The USD, A Tale Of Two Halves (Micro Forces vs Macro Disparity)

As the Brexit echo reverberates incessantly this week, the British Pound has proven to be the obvious casualty of the political mess the UK finds itself in, as UK PM May faces her toughest hours yet amid calls for a leadership challenge.

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 12, 2018

As the Brexit echo reverberates incessantly this week, the British Pound has proven to be the obvious casualty of the political mess the UK finds itself in, as UK PM May faces her toughest hours yet amid calls for a leadership challenge.

The USD continues to rise victorious, although with a big caveat, and that is, I can’t envision these gains to be sustained as the macro outlook stance.

Can the US Dollar appreciate further near term? With the finding of a 2nd bullish leg intraday against the likes of the Euro, the Pound, the Yen, one could expect the ongoing buy-side campaign to continue maturing into a 3rd final leg before a reversal. In today’s report, I make the case why the breakout of the triangle pattern in the DXY should be taken with a bucket of salt.

Meanwhile, backed up by the preponderance of evidence via the options and inter-market analysis, I also find tentative signs that suggest to me that a recovery in the risk profile may see further legs develop short-term ahead of the ECB policy meeting outcome on Thursday.

In the bonus insights, I make a case to be a buyer of CAD/JPY today. Have a look as I see a significant number of stars aligning for further upside potential.

What about today’s tweet shout out? After reading his feed, can’t imagine you being disappointed with the selection I made. Goes by the handle @OddStats& lets numbers do the talk with real gems day in, day out.

Market Drivers

  • The market dynamics in the European currencies continue to be driven by the messy turn of events in the Brexit saga. After UK PM May’s delay over the Brexit vote in parliament due to a premeditated move to avoid a defeat, it looks like fears are now mounting that she might be facing a leadership challenge. The crux of the matter here is whether or not UK conservatives will get the 48 letters needed to trigger a no-confidence vote.
  • Judging by the latest interventions by European leaders, coming exclusively from the big horses’ mouth such as German Chancellor Merkel or EU Commission President Juncker, there are null expectations for them to budge from their hard-line stance. Essentially, they are saying that the current Brexit deal is as good as it will get for the UK.
  • If you wonder why the EUR/USD is coming under such a bearish pressure even on such a disparity with its German vs US yield spread, look no further than Brexit. As I noted in yesterday’s note via a UBS chart, 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.
  • If you thought China would stand pat watching the Huawei show undeterred, think again. After the arrest of the company’s founder daughter on allegations of facilitating business with Iran, a former Canadian diplomat, Michael Kovrig, was detained in China according to several reports. What’s most important, reports are re-surfacing that a Canadian judge is about to make a bail decision in Ms. Meng’s case shortly. UPDATE: Ms. Meng is set to be released on bail (risk positive).
  • However, a symbolic move by China, suggesting they are not letting the Huawei affair mess around with the 90-day trade truce with the US (China has more to lose!), we saw reports confirming that China is set to cut US car tariffs from 40% to 15%. That’s a risk positive.
  • The next 1–2 days will be critical to shed a light on whether or not Italy faces EU disciplinary actions as a re-submission of their revised budget is due. If the Italian yield premium is any indication, the spread vs the German 10-yr suggests calm waters for now. Italy’s Finance Minister Tria has already hinted that no major changes should be expected, and certainly not the ones the EU probably continues to require (reduction of the budget deficit to 2%).
  • Why would politicians in Italy budge to the European demands after the scenes out of Paris over the weekend? The violent acts of vandalism and thousands of angry protesters taking the streets won’t help. To make matters worse, French left-wing groups have filed a no-confidence vote in parliament as France’s president Macro popularity hits new lows.
  • It’s early days, but watch the growing political risk out of the USA as Trump seems to be unhesitant to shut down the government over border wall funding.

Fundamentals

  • We learned that the price index for residential properties for the weighted average of the eight capital cities fell 1.5% in the September quarter 2018, while the index fell 1.9% through the year to the September quarter 2018. According to the Australian Bureau of Statistics: “The capital city residential property price indexes fell in Melbourne (-2.6%), Sydney (-1.9%), Perth (-0.6%) and Darwin (-0.9%), and rose in Brisbane (+0.6%), Adelaide (+0.6%), Hobart (+1.3%) and Canberra (+0.5%). Annually, residential property prices fell in Sydney (-4.4%), Darwin (-4.4%), Melbourne (-1.5%), Perth (-0.5%) and rose in Hobart (+13.0%), Canberra (+3.7%), Adelaide (+2.0%) and Brisbane (+1.7%).”
  • The Australian business confidence measurement, courtesy of NAB, took yet another “turn for the worse”, that’s how Business Insider Australia describes it. Sam Jacobs, an editor at BI, notes that confidence around the outlook fell below its long-term average. Besides, NAB’s chief economist Alan Oster highlighted the growing fears that exist around the risks faced by Australian businesses after the significant slowdown in consumption.
  • We had some splendorous wage growth numbers out of the UK. If it wasn’t for the never-ending Brexit saga, we certainly would be facing a more interesting policy rhetoric by the BoE, with almost all certainty shifting its focus towards a more aggressive tightening cycle. ING bank sums it up, “while the Bo will welcome another great month for UK wage growth, concerns surrounding Brexit will dominate the economic outlook over the winter. The chances of a second-quarter rate hike are fading rapidly.”
  • At last, some piece of positive news to chew on for the interest of Euro buyers as Germany’s ZEW economic sentiment came higher than expected, recording an increase of 6.6 points in December 2018. However, the official release does warrant prudence, as the data is still at very low levels by historical standards. “Despite this increase, the indicator is still clearly in negative territory and remains well below the long-term average of 22.5 points. The assessment of the current economic situation in Germany once again decreased considerably in December, with the corresponding indicator falling by 12.9 points to a level of 45.3 points.”
  • The US Nov PPI, both headline and core, came upbeat. The main takeaway is that with the price of finished goods and services sold by producers rising, it’s not going to make the job of the Fed reverting back to a neutral stance in policies any easier. Read the official release.

Events Ahead

  • For the next 24h, the US CPI is the major economic release. With Oil prices under severe pressure, expectations for the headline estimates have come down significantly. What this means is that an expensive USD faces the risk of finding offers heading into the event as the market aims to position for what is expected to be a poor report. By the way, if you’d like to see a visual representation of what an order book looks like ahead of a tier-1 data release, check below the illustration. Liquidity just evaporates. That’s why many times I keep referring to certain extension in price movements as led by removals of liquidity. Because it takes very little volume for price to move a significant distance when the OB is so thin.

Risk Model

For the last 48h, my risk-weighted index exhibits almost null net changes as a result of the tepid recovery in the S&P 500, the sustained elevated levels US bonds trade at, all combined with a stronger US Dollar, which appears to be breaking its triangle even if I wouldn’t hold much weight given the massive deterioration we’ve seen in the US yield curve and its yield spread vs G10 FX.

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The logical question we must ask every day. What’s the outlook for the assets that make up the index? Starting by the S&P 500, I see a period of indecision ensuing, with buyers trying to capitalize off the head fake at 2,600.00, but major selling interest still abounds, judging by the reversal of the gains in its entirety. Do we have any residual positives to lean on? I’d say yes, we do. Firstly, a decision was made at the critical 2,620–2,600, and that led to many sellers trapped wrong-footed, hence why it’s normal market dynamics to see these accounts now bail at a potential retest of the support. Secondly, note the volume sequences in the ES is bullish (latest 3 selling bars decreasing in volume vs absorption candle on Monday). Thirdly, the VIX is coming down ever so slightly, as shown in the bottom left in red, although that’s partly challenged by the renewed, if only mild, pressure on junk bonds (HYG).

What about the USD index? Like it or not, but I still see the index is trading unjustifiably high based on valuations. I can’t help but see this run as an orchestrated move seeking topside liquidity before a potential mark-down phase post the ECB or next week’s FOMC meeting. Many could be getting sucked into this move wrong-sided folks, be aware. I could be wrong, but I tend to follow the indications of bonds and option traders as senior signals to lean on, and I just can’t simply find enough sympathy to endorse this long trade based on the readings I am getting. Some may argue the USD is the least bad contender amongst the G10 FX, but never forget that trading forex, more often than not, is a game of guessing inflation and interest rate differentials. The US yield curve and the spreads are communicating major anomalies in valuations at present. I can only be a USD seller, especially with gold on bullish mode and on the back of the structural break in the Yuan.

The market I find facing a major stumbling area that will prevent further gains near term is the US bonds, taking as a reference the US 30-yr bond. Here, I reiterate that the test of the highest concentration of volume during most of 2018 circa 144,00 can act as a reversal area to see US yields appreciation ahead of the FOMC meeting next week. If that’s the case, that’s going to remove some pressure off risk-averse conditions, which could assist the case for a risk recovery on Wednesday.

In summary, I remain fairly constructive over the outlook for risk to return in the next 24h. The Brexit jitters have proven to be a vol-isolated European-centric affair (EUR, GBP mainly) with no major bearings on the US equities nor the US bonds, which are the barometers I utilize.

Forex Majors

EUR/USD — Buying On Weakness For Maximal Risk-Reward

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While on a macro scale the German vs US yield spread gives us only one direction to trade, and that’s to the long-side, we need to see a bet coming back in the spread near term to justify purchases of Euros this low. We are at a critical area where the risk-reward to be a Euro bull is obvious. The Italian yield premium, ahead of the budget showdown in the next 24h, is not arguing against this view.

Remember, the daily chart helps my overall bullish synthesis of ideas, following the exhibition of down legs weaker in magnitude since mid-Oct. Besides, as I’ve demonstrated in reiterated occasions, option players, in the new monthly futures contract, have been trailing up OTM puts towards the 1.13–1350 vicinity, essentially telling us that they don’t expect an overextension of the downside or they’d be piling into greater number of insurance contracts via the purchase of cheap options. In other words, the threshold of pain to endure if getting their calls to be long EUR is now greater. Why would they allow that to occur, leaving strikes sub 1.1250 fairly unpopulated?

Besides, the ratio of impl vs hist vol in the EUR/USD is barely above 1:1 in the next 30 days. To me, that suggests that we are still very much in a rotational type of market, and with Euro now at the low end of its range, you should really ask yourself where the highest risk-reward is. Look for areas of liquidity to the downside to keep providing opportunities to fill you into longs if you are a macro player. Short-term, with 2 cycles down confirmed, I wouldn’t be surprised if we complete a third and final one, which may coincide around the time of the ECB policy meeting outcome, which may see the perfect opportunity to take out further stop losses bottom-side and clean the order book before an expected turnaround in fortunes for the Euro.

GBP/USD — Oversold But ‘May’ Not Be Done

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There is no respite for the Pound. The ripple effects unraveling after the delay in the Brexit vote has definitely opened a can of worms for the UK PM Theresa May. The yield spread between the UK and US is rolling over fast, and while it still shows a macro divergence, the momentum is well and truly to the downside, as it’s the strength in the US Dollar. The price action in the daily is far from communicating a reversal in the making, there is just simply no basis on sentiment, valuations, technicals. Remember, the breakout of the weekly range now gives us a target of 1.2140–50 to the downside. With UK PM May’s leadership challenge a real prospect, you must have nerves of steel to count on a possible GBP recovery near term. What’s more, the latest supply imbalance has led to a validation of a 2nd leg down, with a 3rd one now expected.

USD/JPY — Short-Term Buy Campaign Underway, Macro Bearish

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The yen market is a tale of two halves. On one hand, we have the reinvigoration of the short-term outlook, best represented by a massive bullish outside day on Monday. This shift in price dynamics has led to the resistance of 114.00 to now be back into focus. On the other hand (half), I continue to wholeheartedly endorse shorts from a macro perspective at areas of high interest such as 114.00–114.50, where it will be more than justified to be a seller on strength. The formation of a 2nd leg up on the hourly only reinforces the notion that short-term, the side in control is the buy-side, with the next intraday target at 113.75 (100% projection last breakout) ahead of 114.00. By assessing the ratio of impl/hist vol, I am expecting high interest to gamma scalp this market, which increases the likelihood of rotational moves keeping the rate within familiar ranges. Only a break and hold sub 112.90 will be needed to violate the constructive bullish structure intraday (hourly).

AUD/USD — Short-Term Buying An Interesting Proposition

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In the last 48h, even amid the strong performance in the USD, the Aussie has been holding up extraordinarily well. As Asian markets open this Wed, the positive news around China (release on bail of Huawei CFO by Canada, China to reduce US car tariffs and more committal on 90d trade truce). Some facets of the market may lean on the rationalization of an oversold market, but I personally also see a case where I imagine this stagnant behavior is accumulation for a long-side campaign, especially if my scenario of EUR/USD longs play out. A breakout of 0.7240 with acceptance found above is a requisite for this view to be put to the test. Technically, the breakout would confirm carving out a double bottom on the hourly. Just note, there are plenty of liquidity pockets to the upside, which would make any progress being long most likely a slow grind. Besides, the ratio of impl/hist vol in the AUD/USD remains sub 1:1 in the month ahead, so a trappy market should ensue.

Options Market

The data below refers to the latest activity in the options market for Monday, Dec 10. I am in talks with several options pricing software providers to get my hands on real-time data. This way, I will be able to improve the delivery of value to the reader by adapting to the latest changes in positioning.

$EURUSD: The options market has been short-term bearish, as demonstrated by the increase of in the money puts, which helps to explain the downward pressure seen very much in line with the rotational dynamics of a market still in a 1.1250/1.13–1.15 range. On the flip side, as the Euro lands in the 1.13 area, there is growing evidence of downside protection bought at 1.13 for what I believe should be an eventual move back up to retest the 1.1450–1.15 area in line with bullish macro valuations.

$AUDUSD: The options market clearly shows that the 7150/7300 should cover any short-term eventualities in price gyrations. Considering the decent interest to still gamma scalp this market in line with a fairly neutral ratio of impl/hist, these should be the levels with most focus.

After the collapse in the Pound, we’ve come to a critical strike level where most of the OTM puts bought up by option participants can be found. However, notice that most of the volume (2nd window) continues to suggest an increasing interest to buy cheap OTM puts below 1.25/2450. Besides, the market is very slippy judging by the high impl vol, which makes further falls very possible.

$SP500: The options market reveals a major increase for in the money calls, while OTM Call increases by a ratio of 2:1. Both actions are contradictory. It means, we saw players paying up high delta options for a directional move north, but the increase in upside protection via OTM Calls also suggests the market sees the recovery as an opportunity to increase the upside insurance through 2,680/2,700 strikes. Those buying these protections tend to generally still be factoring in bearish tendencies in the index, which makes perfect sense judging by a VIX above 20.00.

$US10-yr bond (proxy of US30-yr): My anticipation of a potential short-term reprieve in US yields and risk, in general, is supported by the notion that the long-end of the yield curve is finding further support via option players. We saw an increase of over 3k IM Puts last Monday, which is backed up by players doubling down their upside protection in US bonds after a 2:1 ratio OTM Calls/Puts.

$OIL: After the OPEC meeting, let’s ask ourselves the following question. Is the market more or less concerned about further downside pressure in the price of crude oil? The options market can help us partially rationalize this answer. If the market is more concerned of downside pressures to resume, then I’d expect the upside protection via OTM Calls to increase. On the flip side, if the market is more hopeful of a short-term recovery, I’d expect OTM Calls to be reduced. By comparing the front end contract (3 days to expiration) to the Jan expiry one, what do we get? Well, it’s blatantly obvious that the market is no longer as interested to find protection via the 55.00 strike while the 50.00 strike continues to attract an awful lot of attention as an insurance if further downside. On top of that, we are starting to see aggressive option player join the bid in high-delta calls. Overall, this picture suggests that a short-term recovery in the price of Oil is a real possibility.

*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 impl vs hist volatility ratios. The markets where we should be expecting the most sticky price action around key liquidity levels include the USD/JPY, USD/CAD, EUR/CAD, EUR/AUD, while NZD/USD, EUR/CHF, EUR/JPY or Gold is where, if we observe key breakouts of daily key areas, we might see a significant directional move on the lack of gamma scalping.

* 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 I were to synthesize all the analysis above, the preponderance of evidence collected leads me to come to the conclusion that we might be in the cusp of putting a temporary cap on risk aversion. At the same time, if I were to think of what countries have shown the starkest contrast in terms of recent fundamentals, I can think of a Japan being on one side of the spectrum with an awful Q3 GDP print. On the opposite camp, we find Canada, with a blockbuster jobs report last week, which should definitely cause a reinvigoration of hawkish consideration by the BoC.

Now, let’s ask ourselves if the price action on the daily is starting to provide clues, and we can immediately see back-to-back bullish hammers printed. What about the augurs for correlated assets (valuations). We can see how the yield spread is breaking into new highs, while my outlook for Oil and risk near term is constructive, which makes the trade, in my personal opinion, a very interesting proposition. One could enter on a retest of the resistance turned support, notice the POC also backs you up here, with a stop on the other end of the broken hourly range for what appears to be a solid RR proposal.

Banks Intelligence Gathering

Aila Mihr, Analyst at Danske Bank, shares his insights on the German economy, suggesting that higher wages should be expected going forward as the labor market tightens. If the view materializes, it will only reinforce my position of playing long the EUR, especially at these levels.

Let’s now look at EM. According to Citi, its global flow measures show strong net buying across emerging markets among the hedge fund community, coupled with substantial net USD selling. Again, if EM FX continues finding bids along the way, with our prop EM FX recently breaking above the 200-day MA, this is yet another reason to stay macro bearish the USD in my opinion.

Morgan Stanley puts out some of my favorite reports. The amount of condensed insights that fit into the 1-page daily research summary boggles me. To sum up, they remain long EUR, JPY vs USD, which are trades very much in line with my macro observations. They also expect a suppression of EM FX volatility, which helps to rationalize why hedge funds have transitioned into the perceived lower risk. They also see the current divergence between weak credit markets and a weak JPY as unsustainable.

Today’s Twitter Shoutout

Seriously, do yourself a favor and follow @OddStats in Twitter. He made it as part of my PRO+ list for a reason. As his twitter reads, a retired finance professional. I just love the amount of interesting data-backed information he/she puts out. Often supported by visuals, which makes the comprehension and appeal of the information gathered even better.

Check out one of the last tweets out. I guess it won’t make you that confident in risk heading into 2019. Seriously, the best part is that he is far from a charlatan, it’s all data-backed!

Quote of the Day

Like What You See?

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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 outlook provided in this report is subject to the impact of the fundamental news. Any unexpected news may cause the price to behave erratically 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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