It turned out to be an eventful and potentially even defining week that passed, and the world is now looking at risk through slightly less optimistic eyes. Certainly, we are seeing increasing outperformance from defensive assets, with rising implied volatility, with the VIX index-tracking into 17.6%. The S&P 500 looked heavy on Friday, with price having closed below horizontal support at 2958, as well as price having filled and surpassed the 2950 gap – best seen on the four-hour chart. S&P 500 and DAX futures are lower by 1% and 0.8% respectively indicating a tough open for both Europe and the US.
A statement of intent from the Chinese?
We are certainly seeing Asia opening on a sour note today, and at the heart has been the moves seen in USDCNH. The PBoC ‘fixed’ the USDCNY mid-point 229-pips higher (at 11:15aest) and certainly higher than what the market had calculated in their respective models. The market took this as a message of intent from the PBoC direct to Trump, while fears of a yuan depreciation and currency wars have ramped up again. This will only compound the issue across broad financial markets, as the market really does not need worries about a capital flight in China at this point in time and a subsequent tightening of financial conditions in the Chinese economy.
The moves in USDCNH are clearly resonating in a weaker AUDUSD, while USDJPY has traded into106.00 and we are seeing broad declines in Asian equity indices today. US Treasury futures are rallying, with US 2s lower by 6bp at 1.65%.
White – USDCNH, yellow – AUDUSD (inverted)
No support from the Fed…yet
Last week’s 25bp hawkish cut from the Fed did not meet expectations, and the market feels exposed, vulnerable and missing the psychological hug from the Fed to justify the dovish implied policy path. The Fed’s “mid-cycle” belief is not shared by the markets, so when we marry that with renewed trade tensions, covering a basket of goods which strikes directly to the heart of the US consumer when consumption and consumer confidence are an area of relative inspiration, the markets turns and demands action.
What is the circuit breaker?
As always though, if risk aversion picks up for any period of time, we search frantically for the circuit breaker that will solve all ills. If we don’t know our circuit breaker, we become risk-averse, it becomes more problematic to price risk, and we lack the visibility to feel confident in our exposures. Markets are driven by semantics, psychology and in most cases, randomness.
In my mind, that circuit breaker comes either from a more a series of constructive Trump tweet and that may not occur in the near-term or from global central bank actions and easier policy, although that is already a mature trade and much is discounted. As such, we see the market now fully discounting a 25bp cut from the ECB in its September meeting, as is the case from the Fed in its September meeting, and there is even a 19% chance of a 50bp cut. Look out through to December, and the markets are pricing close to two cuts.
A re-run of the July FOMC meeting?
At this stage, we’re shaping up for a re-run of the July FOMC meeting, where the likely debate will once again be whether they go 25bp or 50bp cut. This time around the financial markets may play a greater role, as financial conditions were extremely accommodative going into the July meeting, and as we can see, the Goldman Sachs Financial Conditions Index is starting to head higher, highlighting that broad financial conditions are starting to tighten and the Fed will be watching this closely.
Moves in the US Treasury and the global bond market will also be on any policy markers radar. We can take the US 2s vs 10s curve and see this trading at 13bp, and eyeing a test of the multi-month floor at 10bp. If this level breaks, it would likely coincide with higher implied equity volatility and the S&P 500 through 2900 and the 100-day MA.
Where to for the USD?
The USD index (USDX) is a tough one because nowhere else is really offering a compelling alternative, although if this period of higher volatility is pushing capital into the JPY and CHF and they will work best. In Germany, we can see the yield curve negative all the way out to the 30-year maturity. Denmark and Switzerland have had negative curves for all maturities for a while, and the total pool of negative-yielding debt has racked up to $14.5t, or 26% of outstanding bonds.
Gold has been the net beneficiary of this uncertainty, as has the JPY, and in the case of the yellow metal, we can think of it as a currency in its own right, and a hedge against this ballooning pool of negative-yielding assets. That said, gold in AUD-terms is performing strongly, putting on over 3% last week and pushing into a new all-time high. Although that will be tested to a small degree given the event risk from tomorrow’s RBA meeting and Friday’s testimony from the governor, Philip Lowe, who speaks in Canberra to the Committee (09:30aest), ahead of the RBA’s Statement on Monetary Policy (113:30aest).
Judging by AUDUSD implied volatility (expiring tomorrow) the market is expecting the move on the day of about 40-points. This implied volatility has picked up a touch of late, but we’re not expecting fireworks and the bigger influence on the AUD is likely moves in CNH.
USD-denominated gold is up a couple of bucks through Asia and now sits closer to the top of its recent range. A daily close above $1448 would be a bullish development, and given the break of the $1448 to $1380 consolidation range, one would argue for an extension towards $1500. One for the radar, but let’s see how the bond market reacts as gold bulls will be wanting to see further love for fixed income.
It promises to be a big week for markets, and while we identify the circuit breakers, they are perhaps not immediately going to be triggered, so a more defensive stance seems logical here.
Published by Chris Weston, Head of Research, Pepperstone