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.

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