamma or short those options they were selling to people. So you have this short gamma dynamic rush for protection on the macro gap down, the dealers are in. So the lower futures are going, the more futures we have to sell to remain hedged. Because we're short these downside options.
Then too, you have dynamic hedgers. Clients that might not have a constant hedge overlay program, but as in when, they will manage their exposures. So market begins coming off, they're pressing their single name shorts. They're pressing their ETF shorts. They're shorting futures, also exacerbating the move to the downside, and now, it's like 1987 portfolio insurance.
Then there's the source of synthetic short gamma in the market. And that is that other subset of strategies that are systematic. So target volatility, risk control, CTA trend, risk parity to a certain extent, although I removed them because they're slower moving. And what ends up happening is that these strategies in the post-crisis world where it's just been a perpetual grind, lower flattening, if you will, of volatility, in order to maintain their exposures, their target exposures or in order to allocate their leverage and allocate their exposures, the lower the volatility goes, the more you have to load leverage onto a trade.
So in this case, those strategies, let's say in stocks over a 10-year period, volatilities going lower, they have to deploy more leverage onto that trad. When you get a vol shock, these strategies are built to systematically and emotionally de-lever rose trades. And these are not insidious hedge fund entities necessarily, although certainly like a CTA trend fund, might speak to that, but these are products sold by asset managers, insurance companies, variable annuities. Everybody is in these things, they just don't realize that when they're selling it to you for this fee, there's this package- mechanical deleveraging type of trigger based on a preset arbitrary target volatility they're trying to maintain in that portfolio.
So that's this other short or other source of selling pressure on the gap down where they're just mechanically deleveraging, because the realized volatility trigger has been surpassed. That's where the cycle begins to turn, though, because of this world that we have created with central bank omnipotence, central bank interventionism, which is not going away. You end up having these strategies as we spoke to that come in to take advantage of that.
First of all, people want to monetize their hedges. So whether it's discretionary clients that had put spreads on, that want to take those off and lock those in, whether it's retail, VVIX ETNs now who are net long Vega. Since February of last year, net long Vega, like hundreds of millions of dollars of long Vega that want to take advantage of these elevated attractive levels to sell volatility before market soothing comes and for central banks- with Trump's tweets and that's just part of this conditioning that we've developed.
And then two, the same with these other real money type strategies, overwriters as we said, yield enhancement strategies, those types of things. So like let's talk about another source of stabilization the market after these crash downs. There's another entity called to put bomber in the market. The put bomber comes out on these elevated volatility scenarios, attractive places that their models are telling them to sell volatility again, and they come out and they laced the street dealers such as ourselves with a bunch of downside which gets us synthetically short the market.
So we have to go out and buy hundreds of millions, if not billions, of dollars of delta, of S&P futures, to buy to hedge ourselves, which creates this insulating factor, this shock absorber. I would go so far as to say that the growth of these yield enhancement strategies, these short volatility strategies for real money entities is just as impactful from a flow's perspective from actually being there to support the market in these drawdowns as any central bank. Another expression of this are buybacks, corporate buybacks, which have been incentivized by the yield regime by what central banks are pushing, issue paper for free to buy back your stock, strike your options, your stock investors are asking you to do this, you're getting rewarded for it.
What that does is it completely skews supply demand. It shrinks the float creates. Creates our official source of supply. And we know, looking at the largest buyback desks on the street, the biggest corporate repurchase so on the street, they get most active in these shock down scenarios. So that's another stabilizer.
ED HARRISON: You mentioned the buybacks. And that's a good segue into what I was thinking about in terms of September. We can segue into the macro themes with regard to the Fed, but also with regard to what September is setting us up for because we talked about this before. We're talking about a buyback blackout because of earnings coming forward. We're talking about options expiring. We're talking about the ECB and the Fed coming out with their decision making.
So that's a lot of potential errors that could create more volatility going forward in September.