High degree of investor caution

Although risk aversion has declined from recently elevated levels there is still a high degree of caution from investors who are unwilling to take long term bets. The causes of market angst have remained unchanged over recent weeks namely Ukraine tensions, weaker growth in China and US data that has performed below expectations.

It is therefore unsurprising that in the wake of a weaker than forecast reading for Chinese manufacturing confidence yesterday and talk of more sanctions against Russia, European and US equity markets fell overnight and Asian equities have began the day on softer footing.

The Markit US manufacturing purchasing managers’ index (PMI) edged lower, but unlike the Chinese PMI, which remained below the 50 boom/bust level, the US reading was healthy at 55.5 in March. The Eurozone equivalent edged lower but continued to show that recovery was still in shape, with the March reading at 53.

The reverberations from Fed Chairman Yellen’s comments last week also inflicting some damage, with gold prices in particular succumbing to pressure and verging on a test of the 200 day moving average around 1296.83. A heavy slate of data today includes the German March IFO survey, UK CPI inflation, US March consumer confidence and February new home sales.

No relief for risk assets

Perhaps unsurprisingly given the tumultuous build up to the poll the Crimean referendum resulted in an over 90% vote to leave Ukraine and join Russia according to Russian state media. Risk assets were already under pressure leading into the vote and the news is not going to help sentiment in any way, with the West already denouncing the result and Russia seeing it as a validation of its stance. Further sanctions and other punitive measures are likely to be announced leading to a heightening of tensions and increased risk aversion.

Our risk barometer is already well into “risk hating” territory highlighting the intensifying pressure on risk assets and demand for safe havens. Consequently expect the likes of the CHF, JPY and gold to remain under upward pressure and anything with high beta to be under downward pressure.

There is also plenty of data and events to capture the interest of markets this week, with the Fed FOMC meeting capturing top billing. Unsurprisingly no change in policy is expected, with a USD 10 billion taper set to be announced. Fed Chairman Yellen is set to highlight that the bar remains high to any slowing in the pace of tapering while more qualitative guidance is set to be announced.

On the data front US data will remain weather impacted but nonetheless, February industrial production is set to reveal a small gain today while manufacturing surveys will reveal some improvement in March. Additionally housing starts are set to rebound in February. However, Treasury yields are likely to be capped despite more encouraging data as safe haven demand intensifies, leaving the USD also restrained.

In Europe the data flow is less numerous and what there is will support the view that more action is needed by the European Central Bank (ECB) to ease policy. February CPI inflation is set for a downward revision while the German ZEW investor confidence index will slip further.

Geopolitical tensions to weigh on risk assets

There continues to be a disconnection between rising geopolitical risks as tensions between Russia and Ukraine intensify, and the performance of equity markets. US equities ended the week on a high note despite a bigger than expected downward revision to US Q4 GDP and risk sentiment overall remained supported according to our risk barometer. Other data were helpful for markets as February Chicago manufacturing confidence (PMI) and Michigan consumer confidence came in better than expected. The firmer tone to risk assets will not last, with risk aversion set to intensify today.

Markets continue to give US economic data the benefit of the doubt, downplaying the harsh weather impact on economic data. This is set to continue this week, with the release of a plethora of US data including January personal income and spending and February ISM manufacturing confidence, February vehicle sales, the Fed’s Beige Book, January trade balance and last but not least February non farm payrolls at the end of the week. All of the data will be hit by recent unseasonable US weather and therefore will look weak on balance, but markets will once again not fret a great deal.

There are several other key events this week that will garner market attention including central bank decisions from the Reserve Bank of Australia tomorrow, Bank of England, and European Central Bank on Thursday. Hopes that the ECB will easy monetary policy were dashed somewhat by a higher than expected reading for Eurozone HICP February inflation although there is still a possibility that some easing in liquidity conditions are announced. The RBA and BoE are not expected to change monetary policy settings this week.

My Interview on Reuters / ET Now

Watch my interview on Reuters / ETNOW. Click on the link below

videoId=276730253&videoChannel=104″>http://in.reuters.com/video/2014/02/06/need-reform-oriented-government-in-india?videoId=276730253&videoChannel=104

“Mitul Kotecha, head of global markets research Asia & FX strategy at Credit Agricole CIB, is more optimistic on emerging markets than before but sees risk aversion among investors in EM equities. He tells ET NOW, investors are awaiting the election outcome and says it’s essential a reform-oriented government comes to power.”

Attention turns to ECB and BoE

Ahead of two key central bank policy decisions by the European Central Bank and Bank of England where no change is expected as well as tomorrow’s release of the US jobs report, range trading is likely to dominate. Risk aversion measures remain elevated however, and further slippage by US stocks was recorded overnight.

The USD remained supported within ranges, helped by firmer US Treasury yields. Fed officials overnight showed little inclination to alter the pace of tapering despite the recent turmoil in emerging markets suggesting that emerging markets can expect little relief from the Fed.

Meanwhile, US data releases provided mixed signals, with the ADP private sector employment report (a key indicator for tomorrow’s non farm payrolls data) coming in below consensus at 175k in January (consensus 185k) while the US ISM non manufacturing survey (a survey of service sector participants) was slightly higher than consensus at 54.0 in the same month.

Aside from the policy rate decisions December US trade data and Q4 non farm productivity are on tap today although neither are likely to be big market movers.

Markets remain skittish as caution prevails

There has been a slight easing in tensions overnight as reflected in the small decline in my risk barometer and the VIX ‘fear gauge’. However, markets remain skittish and the mood is somewhat cautious as the focus remains on emerging market travails.

Additionally a sharp fall in Apple shares in after hours trading may also dampen equity markets today. Although specific country specific factors may have provoked the current bout of pressure contagion has spread quickly, reminiscent of the onset of previous crises.

The current bout of pressure may yet be contained but there is still some way to go before market stress is alleviated. Consequently correlations between asset classes have strengthened, in particular for currencies. Indeed most emerging market currencies have depreciated especially those of the “fragile 5”.

Overnight US yields rose while US and European equities continued to sell off and gold prices dipped following recent gains. The USD index held gained slightly following the rise in US yields.

Aside from emerging markets attention will focus on the US, with President Obama’s State of the Union address, December durable goods orders and January consumer confidence on tap most attention will quickly shift to tomorrow’s Fed FOMC policy decision. UK Q4 GDP will also garner some attention.

Lower US yields undermine the US dollar

A drop in US yields has undermined the USD over recent days against major currencies although emerging market currencies remain under varying degrees of pressure. US 10 year Treasury yields have fallen by around a quarter of a percent since the end of last year, acting as a real drag on the USD.

A rise in risk aversion over recent days (the VIX fear gauge has risen by over 13% since its low on 10 January) appears to have resulted in increased demand for Treasuries and weaker equities, with markets ignoring generally firmer than anticipated US economic data this week including weekly jobless claims and existing home sales.

Emerging market currencies have come under strong pressure while the usual safe havens have strengthened most against the USD in particular CHF and JPY. The EUR has also made up some ground. Fortunately for the USD expectations of Fed tapering continue to fuel some buying of the currency, constraining any downside. Nonetheless, until US Treasury yields resume their upward movement the USD’s upside momentum will be limited.

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