Brexit Procrastination Leads to Sterling Annihilation

In the first 24h of dealings this week, the Sterling took center stage as it was to be expected, with the subtlety that the ferocious volatility kicked in before it was planned. The reason? UK PM May could smell trouble (read ‘defeat’) in the Brexit vote through parliament from miles away.

The Daily Digest is authored by Ivan Delgado, Head of Market Research at Global Prime. The purpose of this content is to provide an assessment of the market conditions for the next 24h of trading in order to assist one’s decisions on a regular basis. Follow Ivan on twitter.

Summary - Dec 11, 2018

In the first 24h of dealings this week, the Sterling took center stage as it was to be expected, with the subtlety that the ferocious volatility kicked in before it was planned. The reason? UK PM May could smell trouble (read ‘defeat’) in the Brexit vote through parliament from miles away.

As a result of politicians’ procrastination, we saw a ride of GBP value fulmination. A drop worth over 250 pips or about 2%. What’s next in the Brexit conundrum? To simplify, more negotiations.

The US Dollar, amid the headwinds faced via the flattening of its US yield curve, which communicates trouble brewing ahead (markets are pricing slow growth/inflation in 2019 and no rate hikes), was the main beneficiary out of the G10 FX complex, producing some major outside day bars vs EUR, JPY.

In today’s summary, I can’t forget to mention the failed test of the 2,600.00, initially broken but turned out to be a head fake with the bullish candle boding well for a potential extension of the range. Will that be positive for risk if it eventuates? Indeed. Will it be enough? We shall see.

December may continue to be a month where macro valuations continue to trade out of whack as the Brexit developments create further disparity. I still endorse longs EURs or JPY, barring any major shockers from the ECB this week or Fed next week. Short term, price action is king, and it communicates potentially more trouble ahead for the EUR to 1.13 and 114.00 in JPY.

By the way, today’s shout out is to Holger Zschäpitz, who goes by the name @Schuldensuehner in Twitter. Go check his tweet. It contains a barrage of daily insights on macroeconomics, forex, equities. I’ve personally added Holger in my PRO+ must follow list in Twitter. You should too!

Market Drivers

  • UK PM May delayed a scheduled Brexit vote for Tuesday, after it had become abundantly clear that the Brexit compromise reached with the EU would be rejected. The fact that the warnings of not being even a close call reflect how far off consensus is.
  • UK PM will now be heading back to the EU headquarters to re-negotiate a new deal or make tweaks to the existing one, with a legal end-date for the backstop an option on the table. It is yet unclear how long UK PM May will need until she is prepared to go through a vote.
  • The European Council President Mr. Tusk tweeted that while there is no room to re-negotiate the deal with the UK, including the backstop, they are ready to discuss how to facilitate a UK ratification and also prepare for a possible no-deal scenario.
  • The Sino-US relationship after the 90-day trade truce achieved continues on tenterhooks as long as there is no light at the end of the tunnel on a satisfactory resolution to the arrest of Huawei’s CFO Ms. Seng. There is a dangerous correlation to pay attention here. If the situation worsens, could it potentially lead to a breakdown of the temporary trade ceasefire?
  • Italy continues to tweak its budget deficit proposal before being formally re-submitted to the European Union. Time is of the essence as the deadline before EDP measures are applied nears. Complications surrounding the new proposal are still present.

Fundamentals

  • Home loans out of Australia for Oct recovered to 2.2% vs 0% exp. It’s the best read since July.
  • Japan’s Q3 GDP came disastrously low at -0.6% vs -0.5% exp, which as I will document below, has led to a major flattening of the Japanese yield curve.
  • The EU Dec Sentix investor confidence index came at -0.3 vs 8.3 exp. The indicator portrays the concerns surrounding EU growth slowdown, Italy’s budget or France’s political turmoil.
  • The UK Oct GDP came in line with expectations at 0.1%. Meanwhile, the Oct UK manufacturing and industrial production, along with trade data, all disappointed, even if the was barely any focus on this data release as it’s being eclipsed by Brexit discussions.
  • Germany’s trade figures came positive. The trade balance held firm after better-than-expected exports and imports for the month of Oct. The recovery in German exports raises hopes that Germany may see a bounce in its growth outlook for Q4.
  • The US oct JOLTS (jobs openings) report came at 7,079k vs 7,100 exp.
  • The Canadian Nov housing starts came at +215.9k vs 198k exp while the oct building permits stood at -0.2% vs -0.3 exp. Overall, the data is a mixed bag.
  • The latest Aussie data shows the house price index stable at -1.5% q/q while the NAB business confidence deteriorated further to 3 vs 5. Overall, poor readings all around.

Events Ahead

  • Out of the UK, we’ll get the UK employment report. On balance, the expectations are for minimal changes, hence why there is no value on discounting any positive expected result. Not that it’d matter given how much of a shadow Brexit casts on the Sterling these days.
  • A barometer of economic sentiment to monitor closely due on Tuesday is the ZEW survey out of Germany and the EU as a whole. The data is expected to come softer in Dec vs Nov. If we were to look at the trend for 2018, it’s been a one-way street as shown below. Ahead of the data, any EUR sells at liquidity areas may make sense in anticipation of the negative reads.
  • In the US, the series of producers price index is due, with the data expected to come significantly weaker than expected, so again, the data suggests that selling USDs to discount the poor data expectations could be a trade to keep in mind.

Risk Model

My prop risk-weighted index has found some much-needed stability after the turnaround in the S&P 500 and the topside offers found in the ZB contract (30-yr US bonds). The US Dollar has also been able to recover back its mojo amid the Brexit conundrum. To summary, the close of business on Monday leaves behind a picture of USD strength as depicted by the bullish outside day on the index.

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So, what’s the outlook for risk in the next 24h? I think a lot will continue to depend, to a certain extent, on the short-term reactions to the unpredictable outcome that Brexit has become.

There appear to be some tentative signs that suggest risk may be on the mend near term, such as the bullish price action in the S&P 500 or the level US rates trade at. On the flip side, remember that the VIX still trades at 22.6, junk bonds (HYG) remain under pressure, even the yield curves in the US or Germany are back into flattening mode, which indicates slow growth/inflation prospects. Another source of concern for risk, which could leave us to a negative jump start in Asia, is the fact that the Japanese yield curve just saw its sharpest flattening after the poor Japanese GDP readings.

Looking at the VIX Futures Premium, via ivolatility Team we get the following insights after applying Larry McMillan’s day-weighted average between the first and second-month futures contracts.

“With 7 trading days until December expiration, the day-weighted premium between December and January allocated 35% to December and 65% to January for a -10.06% premium vs. -1.04% last week ending November 30. Still very much in the caution area, well below the bottom of the green zone between 10% to 20%. The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month future converges with the VIX at expiration. Previously, declines below 10 and advances above 30 were unstable.”

The head fake type of price action in the S&P 500, with the index spring it back a recovery to close at the very highs of the day, is a testament of the end of day conviction bulls had. The early breakout of 2,600.00 only to see the price recover backup may induce further short-covering on Tuesday.

On the 30-yr US bond yields, the area circa 3.13% represents a major obstacle for US bond bulls, as it aligns with the highest concentration of volume (POC) through the prior broken range. It’s plausible to think that if a level is going to provide appeasement to the overextension in bonds, this could be it.

As per the DXY, the bullish outside day would, in normal circumstance, scream a buy. But the US Dollar is far from being under a goldilocks state, with a US yield curve flattening dramatically, the yield spread against its major counterparts (especially Germany) losing its advantage, while the price action context is still trapped within a developing triangle on the daily. From here on out, the higher the US Dollar goes, the better opportunity that may exist to sell on strength.

Don’t forget, the bullish breakout in Gold but also in the Chinese yuan is a reminder that the backdrop is far from supportive for the US Dollar to sustain a new bullish trend. There may be episodes of strength from day to day as natural risk profile gyrations occur, but I remain of the firm belief that based on the deterioration in US rates, we are in USD selling territory.

Forex Majors

EUR/USD - Macro Bullish, Brexit Weighs Short-Term

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From a macro perspective, remember that the lower the EUR goes, the more appealing it becomes to engage in buy-side business out of liquidity areas. This thesis hinges on the major divergence observed between the pricing of the pair and the German vs US yield spread (using the 5-yr as ref). What’s more, as a risk barometer, the Italian premium vs German is out of danger territory too as depicted by the magenta line (German vs Italian spread at the highest since late Sept.

On the daily chart, the unambiguous bearish price action heralds that more downside may be in store short-term, mainly driven by the spillover effects of delaying the Brexit vote. A revisit of 1.13-1310, if it occurs, would most likely be greeted with strong buying interest by macro accounts. On the hourly, we’ve confirmed a new hourly cycle low, making any correction a potential sell-side opportunity from a technical standpoint, but in direct collision with fair value, which suggests 1.17 in the EURUSD.

GBP/USD - Sterling Suffers After No Vote, Depressed Sentiment

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It’s been a one-way street for the Pound after UK PM May delayed the Brexit vote. The Sterling has reached its 100% projection target on the hourly circ 1.2520, ahead of 1.25. Remember, the area of 1.2550 reveals where most OTM Puts were bought as downside insurance, hence an area that appears to be a logical short term target now being achieved. The overextension of the Pound offers very poor risk-reward unless you are an intraday trader in and out for quick profits. That said, the sentiment in the Pound has been badly damaged amid the renewed uncertainty. On the basis of a higher UK vs US yield spread, the pair should be trading higher, but Brexit as we know rules.


USD/JPY - Trades At Expensive Levels, Can’t Argue Against Bullish Bar Near Term

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From a macro perspective, the EUR/USD and USD/JPY in many respects are inversely analogous in outlook. Despite the screaming bullish outside day, the higher the pair goes, the more justified it its to engage in sell-side action for an eventual turnaround in fortunes (lots of patience needed at times). Both, the risk-weighted index (in orange) and the US vs JP 5-year yield spread are in complete disconnect with the rate being paid to exchange dollars for yens.

On the daily, the bullish outside day has set in motion the potential for higher valuations near term, that’s hard to ignore, let’s just be aware that the move will be mainly fueled by technicals and potentially short-term value if divergences are found at a micro scale between the pricing of the pair and the risk profile. However, any approach towards 114.00 should see plenty of grateful sellers. On the hourly, an area to potentially engage in buy-side business would be 112.90/113.00 (POC Dec 10, retest of the previous swing high Dec 7) ahead of 112.60 and 112.25/30. These are the area where the highest concentration of liquidity on the way down is expected near term. Watch 113.50/55 as the immediate topside target (100% proj level hourly) ahead of 113.75 and 114.00.

AUD/USD - Downside Limited After Overextension?

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The value in the Aussie should be a tad firmer if we were to use the Aussie vs US yield spread as a reference However, the pressure in the Hang Seng index or the strength in the DXY are capping the upside for now. Nonetheless, it’s worth noting that the resilience of the currency on Monday potentially conveys an interesting message. Has the AUD reached exhaustion near term?

By checking the price action on the daily, the candle is far from promising, as the retest of highs was rejected, forming a substantial tail in the process. Don’t forget, this is a market that printed a sizeable bearish engulfing candle on the weekly, so the inherited pressure to the downside is justified. But, as I argued, the risk-reward, after such an overextension, is just not there for swing or macro traders.

On the hourly, be reminded that there may be a bit more of room to fall is 0.7190 gives in, with the next target found circa the 0.7160 or thereabouts, where a daily liquidity level comes into contact.

Options Market

At 1.30 GMT, the CME Group nor other platforms that I follow have published the latest options data for Dec 10, which is very rare. Unfortunately, I can’t provide an update yet. See below. All 0s… :(

*It is common practice by institutions to use OM Calls or Puts for hedging purposes, as the cost of buying Calls or Puts out of the money are way cheaper than IM Calls/Puts (it acts as an ‘insurance’ against their desired direction). If we see strong activity in OM Calls, that generally means the market is looking to go directionally short and are using these cheap calls out of the money (at a higher level than current prices) as protection should the underlying asset class turn against their favored directional bias (short). On the contrary, if we see strong IM Calls activity, that means institutions are in a hurry to buy the asset for what they perceive could be a directional move brewing.

Find below today’s implied vs historical volatility ratios. In the next 7-days, other than the Sterling, which carries ratios nearly 2:1 or above as the Brexit conundrum continues, the markets with the risks to continue trading quite directional include the NZD/USD with a ratio above 2:1 (impressive), EUR/CHF which carries a ratio of 2.3:1 or the EUR/JPY, with a ratio of 2.03%. Gold is also an interesting market, as the ratio remains above the 1.5:1, suggesting further slippery gyrations.

* Remember, if implied vol is below historical vol, represented by a ratio < 1% in the table above, the market tends to seek equilibrium by being long vega (volatility) via the buying of options. This is when gamma scalping is most present to keep positions delta neutral, which tends to result in markets more trappy/rotational. On the contrary, if implied vol is above historical vol, represented by a ratio > 1%, we are faced with a market that carries more unlimited risks given the increased activity to sell expensive volatility (puts), hence why it tends to result in a more directional market profile when breaks occur. The sellers of puts must hedge their risk by selling on bearish breakouts and vice versa.

Bonus Insights- What Are You Missing?

If you wonder why the world is suffering from chronic low inflationary pressures, check the following chart to understand the huge disparity in the ratio CRB index (commodity index via Reuters) / SP500. It’s the lowest on record as far as tradingview goes. Anyone fancy long commodities vs equities?

Wonder why market commentators are calling for potential risks that the ECB may delay its policy normalization heading into 2019? Check the following chart via @Schuldensuehner

Worried about the Australian housing and how it may affect the RBA policy into 2019? The latest Aus GDP in Q3 doesn’t paint a pretty picture. This chart, via @ShaneOliverAMP is another reality check.

As Shane notes: “Prelim Domain auction clearances. Syd 44% (=final ~39.5%,last wks final was 36%). Melb 44% (=final ~39%,last wks final 41%). Continuing v weak as perfect storm of tight credit, supply surge, fall in foreign demand, int only to P&I, fear of tax chgs & FOMO->FONGO impacts.”

Besides, check this cool price declines representation as well, via @PhilipSoos. It shows the history of housing market declines in Australia since 1980. Check out Sydney and the state of Victoria.


Banks Intelligence Gathering

Brent Donnelly, Spot FX Trader at HSBC, notes: “I don’t want to overstate the importance of the strength in soybeans, but maybe, just maybe it is a good sign?” Have your say, just remember that the atrocious Aus GDP print for Q3 last week has shifted the focus to potential RBA cuts next year.

Did you know that Nomura’s European Economics Team is of the opinion that the probability of “Referendum 2.0” in the UK is rising? According to their thesis, a heavy loss in this week’s UK Brexit vote in parliament could end up with a “people’s vote”. Well, guess what, there wasn’t even a vote.

Here is a preview of this week’s ECB policy meeting via Barclays. According to the bank, the focus is shifting towards discussions about QE reinvestments as the next step in the normalization process. They look at three different policy aspects with a significant bearing on the policy outlook for 2019.

UBS reminds us that the impact of Brexit-related news on the pricing of the EUR/USD is now having the strongest influence ever since the Brexit cycle began back in mid 2016.


Today's Twitter Shoutout

Holger Zschäpitz, who goes by the name @Schuldensuehner in Twitter, is a market maniac at @Welt & Author of 'Schulden ohne Sühne?' a book on states' addictiveness to debt. If you find the time (you should) to go through a brisk passage of his twitter, it will become abundantly clear why he makes it to today’s twitter account recommendation. Plenty of insights into macro economics, forex, equities, as a very credible source of insights through Holger’s lenses. Kudos Holger!

Quote of the Day

If you can’t take a small loss, sooner or later you will take the mother of all losses. – Ed Seykota

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Important Footnotes

  • Risk model: The fact that financial markets have become so intertwined and dynamic makes it essential to stay constantly in tune with market conditions and adapt to new environments. This prop model will assist you to gauge the context that you are trading so that you can significantly reduce the downside risks. To understand the principles applied in the assessment of this model, refer to the tutorial How to Unpack Risk Sentiment Profiles
  • Cycles: Markets evolve in cycles followed by a period of distribution and/or accumulation. The weekly cycles are highlighted in red, blue refers to the daily, while the black lines represent the hourly cycles. To understand the principles applied in the assessment of cycles, refer to the tutorial How To Read Market Structures In Forex
  • POC: It refers to the point of control. It represents the areas of most interest by trading volume and should act as walls of bids/offers that may result in price reversals. The volume profile analysis tracks trading activity over a specified time period at specified price levels. The study reveals the constant evolution of the market auction process. If you wish to find out more about the importance of the POC, refer to the tutorial How to Read Volume Profile Structures
  • Tick Volume: Price updates activity provides great insights into the actual buy or sell-side commitment to be engaged into a specific directional movement. Studies validate that price updates (tick volume) are highly correlated to actual traded volume, with the correlation being very high, when looking at hourly data. If you wish to find out more about the importance tick volume, refer to the tutorial on Why Is Tick Volume Important To Monitor?
  • Horizontal Support/Resistance: Unlike levels of dynamic support or resistance or more subjective measurements such as fibonacci retracements, pivot points, trendlines, or other forms of reactive areas, the horizontal lines of support and resistance are universal concepts used by the majority of market participants. It, therefore, makes the areas the most widely followed and relevant to monitor.
  • Trendlines: Besides the horizontal lines, trendlines are helpful as a visual representation of the trend. The trendlines are drawn respecting a series of rules that determine the validation of a new cycle being created. Therefore, these trendline drawn in the chart hinge to a certain interpretation of market structures.
  • Correlations: Each forex pair has a series of highly correlated assets to assess valuations. This type of study is called inter-market analysis and it involves scoping out anomalies in the ever-evolving global interconnectivity between equities, bonds, currencies, and commodities. If you would like to understand more about this concept, refer to the tutorial How Divergence In Correlated Assets Can Help You Add An Edge.
  • Fundamentals: It's important to highlight that the daily market outlook provided in this report is subject to the impact of the fundamental news. Any unexpected news may cause the price to behave erratically in the short term.
  • Projection Targets: The usefulness of the 100% projection resides in the symmetry and harmonic relationships of market cycles. By drawing a 100% projection, you can anticipate the area in the chart where some type of pause and potential reversals in price is likely to occur, due to 1. The side in control of the cycle takes profits 2. Counter-trend positions are added by contrarian players 3. These are price points where limit orders are set by market-makers. You can find out more by reading the tutorial on The Magical 100% Fibonacci Projection
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