Posted on: 05 Dec, 2018
Quite a painful way to start one’s day if you’ve been stuck with a risk-seeking mentality on the aftermath of the temporary truce reached by US President Trump and China’s President Xi.
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The psyche of the market has been severely damaged after an intense sell-off in risk assets on Tuesday. The synchronized Monday’s run-ups in the S&P 500 and US bonds were a rare occurrence poised to not to last. It was just a matter of which one would give in. Ultimately, US bond vigilantes kept a steady hand and equity holders caved in, letting sellers take full control and play the needed catch up with bonds. Can we blame the full-blown crisis in risk sentiment to what is perceived to be a vague and non-committal US-China trade truce? I’d say partially as the market is not buying into both superpowers finding sufficient common ground to arrest concerns over more punitive actions next year. Trump’s latest tweet storm, calling himself ‘tariffs man’ or the lack of follow up details can’t possibly be helping the case near term.
Can we attribute the sea of red to the sudden change in the Fed’s communication? Judging by the dramatic flattening of the US yield curve, you bet. As the lay of the land stands, if the Fed has any intentions to raise rates in 2019, the market is unambiguously telling us ‘better press the brakes and re-consider the normalization path’. By the end of business at 5pm New York time, the textbook risk-off aversion climate led to the usual suspects (Gold, Yen, bonds) being bid to the boots while risk-on linked currencies and stocks suffered badly.
Quite a painful way to start one’s day if you’ve been stuck with a risk-seeking mentality on the aftermath of the temporary truce reached by US President Trump and China’s President Xi. The market has called the meeting bluff and with it, a sea of red has taken over. Judge by yourself…
Our prop risk-weighted index (RWI), by hitting the lowest reading since mid-August this year, embodies the dismal picture in risk conditions. Find an illustration below.
Ever since the peak on the RWI reached at the open of markets on Monday, risk-seekers have certainly been hit by a reality check, as it reflects the sharp fall of nearly 9% in the index. The immediate thought that comes to investors’ and traders’ mind is to stay much more defensive in equities plays, consider currencies the likes of the Japanese Yen, to a lesser extent the USD, while being extremely vigilant if you are looking to endorse commodity-linked currencies.
The flows have clearly reverted back into unambiguous extreme ‘risk-off’ conditions and the velocity of the sell-offs must not be ignored. No conjuncture can be drawn between the intense sell-side flows and market cycles (structures) just yet, with the S&P 500 still in an hourly upcycle off the Nov 26 low even if the technical outlook is now severely damaged due to the extreme velocity of the move down.
The deterioration behind the RWI can be mainly explained via the implosion suffered by long-dated US rates, with the 30-year risk sensitive US Treasury exhibiting a dramatic fall. However, with the price now leaning against a macro weekly support at 3.14%, I can’t help but think those bottom pickers will show up aiming to capitalize on the over-extension of the US rates rout.
What I personally find most perturbing for the interest of the US Dollar and risk conditions in general, is the outperformance in gold prices. The metal has, once again, decoupled from its 2018 relationship as a function of US Dollar performance, and is trading much higher. The notion of acting temporarily as a safe harbor amid the reduction in diversification options out there is back in vogue.
In times of financial stress, US bonds, Yen and gold are the ultimate shelters to find refuge, and that’s precisely what we saw on Tuesday. Be on high alert!
I remain of the view that the EURUSD is setting the stage for higher valuations in December based on various factors, such as the completion of 3 legs down (each weaker in magnitude) , a major divergence vs German-US yield spread/Italian premium, and a bullish outside day at decision level 1.13. Capitalizing on weakness does make sense sub 1.13. In the last 24h, the bearish reversal does suggest that another attempt down towards the round number is on the cards. Any test of liquidity areas at 1.1285 and beyond do represent genuine long opportunities based on valuations. From an hourly perspective, the impulsive move from levels above 1.14 has set into motion a potential downward extension to retest 1.1319 liquidity area ahead of the critical 1.13.
The increase in sell-side volume on the way down backs the case for lower levels. The sharp pullback has also invalidated the hourly upcycle as the price discovery matures into a potential intraday downcycle. However, I am still expecting plenty of buying interest, especially if risk off can ease. A major demand area (highlighted in green), the deteriorating outlook for US rate hikes heading into 2019, higher valuations, all support the notion that sub 1.13 should represent genuine value to engage in buy-side campaigns if risk permits.
The bearish price action ahead of the key support at 1.27 enhances the prospects of a potential breakout. While Tuesday’s candle close held the level, the full reversal candle (V-shape type) tends to be a sign that increased downward pressure is likely. If it serves of any consolation, the UK vs US 5-year yield spread does not justify a breakout, but with risk off at full steam and the lay of the Brexit land is still very muddy, one can certainly find enough triggers that would lead to an eventual resolution south-bound. The hourly chart shows a clear range with 1.27-1.2840 the lines in the sand drawn by market participants.
The second attempt at 1.27 on Dec 4th, which followed the tepid one the prior day, has been greeted by a huge absorption candle, which makes a retest of 1.27 a potential exit for those trapped shorts on the breakout. This means we may see intraday upward pressure into Dec 4 POC at 1.2740. Only a break and acceptance above would then increase the prospects of a range extension. When trading ranges, pay attention to the side in control of the mid-point of the range at 1.2770.
The daily chart communicates more trouble ahead. The close near the day lows after an outlier move of nearly 2x the average range in increasing volume ticks all the boxes. The price action is a reminder of the current disconnect that has existed and still does between the pair pricing and hammered risk-off conditions / US vs JP yield spread. A break through 112.50 daily liquidity would expose the next key decision point at 112.00 round number ahead of 111.70.
The hourly chart has confirmed a fresh downcycle, with an amplitude of extension exceeding the previous leg down, which bodes well for the interest of shorts. The selling volume has been very steady throughout the move down, which reinforces the sell-side outlook. The key areas to engage as a seller for the most attractive prices include 113.20 ahead of 113.39.
The Aussie is on a 3rd leg upcycle. Whenever a 3-sequence interval completes, it makes the prospects of further headways challenging. For now, the daily liquidity at 0.7330 has been chewed up by increased interest to sell risk and a dismal Aus GDP in Q3, placing the focus back into 0.73. If that level gives in, it’d be most likely the turn to test the next cluster of bids at 0.7270 ahead of an ascending trendline circa 0.7245/55. Also, be aware that both the Aus vs US yield spreads and the Hang Seng index as a proxy for the Aussie, are both rolling over.
By analyzing the pair’s anatomy in the hourly chart, the Aus GDP print secured an additional 50+ pips to the downside as the pricing adjusts to the fundamentals. The breach of the ascending trendline is one technical bastillon out of the way, as it’s the fact that the structure has now reverted into a downcycle, confirming a double top in the process. Overall, it makes propositions to be a seller on strength near term a more appealing concept to consider.
We’ve seen Gold futures (GC1!) bought with impetus since last week. Ahead of the Trump-Xi G20 summit, the market was aggressively buying 'Out of the Money' (OTM) Puts as cheap insurances in what appears to have been an anticipation of a bullish price action in the front month (Dec) contract. The latest activity saw participants trailing up OTM Puts purchases up to $1,200. What’s more, the latest leg saw over 8k new contacts added on Monday, which supports the notion of buying into weakness, especially as the US10Y-US2Y curve makes fresh lows.
Last Friday's options activity in Oil (WTI) saw aggressive buyers of IM Call ~1.5k contracts, backed up by nearly 2/1 ratio of OTM Puts/Calls. Accounts buying options for a ST buy-side move also made sure to protect the downside via $50 strike OTM Puts
Did you notice Monday’s campaign to pile into long US bond contracts? Check this out. We had aggressive ‘In the money’ Call buyers circa 119,50, which was backed up by a surge in ‘out of the money’ puts to the tune of over 20k contracts. There were certainly some players betting for a short-term directional move in US rates. And gosh, did they get it right this time.
This week’s Aussie turnaround in fortunes makes the perfect example on why monitoring implied volatilities can be an important extra consideration. On Monday, the 1-week implied volatility in the Aussie open of 0.7313 stood at just over 81 pips. Guess where the market found the double top? Precisely after an 81 pips run-up. Will it always be this accurate? Absolutely not. Nonetheless, implied volatility is definitely a dynamic blueprint to anticipate measured moves. When combined with other confluent factors, it adds another layer to account for.
Remember, if implied vol is below historical vol, the market tends to seek equilibrium by being long vega (volatility) via the buying of options, which is when gamma scalping is most present to keep positions delta neutral by covering one’s risk. On the contrary, if implied vol is above historical vol, we are faced with a market with unlimited risks given the increased activity to sell options. Other than GBP, which runs a far greater implied vol than any other currency, one should not be oblivious to the downside risks in EUR/JPY based on the current ratio above 2%, which means a market significantly short vega (volatility), as such, a follow through acceleration move through 127.70/80 may be on the cards amid the absence of gamma scalping.
Today, I want to bring to your attention a tweet by Otavio Costa, Crescat Capital global macro analyst. He ruminates on the recent anomaly of the synchronized rise in both the S&P 500 & US bonds. Since stats & history should serve as a means to measure probability in outcomes, Mr. Costa’s tweet should definitely provide some food for thought as an early warning signal. So far, judging by the moves in equities on Tuesday, he is definitely ‘on the money’.
Courtesy of Holger Zschaepitz, market analyst, comes another chart, one that has been doing the rounds to become the market’s central focus. I am talking about the first shoe to drop in the US yield curve. The inversion of the 5y-3y is now a reality as illustrated in the chart below.
What about the Yuan? USDCNY has found equilibrium sub 6.87. The breakout below its previous daily swing low represents the very first transition into a bearish structure since Jan'18. Combine this price action w/ a hammered US yield curve. I stand by the vision of risks for a lower USD.
Oil technicals show the price bouncing off May'16-Nov'17 POC & 100% proj target. In terms of fundamentals, Dec 6 OPEC meeting looks to address the oversupply issues with expectations for cuts on the agenda. Interestingly, "Managed Money,” which is the group that most correlates with the price covered more shorts than they decreased longs + longs as % of OI at extremes.
Morgan Stanley stands by its perma USD bear calls. In its latest research report, the bank reveals that it has added a new long play in EUR/USD for an ultimate target of 1.18. As I argued above, Morgan Stanley sees the downside resolution in USD/CNY as a potential catalyst to unravel further weakness in the US Dollar. EUR shorts in money markets may soon run to the exits, the bank believes. Find an extract of Morgan Stanley’s research below:
Sacha Tihanyi, Deputy Head of Emerging Markets Strategy at TD Securities, put together his thought on what could go wrong for China in 2019. Risks of China under-delivering on growth expectations? The massive 40%+ decline in its stock market this year is a reminiscence of a country in trouble, hard to argue against that bit of evidence. The analyst argues that next year’s underperformance may lead to greater monetary and fiscal support for the economy, exacerbating China’s debt burden and as a result, may see the Chinese Yuan under downside pressure as capital exits. Read TD Securities research extract below:
"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." - Warren Buffett
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