Low volatility unsustainable

There seems to be a real disconnection between the problems / tensions in China, Ukraine, Turkey, Thailand etc and market sentiment.

Even in the US the market has happily swallowed Yellen’s speech that data weakness is all related to bad weather (US equities rose to record highs overnight while the VIX index has edged lower). Well once the weather improves the data had better improve too otherwise that theory will be shot to pieces and markets will be hit.

In particular there really does appear to be a surprisingly degree of complacency towards events in Ukraine (see earlier comments). On that note even if the Ukraine avoids default via money from US/Europe/IMF tensions with Russia remain a major issue.

In terms of FX reaction JPY and CHF could face more upward pressure while the EUR is looking increasingly exposed. High beta FX EM FX will look increasingly vulnerable against this background.

What is surprising is that both major FX and EM FX implied volatility indices (1m, 3m) are tracking below their historical vol indices. The low level of volatility in both FX and equity markets looks unsustainable.

EUR and JPY outlook

EUR/USD took some advantage of a softer USD tone, with the currency pair breaking above 1.37 once again. However, the release of flash Eurozone HICP inflation readings today will take the shine off the EUR given that it will likely support the case for further policy easing at the 6 March European Central Bank policy meeting.

Benign readings for both headline and core inflation estimates are expected to be revealed today, consistent with small cuts in the ECB’s refi rate and strengthened forward guidance. EUR/USD will find strong resistance around its 2014 high at 1.3776.

Japan’s data slate released this morning came in better than expected. The jobless rate held at low level at 3.7% while the jobs to applicants’ ratio increased to 1.04 in a further sign of strengthening job conditions. CPI inflation marked its 8th straight month of gains while industrial production, retail sales and overall household spending beat expectations.

The main take away is that inflation is close to peaking and the risks of further Bank of Japan policy action is rising. This will limit the downside for USD/JPY but further slippage in US yields overnight mean that USD/JPY upside remains restrained. 101.67 – 102.85 is likely to hold as a near term range for the currency pair.

Posted in ECB, Japan. Tags: , . 2 Comments »

It’s all about the weather

Fed Chairman Yellen helped allay concerns that something more sinister than bad weather was impacting the US economy in her speech to the Senate Banking Committee yesterday. While highlighting that tapering will go on unabated and likely end by the fall, the comments gave hope that the poor run of US data will come to end soon, once the weather impact reverses.

Risk assets liked what they heard, with US equities closing at record highs and the VIX “fear gauge” edging lower. Reduced safe haven demand helped US Treasury yields to move lower undermining the USD in the process. Against this background markets will ignore a likely downward revision of US Q4 GDP today, which will be seen as largely backward looking.

The relief from Yellen’s comments was sufficient to outweigh the increasingly precarious situation in the Ukraine where the regional parliament in the largely Russian speaking region of Crimea was overtaken by armed gunmen hoisting the Russian flag. Subsequently Crimea has now set a referendum to decide whether to opt for sovereignty for the region.

Given the increased jawboning by Russia and military exercises along the border with Ukraine, together with warnings by Western nations for Russia not to get involved in the situation, the risk of a further escalation of tensions are high. Indeed, the scenario increasingly resembles the type of stand off taking place during the “cold war” and markets may be underestimating the potential impact.

USD undermined, GBP supported for now

Despite its overnight bounce the USD index is trading close to its lowest levels this year undermined by a series of weaker economic data and related to this a failure of US bond yields to push higher. Alongside this relatively soft USD tone is a generally subdued and range bound tone to FX markets in general.

Even my quantitative models suggest little impetus for big moves in EUR/USD and USD/JPY. However, I expect this to change over coming weeks. Once the US economy shakes off the shackles of poor weather conditions the USD will be in a better position to recoup its recent losses.

In the near term Fed Chairman Yellen’s testimony today will garner some attention but the speech is unlikely to break the USD or FX markets out of their malaise.

GBP is holding up well, taking advantage of a subdued USD tone. As a consequence of firmer data the market appears to be gearing up for an eventual rate hike, with Bank of England members sounding more upbeat, even if it is unlikely to occur anytime soon.

Consequently over the near term GBP looks well supported although eventually we expect the currency to settle back to earth. In particular 3 month interest rate differentials with the USD appear to suggest that GBP/USD gains are overdone.

This doesn’t mean that its time to sell now but market positioning has turned more positive over recent weeks, above its 3-month average, suggesting further short term gains will be more gradual, with strong GBP/USD resistance around 1.6745.

CNY / CNH pressure continues

CNY/CNH the downward pressure is unlikely to abate in the near term. The desire to 1) implement two way risk, 2) higher volatility and 3) curb strong capital inflows 4) prepare for band widening, will not end quickly. A resumption of a strengthening trend in CNY / CNH will undo these aims quickly as inflows resume. Hence, if China really wants to instigate significant volatility in the currency the weakening trend is set to continue for a while to come.

At what level does the weakness in the CNY stop? Well my quantitative model already suggests that USD/CNY has already overshot its short term fair value (6.0904) but the bottom line is that this overshoot may persist for several weeks. Nonetheless, CNY has reversed all of its strength versus USD from early October and further weakness may be less rapid.

Further out, the CNY is likely to resume a stronger tone but this may be some weeks away. China continues to benefit from large foreign exchange reserves and a healthy external balance and this will eventually result in upward pressure on the currency. A move back to around 6.00 versus USD by year end remains likely but China’s authorities will want to ensure that the market does not believe that the path there will be a one way street.

China worries inflicting damage globally

A combination of worries on both sides of the pond has inflicted damage on risk assets globally. US equities closed lower, Treasury yields dropped, USD was weaker while gold prices rose. In Asia, China growth concerns, overexpansion of credit, and currency weakness are increasingly infiltrating markets globally.

Meanwhile in the US, consumer confidence surprisingly slipped in February, albeit from a high level while the annual pace of house price gains slowed slightly in December. The data added a further layer of pressure on stock markets and US January new home sales data will not help matters as it is likely to give further evidence of slowing housing momentum.

While it is now easy to blame much of the weakness in US economic data on adverse weather conditions hopes / expectations that US data will improve going forward will be tested soon. In the absence of first tier data today, attention will remain firmly fixed on events in China and in particular whether the CNY and CNH registers further declines.

Given all the attention on the Chinese currency, major currency markets have been lulled into tight ranges, with our measure of composite implied G3 FX volatility declining further. Our implied volatility index has now dropped to the lowest levels since the end of October last year.

USD/JPY is likely to face some downward pressure in the short term given the rise in risk aversion and lower US yields overnight. EUR/USD remains supported but remains susceptible to downside risks given the potential for easier monetary policy at the upcoming European Central Bank meeting next week.

Chinese currency drops sharply

Once again the Chinese currency CNY dropped, this time recording its biggest drop in 2 years. The message is clear China wants to deter hot money inflows ahead of a potential band widening.

Weaker Chinese economic data is also undermining demand for the CNY from exporters while the Chinese authorities want to increase the volatility of the CNY and engineer a degree of two way risk.

Chinese officials have played down the drop in the CNY and CNH but nonetheless, markets are seeing it as a shift in policy following recently weaker economic data. China’s Finance Minister Lou Jiwei noted that that move in the yuan is “within normal range” an indication that officials are not particularly concerned about the currency.

From a technical perspective the move in USD/CNY is significant. The currency pair touched 6.1227, breaching its 200 day moving average around 6.1018. The MACD (moving average convergence/divergence) has turned bullish too although the RSI (relative strength index) suggests that USD/CNY may be overbought.

Overall, expect further CNY weaknes in the short term (next few weeks) but dont expect this it to turn into a long term trend. Eventually CNY will resume an appreciation path assisted by continued strength in the country’s external balance.

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