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.

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