Residual Risk Appetite Persist After Friday’s Fed Put

The Daily Edge 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. The report takes an in-depth look of market dynamics, factoring in fundamentals, technicals, inter-market, futures and options, in order to determine daily biases and assist one’s decisions on a regular basis. Feel free to follow Ivan on Twitter & Youtube.

The State of Affairs in Financial Markets — Jan 9, 2019

The US Dollar saved the day by regaining some of its strength, especially against the European block, allowing the DXY to move gently away from a key area of support circa 95.70 as the chart below shows. The residual bouts of risk appetite on the back of Fed’s Powell dovish tilt last Friday are still feeding through, with the S&P 500, as the bellwether of the overall US equity complex, extending its technical correction, while the US fixed income market found another leg down, with the 10yr bond yield creeping up to 2.73.

Under lingering risk-on conditions, which were further supported by Trump’s tweet that trade talks with China “are going very well”, flows into the US Dollar should have, in theory, receded on Tuesday. However, the weakening trend in the Eurozone economic data is no longer an aberration but a clear pattern that sooner or later the ECB must take note by adjusting its overblown growth estimates. And because of that, alongside Brexit risks, the US still becomes a safe house to hide when overstretched vs the EUR or GBP.

The reason we ended up with limited demand to lift the Euro can clearly be explained by the atrocious German industrial production, which plummeted way below consensus, and as Daniel La Calle, an acclaimed economist at Tressis notes, “while consensus keeps impossible EZ growth expectations.”

Source: @dlacalle_ia

To put things into perspective, the fall in Germany’s industrial production on a yearly basis was 4.7% n December, which means it’s by far the largest since December 2009. To make matters worse, the European Commission’s economic sentiment indicator (ESI) for the Eurozone fell from 109.5 in November to 107.3 in December, which makes 12 out of 12 months in declines. These latest data points have led to starting to see calls of a technical recession in Germany in H2 2019.

Carsten Brzeski, Chief Economist ING in Germany notes: “ At face value, today’s industrial production data has clearly increased the risk of a technical recession in Germany in the second half of 2018. Watch out for tomorrow’s trade data. Another disappointment, combined with the high inventory build-up in 2Q and 3Q, would clearly increase the likelihood of a technical recession. On the other hand, private and public consumption still have the potential to offset recession forces. Looking ahead, however, even a technical recession should be nothing to be too worried about. It should be technical, without any significant marks on the labor market.”

Meanwhile, Eurozone corporate spreads and sovereign spreads keep rising even as the environment continues to be relatively stable since the Powell Put. On corporate bonds, what’s even more worrying is the fact that, as Asif Abdullah, Strategist at Scotiabank, explains, “unlike the Fed, the ECB holds corporate bonds. If ECB actually winds down its QE and starts reducing assets, these spreads would rise even further.”

What the above observations translate to, in layman terms, is that the ECB won’t allow this tightening of economic conditions to keep on going. That’s why we are progressively moving towards a phase in which the ECB is entering a state of virtual reality if they so believe they can wishfully think the normalization of its policies can occur anytime soon (read 2019).

Source: @Asif_H_Abdullah

However, there are still some actors, such as ECB’s member Hansson who can always take the other side, of course. The policy-maker had the following to say on Tuesday: “Labor-market data remains unexpectedly positive. ECB rate guidance rather precise if economy on track. The balance of risk hasn’t shifted after recent data. For every bit of bad news, you get a bit of better news, and on balance I don’t see this creates risks that shift the balance of risks,” he said.

“Once the labor market tightens, wage pressure increases… Eventually, that will spill over into prices and create a firmer basis for inflation,” he added.

To me, that sounds more in tune with an overly optimistic approach. It seems as though Hansen may have been living under a rock not realizing that all the trillions of QE spent to reinvigorate the Eurozone economy and support prices have had marginal and far from exponentially incremental changes in asset multiples. Or perhaps he should be reminded of the deflationary pressures that Oil prices are set to cause to headline inflation in the Euro area.

Source: @jsblokland

Countries like the Saudis are starting to get quite desperate on the shortage of revenue the Oil decline has created on its aggressive budget aimed at diversifying away beyond petroleum products, and as the WSJ reports this week, they are planning new export cuts as a bet to lift up the price of oil. The WSJ reads: “Saudi Arabia is planning to cut crude exports to around 7.1 million barrels a day by the end of January in hopes of lifting oil prices above $80 a barrel, according to OPEC officials.”

This is one of the reasons why I’ve been unable to conceive a trading environment in which the Euro exchanges hands significantly above the $1.15. Don’t get me wrong, I am still overall positive on the pair as I am ultimately a slave of my process, one that follows the German vs US yield spread as the ultimate barometer of the most heavily FX pair valuation. Even if the spread has been moving lower in a micro scale as Germany’s bonds continue to attract demand, on a macro scale, capital flows towards the US should recede as the yield advantage evaporates on a more dovish Fed.

According to the latest research note by Bank of America Merrill Lynch, there is currently opposing forces keeping the USD index confined in familiar levels with hedge funds selling USD, particularly against JPY, while real money is buying USD, particularly against EUR. BoAML adds that “for the USD weakness to gain momentum, real money has to also start selling.”

A currency that is finding it harder to keep up its pace is the Sterling as the market seems to now anticipate a plethora of negative headlines about to pour in amid a very gloomy outlook for the UK Prime Minister May to gather enough support on the upcoming meaningful vote of the Brexit deal on January 15th. There has been growing commentary across media outlets that the UK and Europe may be negotiating an extension of the article 50 to allow for a delayed divorce so that both parties can go back to the drawing table so that the UK can get the concessions needed. However, the cynic within me still thinks that the EU won’t budge, and the article below, reflects my view. Ultimately, the European Union has to stick with its toughness to send a message to the rest of Euro-area nations.

The Sterling has now reached a critical level of resistance, one that I perceive as the top of its current range between 1.28 and 1.25. Tuesday’s bearish outside day marries well with the prognosis that a turnaround in fortunes for the detriment of sellers might be on the cards.

Moving on, I must admit that in the US economy, even as the positives echoes of last Friday’s US non-farm payrolls still reverberate on the back of our minds, Tuesday’s jobs openings didn’t live up to the expectations after a fall to 6888 vs 7050. With the Fed now having confirmed a pause in rates for the time being, each data point is of extreme interest to markets. I still find that on aggregate, the recent negative inputs emerging from the US ISM manuf PMI, non-manuf ISM act as an offset to rising job figures and allow the Fed room to maintain its pause and support the overall risk.

Source: @jsblokland

An important point I made yesterday so that we can understand how the Fed has gotten to this point in its normalization cycle, is what Soros coined reflexibility and why this theory is manifested in present market conditions to an extent unlike we’ve not seen before. Thomas Harr, PhD, Global Head of FI&C Research, at Danske Bank, writes about this inflexion point:

One of these inflection points for the market, other than the re-calibrated Fed narrative, is the ongoing Sino-US trade war, and whether or not concessions from both sides can be enough to find a more protracted accord that really lift the mood in markets. However, on the back of my mind, at least during H1 2019, I question if any deal would be too little too late to meaningfully reverse the risk-off course, given that the rhetoric has evolved from a China slowdown to a global growth issue.

Headlines of this caliber, just crossing the wires:

*TRUMP WANT TRADE DEAL WITH CHINA SOON TO BOOST MARKETS

Makes you think that for the US, it’s all about a recovery in risk assets and a relaxation in the tightening of financial conditions. Not to mention China, that is in desperate need to address its massive imbalances and reinvigorate its economy by any means possible. The following research note by Nordea’s Amy Yuan Zhuang sums it up.

Source: Nordea

Heading into Wednesday, the focus shift towards the North American Central Banks. First up is the Bank of Canada followed by the Fed minutes, where the market will keep an eye on any subtle changes in rhetoric as part of the internal discussions in relation to monetary policy.

Heading into the BoC, Adam Cole, Chief Currency Strategist at RBC Capital Markets, shares his take: “We are in line with the consensus in seeing no change in the overnight rate on January 9th. Financial market developments have been huge in the month since the December confab, with 2-, 5- and 10-year yields all ~30bp lower in the broad global risk-off move. Governor Poloz & Co. were noticeably more dovish at the December meeting and associated economic progress report, highlighting risks from lower oil prices and the possibility of an output gap re-emerging due in part to GDP revisions and softer Q3 GDP details. Near-term growth looks to be soft at just over 1%, with oil production curtailments and a postal strike weighing. We do expect GDP growth beyond to be at or above potential and see 2019 at 1.7% overall. Combined with underlying inflation remaining around 2%, this should be enough to see two hikes later this year.”

Lastly, we await the US President Trump speech at 2 GMT with talks in the street that he is set to declare a state of emergency amid the inability to reach a deal with Democrats on a reopening of the US government due to the controversial building of a wall.

Risk Events For Today

Source: Forexfactory

Options — 25 Delta RR & Vols

* The 25-delta risk reversal is the result of calculating the vol of the 25 delta call and discount the vol of the 25 delta put. … A positive risk reversal (calls vol greater than puts) implies a ‘positively’ skewed distribution, in other words, an underperformance of longs via spot. The analysis of the 25-delta risk reversals, when combined with different time measures of implied volatility, allows us to factor in more clues about a potential direction. If the day to day pricing of calls — puts increases while there is an anticipation of greater vol, it tends to be a bullish signal to expect higher spot prices.

Source: http://cmegroup.quikstrike.net (The RR settles are ready ~1am UK).

Options — Ratio Imp/Hist Vol & Insurance Protection

Source: https://www.investing.com/currencies/forex-options

* 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.

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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