Posted on: 19 Dec, 2018
In the last 24h, the intensity of the US Dollar sell-off gathered further steam. This dynamic clearly indicates that the market is not placing too high its hopes. The behavior in the US Dollar leading up to today’s event communicates the market is betting for an uber-dovish rate hike.
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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 market conditions. The report takes an in-depth look on 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.
In the last 24h, the intensity of the US Dollar sell-off gathered further steam. This dynamic clearly indicates that the market is not placing too high its hopes. The behavior in the US Dollar leading up to today’s event communicates the market is betting for an uber-dovish rate hike. In other words, the FOMC may still raise its interest rate one more time, although it will probably set the bar much higher to keep the tightening campaign going.
If they opt for the dovish hike, it won’t necessarily look like a Central Bank compromised by the recent tweets of Trump, but rather, acting in a way that helps to ease the further tightening of financial conditions, a dynamic that has only worsened via higher funding costs/lower liquidity in the system. The flattening of the US yield curve also communicates the Central Bank is getting ahead of itself. These developments disincentivize the Fed to keep its aggressive rate hike rhetoric, so they’d be less compelled and keep the powder dry, even if they will continue to highlight, especially via such a pragmatist as Fed’ Powell is, that the Central Bank will remain data-dependent.
One of the most pressing issues to address in today’s FOMC meeting includes the update of the dot plot rate forecasts, as well as potential upcoming revisions to the Fed’s balance sheet normalization process.
The only way to explain the changes in option premiums heading into the event is by accepting as true that the market’s view — as a hint — is that expectations for rate hikes heading into 2019 may be nullified as the eurodollar futures market or the US yield curve indicate. Similarly, we might see a Fed shifting the narrative towards an adjustment in its balance sheet normalization process too. Only under these dovish circumstances or similar in USD downside impact I can justify the change in options pricing.
Let’s now get into the details. What I’ve learned from today’s cross-asset analysis, judging by the variations in the pricing of options, is that the consensual view via US treasuries and equities substantiates the notion that the Fed may be working to engineer some type of circuit breaker in the soulless stock market. Even if the pricing to own puts in the E-mini S&P 500 is still much more expensive, the major reduction in premium cannot be ignored and tells us that the market is less bearish in equities heading into the event.
Just as it cannot be ignored the higher prices to own calls in US treasuries, jumping by over 100% from its previous 25-delta RRs. Throw into the mix the decrease of over 0.5bp in 25-delta risk reversals in the USD/JPY, and it looks like the US Dollar is poised to suffer further downside pressures. However, it may not be a broad-based move, as commodity currencies still remain largely unfavoured, not just in its spot technicals, but via the pricing of options.
That’s what options traders are telling us. They certainly have taken note, as bond traders did via the flattening of the US curve, that trade tensions, the fading of the fiscal ‘sugar rush’, the US twin deficits, weakness in the housing market, the slow down in investment growth, the late business cycle, Powell’s shift in narrative from a long way from neutral (October 3rd) to rates being “just below” estimates of neutral policy (November 28th), when compounded, place the risks of a more relaxed Fed into 2019, outweighing the pros.
In today’s report, I’ve also noted additional downside protection bought — via OTM puts — in the EUR/USD this week. A market that I find personally very interesting to endorse in buy-side action if the view by options traders materializes is gold. Vol is going to pick up substantially, but some pairs such as the EUR/USD, AUD/USD, judging by its implied vol, may still be contained in wider yet familiar ranges. However, gold appears to be an exception, together with the EUR/JPY, amid low gamma-scalping requirements.
All in all, brace yourself for a wild ride, in what’s set to be one of the major events of the entire year. It will set into motion the stage to approach 2019 with from a point of greater clarity to diversify one’s portfolio.
This is a market that continues to go ‘cash’ as the risk aversion dynamics fail to recede. Tuesday’s sharp decline in our risk-weighted index, down by more than 2%, follows further synchronized bearish movements in both US equities and rates. The follow-through selling wave in stocks alienates with the increase in volume, open interest and put premiums seen on Tuesday.
Heading into Wednesday, the cues out of the VIX index (above 25.00) or US credit markets (junk bonds) are far from compelling. If anything, it suggests the pain is not over. While the volume in the ES contract is tapering, it’s still way above the 20-day moving average, while the close at the very low of the day is a precursor that confidence exists to be a hero aka a bottom picker. That said, the reduction in the Puts premium, as shown below, does suggest that a turnaround is being priced in once the FOMC is released.
The correlations indicate there is only one direction to endorse this market from a macro view, and that’s be Euro buyers. However, we need discounted prices to find these opportunities. The chance was presented last Friday circa 1.13. At current levels, unless you are an intraday trader, I can’t envision the value in jumping on Euro buys. Most importantly, with the FOMC just hours away, it will soon be ‘reset’ time for the price, therefore be patient for the next clues to reveal themselves.
In the daily, we can clearly see a long tail refuting to accept levels above 1.14, which marries well with the notion that ahead of the FOMC, this was a market poised to still exhibit a rotational profile. On the hourly, if you have an inclination to engage in intraday activity, the biases have turned more constructive, with buyers exerting the overall control of the hourly chart after successfully taking out the descending trendline originating from the Dec 10 high. However, be aware, the volume profile printed on Tuesday (one single distribution) does vindicate my point of a market with rotational traits, in other words, low risk of breakouts of the range extremes. Today’s key levels have been circled in the hourly chart. Consider theses the areas with the highest interest ahead of the FOMC.
The UK vs US yield spread keeps reminding us how cheap the Sterling trades. However, don’t let this distract you from the political reality, which is a mess due to Brexit. Therefore, with the risk of a no-deal exit of the Eurozone rising and technicals bearish (weekly close sub 1.27), it’s little wonder that, as promoted in yesterday’s report, the Pound found grateful sellers as 1.27 handle got retested (major clustering of offers). The retracement has found a rejection at Monday’s POC, which is the next juncture to be retaken for sellers to take control again. A third push higher, in which case more selling should ensue, is not an unforeseen scenario either, given that the most recent intraday structure sequence continues to promote higher highs.
All the stars continue to line up for the Yen to gain further ground against the US Dollar. However, unless you trade based on momentum, I can’t see how the current prices can make a good case to engage in short-side business after the days of sharp falls. The valuation of the pair is certainly suggesting we should be trading at least at 110.00, that’s hard to disagree on judging by the massive roll over in both the risk-weighted index (red) and the US-JP yield spread (blue).
The latest sell-off found, yet again, support at an area that has acted with strong bouncing effects in the prior three occasions. The pair is now encapsulated in a 112.25–65 box, with a resolution above or below needed to dictate the next directional bias. With the FOMC coming up next, the expected removal of liquidity may find it hard to break such sticky support. Any test of the downside, unless accompanied by a strong pressure in equities, may present short-term buy opportunities. Remember, the clock is ticking away before we see a major ‘reset’ of this chart, with vol to kick in style.
Based on intermarket analysis, the Aussie remains underpinned by a higher yuan/Aus-US yield spread, while most of the pressure keeps emanating from the sell-off in equities (Hang Seng the most correlated instrument). The reluctance of the Aussie to trade sub 7160–70 harbingers that the downside should remain limited until the FOMC meeting. The same story applies to the upside, with constant failures to trade above 7200 suggesting that the 30–40 pips range may cover all the eventualities until vol kicks in. Exercise patience until the range breaks out.
The latest options data for Dec 18th reveals a market that is lightening up its expectations for further downward pressure in equities, as reflected by the major reduction in Put premiums, observed via the S&P 500 25 delta RR of -2.6 vs -4.48 just 24h ago. What this means is that participants are betting for the Fed to provide some type of circuit breaker in equities.
The day-by-day variations in the 25-delta RR in the currency market also leave some generous breadcrumbs to pay attention in terms of the directional bias the market is betting on. Spoiler: Bearish the US Dollar as reflected by the major deterioration in the 25 delta RR in the USDJPY, moving from -1.06 to -1.58, a clear testament of the downside risks. Market makers in the options market are demanding a higher premium to buy calls in the Yen contract, so it’s not boding well.
Interestingly, there has been a significant decrease in the 25 delta RR in the Aussie. The market demands a higher premium than 24h ago to buy Puts. Meanwhile, EUR/USD 25-delta RR exhibit little changes, which somehow reinforces the notion that the pair may continue to be stuck in a familiar 1.1250–1.1500 range, as indicated by the 1w high-low based on impl vols.
Another instrument that offers major clues as to what side the FOMC will tilt the balance comes courtesy of the US 10-year US bond. The pricing of options communicates a massive spike in the premium that must be paid to own Calls vs just 24h ago, as illustrated in the table below.
Bottom line: The combination of more expensive Calls in US Treasuries, the reduction in Put premiums in the S&P 500, combined with a significant jump in USD/JPY Puts premium (Calls J6 contract), clearly communicates a market pricing in further US Dollar weakness on the aftermath of the event.
* 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).
Out of this week’s out /call volume activity in the EUR/USD, which should serve as the bellwether to understand the market’s positioning in the US Dollar ahead of the FOMC, the ratio P/C continues to be largely skewed towards the buying of puts ‘out of the money’. As I’ve reiterated in many occasions, this translates in a market more interested to buy low-cost downside protection in the potential anticipation that the Fed outcome may cause the US Dollar to depreciate, hence traders are looking to position long spot and find ways via the options market to be insured if their view is wrong.
*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.
If you are looking for markets with the traits for a directional profile in the next weeks/months, according to the ratios exhibited below, the instruments expected to trade slippier include, other than the Sterling pairs, the EUR/JPY as well as the price of Gold. Find below today’s ratios.
* 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.
When we talk about the market doing the job for the Fed by WORSENING tightening conditions, the chart below, via Holger Zschaepitz, embodies perfectly some of the developments that are making more difficult/expensive the access for funding. The LIBOR, which is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another, just keeps soaring… Each bank estimates what it would be charged were it to borrow from other banks.
Here is another chart, courtesy of Otavio Costa, Macro Strategist at Crescat Capital. The chart has served well over the years as a predictor of recessions. Similarly, I’d argue that if the chart, by historical standards, may be about to peak and revert back to the mean, doesn’t it make it incredibly interesting to consider buy-side propositions in the Euro/US Dollar macro wise?
Here is an interesting take via Brent Donnelly, Spot FX Trader at HSBC. In a nutshell, Brent anticipates that the Fed decision today may include the option to slow the reduction of its balance sheet into 2019. If confirmed, even if still delivering a well-telegraphed rate hike, would be uber bullish EM/US according to the trader, who sees the move as a circuit breaker without undermining Fed’s credibility.
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