Nomura warns: The market is overly hedged against Trump's trades, a "Harris surprise" may occur

Nomura's Managing Director and Macro Strategist for the Americas, Charlie McElligott, warned in his latest report that in recent weeks, the market has over-hedged the assumption of Trump and the Republican Party winning both houses of Congress in the election, which could lead to a scenario where Harris's support rate is higher than expected and the election becomes deadlocked. In such a situation, there is a risk of asset reversals, such as US Treasury bonds potentially rising due to short covering, and the stock market plummeting with the Democrats becoming the majority party in both houses of Congress.

Firstly, McElligott's report points out that the bond market is in a continuous "severe moment" as it will experience significant issuance by the US Treasury in the coming days and weeks, including $70 billion in five-year US Treasury bonds, $69 billion in two-year Treasury bonds, and $44 billion in seven-year Treasury bonds, along with the JOLTS report disclosing US job vacancies, the latest refinancing announcements from the Treasury, Personal Consumption Expenditures (PCE), Non-Farm Payrolls (NFP), US Presidential Election Day, and the November FOMC meeting of the Federal Reserve.

The US government's massive budget deficit spending will boost nominal GDP, and compared to persistently high inflation above the Fed's target, the Fed places more emphasis on the employment task in its dual mandate, with employment clearly seen as the greater economic risk. In light of this, the recent rebuilding of term premiums on US Treasuries for several weeks has become easily justifiable.

However, now, US presidential candidates may adopt a more "fiscally expansive" policy. The theme behind the bullish gold/crypto narrative is that in a "fiscally dominant" world, the future US dollar will "depreciate," coupled with the Fed and the market "anchoring" at elevated US inflation levels above target. If you will, you can understand this as the CDS of central banks and governments.

Especially in the scenario of market actively hedging Trump's election and the Republicans winning the majority of seats in both houses of Congress—a so-called red sweep, this is the most pessimistic outcome for US Treasury term bets, as in that scenario, the new US government will implement a highly stimulating policy mix, significantly easing regulations, coupled with tax cuts, and on Trump's first day in office, the impact of tariff shocks on prices will bring about an "inflationary impulse."

The August "hard landing" panic and "Fed policy mistake" left tail panic triggered by the employment data at the end of summer have become distant memories as "recession trades" have essentially unwound. In recent weeks, the shift of funds to the long end/bonds and Short-Term Interest Rate Futures (STIRS) for downside protection has been evident, with traders expecting government spending to continue growing in almost all scenarios in the futureDue to the "animal spirit" from the recognized Federal Reserve's Financial Conditions Index (FCI) easing this year, it has triggered an economic chain reaction, helping the Atlanta Fed's GDPNow economic growth forecast to rise to 3.3%. While the US is easing policies, China is also implementing stimulus measures and hedging against the results of Trump's red sweep in the election.

There still exists a traditional long position with continuous deleveraging risk in bonds and STIRS, which still comes from the systematic trend/CTA managed futures field. Nomura estimates that in the past month, the scale of G10 national bond sales in this field is about $90 billion, and the scale of STIRS sales is about $54 billion.

Currently, Nomura believes there is still a significant bias towards further "supply" risk, with a 2% downside risk in futures. Nomura estimates that in the case of further catalysts for selling, the more selling occurs, the lower the bond/STIRS prices in the negative Gamma situation, there may be an additional $241 billion in bonds and $247 billion in STIRS sold.

In summary, after being impacted by so much hedging related to "Trump/red sweep" in recent weeks, the biggest "shock" in the bond market will occur when the result known as the "Harris accident" happens, especially in terms of duration "Harris + election deadlock/Congressional split" result, which will trigger various assets' "reversal risk", especially the subsequent rise in bonds/shorting leading to the flattening of the US bond yield curve.

Therefore, Nomura sees some upside potential for STIRS and US Treasuries, that is, in the event of a "Harris deadlock/split" result, there will also be a reversal of related thematic stocks (bearish spread on banks/financials - betting against Trump's sweep/"overheating economy"/relaxation of regulatory thematic stocks' unwinding risk) and expects that in the case of a Harris "deadlock" trade, gold/cryptocurrencies will be squeezed.

At the same time, Nomura believes that as the lowest Delta election result, the so-called "blue sweep" where the Democratic Party wins the majority in both houses of Congress is the only scenario that could cause a significant "decline" in the stock market. If a blue sweep occurs, the stock market may fall by 7% to 10% in the next one to three months, as the re-strengthening of regulations and taxes will have a negative impact on earnings per share (EPS) growth, especially after a significant rebound before the electionThe stock market situation is still in a state of "excessive hedging" due to the clustering of event risks, as McElligott has been saying for months. After experiencing two "volatility shocks" in the past three months, it is now undergoing "risk management" forcibly.

If the worst-case scenario mentioned above does not make headlines multiple times, the risk will be "cleared," and over-hedged trades will be closed out, resulting in mechanical "bidding" until the end of the year. Many people failed to capture the rally before the election, and will subsequently chase performance out of fear of missing out on the rally due to FOMO mentality.

This sets the stage for the "clearing" of event risks after the election, which will lead to a reduction in volatility and potentially drive up spot stock prices. This is because: 1. Loss-making OTM downward stock index hedges are lifted, followed by traders repurchasing their short futures on a scale of hundreds of billions of dollars in Delta; 2. Slowly built "short upward call options" right tail hedges rise in Delta;

1. The "reset lower" index iVol and DECQ options expiring in December create additional Vanna tailwinds; 4. The window for corporate stock buybacks reopens after earnings reports; 5. Systematic target volatility/volatility control funds are mechanically buying large amounts of futures from realized volatility resets; 6. Due to holiday market closures, all markets enter the worst liquidity period of the year, meaning wider bid-ask spreads, lower risk tolerance/convenience, which often exacerbates volatility. As prices rise, all buyers may resemble "a basketball going through a fire hose."