Risk appetite firms

Despite the decision by Crimea’s parliament to formally request accession to Russia markets risk assets performed well overnight, with US and European equity markets registering solid gains. Consequently US yields rose overnight while the USD made gains against safe haven currencies.

Market relief probably reflected the fact that the referendum itself passed without violence while the reaction by the West in terms of sanctions was not seen to have a particularly detrimental impact on sentiment.

China’s decision to widen its currency band also passed with little fanfare given that such a move was largely anticipated. There will be some positive pass through into the Asian session from the gains in asset markets overnight although a degree of caution continues to be warranted given the still precarious situation in the Ukraine and ongoing tensions between Russia and the West.

Risk aversion edging higher

As the reverberations from China’s poor trade data, weaker loan growth and money supply, as well as continued tensions in the Ukraine ahead of a referendum next Sunday, spread through the market, risk aversion continues to edge higher according to our risk barometer.

Lingering questions over the weather impact on the US economy are also capping risk appetite even after the better than expected US jobs report at the end of last week. Although there is no sign of any panic selling of risk assets at present the tone is decidedly cautious.

Consequently safe haven assets remain in demand, with for example gold prices holding up well and US Treasury yields being capped. Additionally industrial commodity prices have taken a hit, with iron ore prices under major pressure.

There is little on the agenda today that will give a clearer picture for markets, with the Bank of Japan policy meeting and UK industrial production data, the key events for the day. As a result, caution is likely to prevail.

Ukraine fallout

So far most of the damage from the escalating crisis in the Ukraine and growing tensions between the West and Russia has been inflicted on Russian markets but global asset markets are also feeling increasing pain from the fallout. The most recent developments highlight that tensions have worsened further.

Equity markets in Europe were next in line for selling pressure, with sharp declines registered while US stock also dropped, but to a lesser degree. Commodity prices have also felt the shock, with European natural gas prices rising sharply and oil also higher. Gold has been a major beneficiary extending gains to around USD 1350.

US Treasury yields settled around 2.6% while the USD bounced as risk aversion spiked. My Risk Aversion Barometer rose over 3% while the VIX “fear gauge” jumped. Asian markets are likely to feel some pressure today although the impact is likely to be much less significant than elsewhere. Nonetheless, the lack of first tier data releases means that most attention will be focussed on developments in Ukraine over today’s trading session.

Weak US data overlooked

Although US stocks could not hold onto record highs overnight they still managed to close higher following on from gains in European equity markets. Firmer US equities will give a positive lead to Asian markets today although the gyrations in CNY and CNH will be watched closely. Our risk barometer as well as the VIX ‘fear gauge” indicate that risk appetite is on a positive trend while US Treasuries and the USD consolidate.

Weaker data in the US in the form of the Chicago Fed activity index and Dallas Fed activity index as well the Markit service sector PMI confidence index were shrugged off by the market, with weakness continuing to be attributed to harsh weather conditions. This theory will be tested over coming weeks as weather conditions normalise but for now markets are giving the US economy the benefit of the doubt.

Meanwhile, Eurozone inflation data yesterday highlighted the significant amount of room that the European Central Bank has to ease policy further. On tap today of note is the French INSEE survey and US consumer confidence, both for February and neither of which is likely to prove particularly market moving.

USD/JPY bracing for a rebound

In the post below I look at the arguments for JPY weakness in the weeks and months ahead.

A combination of elevated risk aversion and a narrowing US / Japan yield differential have been the major contributors to the strengthening in the JPY over January resulting in safe haven JPY demand and repatriation flows. The sensitivity of the JPY to both factors has been especially strong and it will require a reversal of one if not both of these to spur another wave of JPY selling.

Improving risk appetite required
If there is not a metamorphosis of the current bout of pressure into a full blown crisis as seems likely, risk appetite will improve and the upward pressure on the JPY will abate. Any improvement in risk appetite will however, be gradual and prone to volatility, especially in an environment of Fed tapering. It may therefore require more than simply improving risk appetite to weaken the JPY anew.

Japanese equity performance will be eyed
Of course associated with any improvement in risk appetite has to be a reversal of the recent negative performance of Japanese equities. Although Japanese equities will continue to be hostage to the fortunes of global risk sentiment, assuming that “Abenomics” continues to deliver results and growth in Japan continues to pick up (our forecast this year is 2% YoY GDP growth) further fallout in the Japanese equity market may be limited.

Flows will need to reverse
Over the past several weeks Japan has registered net inflows of capital in large part due to repatriation by Japanese investors. JPY has faced upward pressure from such inflows over recent weeks. Looking ahead assuming that risk appetite improves and US yields increase net capital outflows are expected to resume, which will put further downward pressure on the JPY.

Yield differentials will be particularly important
The extra dose of JPY pressure and important determinant of renewed weakness will be a re-widening of the US / Japan real yield differential. Eventually US bond yields will resume their ascent, driving the yield differential with Japan wider, and putting upward pressure on USD/JPY. The same argument will apply for EUR/JPY, albeit to a lesser degree.

Speculation positioning more balanced
The recent short covering rally has likely resulted in a market more evenly balanced in terms of positioning, providing a solid footing for the next leg lower in JPY. Indeed, compared to the three month average, JPY positioning has bounced back and is susceptible to a rebuilding of JPY shorts over coming weeks, driving the JPY lower.

Model points to renewed JPY weakness
Combining the factors above (except positioning) and adding in forecasts for US bond yields, risk aversion and conservative estimates for a recovery in Japanese equity markets over coming months, my quantitative model for USD/JPY highlights the prospects of a major rebound in the currency pair.

A further blow to risk appetite

Amid a market that is already very nervous the much weaker than expected US ISM manufacturing confidence index (51.3 versus 56.0 consensus) taken together with the weaker Chinese non manufacturing purchasing managers index (53.4 versus 54.6 prior) dealt another blow to risk appetite.

Consequently the VIX fear gauge has spiked to its highest level since the end of 2012 and our risk barometer has moved swiftly into risk hating territory. US Treasury yields have continued to drop, with the 10 year yield having slid by around 45 basis points so far this year.

Suffice to say investors should steer clear of risk assets over the short term as the turmoil does not look like it will be over anytime soon. A combination of tapering, a confluence of country specific emerging market country concerns and weaker growth in China provide the backdrop for a volatile few weeks if not longer, ahead.

The main event today is the Reserve Bank of Australia meeting where we look for no change in policy. However, the key events of the week are yet to come, with the European Central Bank and Bank of England policy decisions and US January jobs report all on tap over coming days. In brief, no change in policy is expected from either central bank and payrolls are expected to come in around 200k.

Risk appetite still supported

Relatively subdued trading yesterday ended with stocks higher and US bond yields lower. Our risk barometer is currently around its lowest since February 2011, signifying still strong appetite for risky assets, as also reflected by the drop in the VIX “fear gauge”. After a sharp 30+% drop since early October the Baltic Dry Index has also turned higher while gold prices are holding in a relatively tight range around its 100 day moving average at USD 1320.

There are a few releases and events to give direction to markets, with the RBA policy meeting, European Commission autumn economic forecasts, and service sector confidence surveys from the UK and US, all on tap today. Overall, there will be little to dent the positive risk bias but caution will intensify ahead of the ECB Council meeting and US employment report towards the end of the week.

Following last week’s USD rally the currency is likely to consolidate its gains over the short term ahead of Friday’s US October employment report. A dip in US yields helped by a softer US factory orders report took some of the steam out of the USD as caution crept in. A series of Fed speakers overnight did little to clarify the picture regarding the timing of tapering and thus provided little direction for the USD.

Nonetheless, despite some near term consolidation the USD looks set to gain further over the coming weeks helped by the fact that the market had already squared a lot of long positions over past weeks. A renewed increase in US yields accompanied by better economic data will help the USD’s cause but much will depend on when there is greater clarity regarding the timing of tapering. Expectations of a March 2014 may yet prove off the mark, leaving the USD plenty of scope for further recovery.

AUD benefitted from the robust September retail sales report yesterday but faces another hurdle today in the form of the RBA policy meeting. Although AUD remain a loser year to date, the currency has registered impressive gains from the beginning of September, much to the chagrin of the RBA.

Although a policy rate cut is highly unlikely today (I believe the RBA is at the bottom of its easing cycle), Governor Stevens is set to warn that the strength of the currency could warrant further policy easing in the months ahead. However, such warnings may sound hollow given worries about house price inflation and recently firmer data. Given some likely restraint in the USD ahead of the US employment report, AUD/USD will find some any losses limited to support around 0.9430.

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