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Volatility has made a comeback in a big way, and it has seemingly come out of nowhere and hit traders square in the chops.
Statistically, we don’t see eight Z-score moves often in any data set. It is an extreme event, but that is precisely when played out in the S&P 500 yesterday. While the moves we see in Asia today, relative to the 90-day average daily moves, have been statistically extreme, and volumes are huge too. We can take the ASX 200 and see value 40% above the 30-day average (for this time of day), and in Japan and Hong Kong, value is 40% and 91% above the average.
Without seeing the institutional flow, it feels as though this is a mix of forced selling, absolutely no buyers, and naturally, in this environment, the short sellers are having a field day aligning positions to what is a falling knife.
The biggest issue being asked on the floors today is what exactly caused the sell-down. The fact that there is no one smoking gun breeds uncertainty, as the market craves to understand what is the trigger mechanism so they can understand what could be the circuit breaker to gain confidence to buy the dip – which is what everyone is programmed to do these days.
The technical set up of the S&P 500 is key here and was a chart I posted yesterday, where we looked at the symmetrical risks, with the index at a critical juncture. Well, the path the market choose is there for all to see. We can even take things back and see the rising trend drawn from the 2016 lows at 2775 ahead of the 200-day moving average at 2765, and logically the bulls simply have to defend these levels tonight, or we can really start talking about a genuine index correction.
Given the further 0.8% drawdown in S&P 500 futures through Asia today, it suggests that if the S&P 500 cash market were to open now, then it would open through both of these levels. We shall watch with interest, as we will in tech stocks which are just getting taken to the woodshed, where the FANGS basket closed 5.6% lower and breaking out of a multi-month channel. One suspects that if implied volatility (vols) keep heading high, then volatility targeting funds will only further raise cash levels, while implied vol is also such an important consideration for trader’s position sizing, and right now with the level of range expansion we have seen this should be kept to a minimum.
The US 30-year Treasury has also been on the radar for a while, and the upcoming cash session will also garner strong attention. As we can see from the daily chart, duration buyers are kicking into gear, and we see yield under last Wednesday spike high. That said, if we look at the sizeable build in short UST 30-year futures of late (in the weekly CFTC report), perhaps we are seeing an element of short-covering here ahead of tonight’s $15 billion 30-year UST auction, which is really going to tests the markets interest in owning duration and having exposures to the ultra-long end of the curve.
(Source: Bloomberg)
The failure to close through the 1999 downtrend could be fitting here, with US inflation in play in the session ahead, so it feels as though the bond market is once again our guide. A strong US inflation print (out at 23:30 AEDT), with core CPI above, say 2.5% and/or followed by weak demand in the 30-year auction (although foreign demand seems key) and we could be staring at a further leg down in risk assets.
Traders in Asia are front-running a weaker European equity open, with European markets likely down 2% to 2.5%. One interesting aspect is that the USD has been sold against all G10 currencies through Asia, even against the higher beta currencies such as the AUD and CAD, which is impressive given Chinese markets have been smashed, with the CSI 300 trading to new cycle lows (-4.4%) and US crude a further 1.8%.
What is interesting is while the USD is lower against G10 showing this is firmly a play on US-specific concerns, we see solid buying against the CNH and CNH, so the fact AUDUSD has pushed higher in this environment tells a story in itself. It feels as though traders are looking at the Sino-US relationship and asking who on earth is going to fund the US deficit in the years ahead when the CBO see the US debt/GDP ratio hitting 100% over the coming decade (currently 80%).
When China is looking to reduce its exposures to US Treasury’s and Japanese funds will likely have greater opportunity to invest domestically in the years ahead, and it’s expensive to hedge their exposures, clearly domestic funds are going to make the shortfall. This means capital having to be reallocated away from other future investments, which could impact US domestic growth and with the Fed’s balance sheet in decline amid concerning deficit dynamics, investors will need to be compensated with higher yields. Higher yields impact the corporate landscape as they are an essential consideration when companies assess investment opportunity and they look at the Net Present Value (NPV) of an investment and the internal rate of return to bring a project to market.
Heaven forbid Steven Mnuchin labels China a currency manipulator next week, as this could cause a meltdown! It is seemingly a low-ball probability, but the fact Trump is on the offensive at a time when his fiscal policies actually need a leader who is reaching out to attract external funding is one thing, but the moves in bond yields seem to have been a tipping point, although we can add in technical and forced selling from certain players in the market as volatility pushed higher.
The fact Trump is going after the Fed is probably not helping either; although this is his economic, political put and should the economy start to falter, he would have already laid the foundations to fully blame the Fed for lifting rates. One could argue that we are even seeing the market going after the Fed here too, and trying to see at what stage the Powell ‘put’ is triggered, where moves in risk assets represent such a tightening of financial conditions that the market prices out rate hikes and the Fed turns more dovish at the margin.
We can never rule out a snapback rally in risk assets, but unlike what we have seen in other bouts of higher vol and risk aversion, it feels like the market still has too many questions as to what is driving this and not getting a lot of answers.  

Published by Chris Weston, Head of Research, Pepperstone