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Pick Up In Vol As Risk Off Rules

Pick Up In Vol As Risk Off Rules

The agitation in financial markets, triggered by a shocking miss in the German PMI last Friday, is evident across a wide spectrum of instruments. The rampant Yen is the manifestation of a phase, spearheaded by European & US yields, in which the proverbial has finally hit the fan...

Date: 3/25/19

The Daily Edge is authored by Ivan Delgado, Market Insights Commentator 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 in order to determine daily biases and assist one’s decisions on a regular basis. Feel free to follow Ivan on Twitter & Youtube.

Quick Take

The agitation in financial markets, triggered by a shocking miss in the German PMI last Friday, is evident across a wide spectrum of instruments. The rampant Yen is the manifestation of a phase, spearheaded by European & US yields, in which the proverbial has finally hit the fan, as we finally see the German 10y Bund trading sub 10% or the inversion of the US yield curve in the 10y-3m. The dramatic fall in yields had immediate spillover effects into equities, vol measures (VIX), credit markets (junk bonds down big), and as mentioned, the Yen is the clear winner. In yet another demonstration of the disjointed dynamics between the Sterling and the rest of FX, even under such risk-averse fluctuations, the currency managed to follow the Yen in almost lockstep as the market prices in the positives of an extension of Article 50 for all of us to contend with more weeks of Brexit. Just wonderful! The next pack of currencies displaying a decent performance includes the USD, underpinned by the risk-off diversification flows, while the Kiwi is more of a fundamental play I reckon, with the RBNZ one of the only Central Banks not blinking to further easing just yet. The Aussie and the Loonie follow next, as part of a group trading on the backfoot vs most peers. However, no currency is under more intense pressure than the Euro as the market re-adjusts to levels more congruent with the possibility that Germany goes through a prolonged recessionary period.

Key Narratives in Financial Markets

  • The theme of poor European data went from bad to worse as the German flash manufacturing PMI collapsed to 44.7 vs 48 exp (lowest reading in 6 years), triggering fears of a deeper global slowdown as Germany acts as a proxy to take the pulse of the global economy. The details of the report gave no reasons to feel encouraged, with an even weaker outlook into Q2.
  • The favorite measure of the yield curve by the Fed, that is, the 10y US bond yield minus the 3-month bond yield, has inverted. Whenever this event occurs, if history is any indication, it communicates an economic recession in the US follows, on average, 311 days later. The 10y US bond yield has broken a major monthly support, the 10y Bund trades sub 0, while in Australia, the 10y bond yield is at its lowest level on record. Not pretty.
  • A few caveats must be pointed out whenever we have an inversion of the yield curve and for this signal to become more reliable. Firstly, the inversion should be prolonged in time for at least a quarter to add further weights to its predictability, while at the same time, given the unorthodox Central Bank policies (QEs) and the external forces at play (slowdown driven by China, which has hit the EU real hard), it makes drawing historical parallels trickier.
  • Clear signs of stress in financial markets in the last 24h of trading, with the microflows turning ‘true risk off’ as reflected by the sharp selloff in US and European equities, global yields at historic or near historic lows across the world, while the Yen goes gangbuster.
  • UK PM May is under tremendous pressure to resign as it faces an ongoing revolt from her own Cabinet, aimed at replacing her with deputy David Lidington. A highly fluid situation which follows an agreement to extend Article 50 until April 12th with conditions attached.
  • UK PM May said she will only put her Brexit deal to a vote through Parliament this week if she managed to gather enough support, which is unlikely at this stage. The parliament is set to hold what’s referred as ‘indicative votes’ this week on possible alternatives, which include from revoking Article 50, canceling Brexit, celebrate a new referendum, a customs union solution, an approach for free-trade agreements, an EEA membership or a no-deal (hard) Brexit.
  • Special counsel Muller released the findings of its report over the Trump-Russia investigation to the US Attorney General last Friday. Mueller found no sufficient evidence of a collision with Russia but did not consider there was sufficient ground to exonerate President Trump on the charges of obstruction of justice. Long story short, expect months of more court rulings.

Recent Economic Indicators & Events Ahead

Source: Forexfactory

RORO - Risk On Risk Off Conditions

As the template above demonstrates, the environment supports the notion of ‘true risk off’ flows being the dominant dynamics in the market, which is why we’ve seen the likes of the Japanese Yen, the Pound (Brexit-based) and to a lesser extent the USD the main beneficiaries. The harshness of the selloff in all JPY cross is in line with the synchronized one-street movements in US equities and the US yields, with the latter in absolute free-fall sub 2.90% in the 30-yr. Surprisingly, Gold is yet to catch a strong bid, suggesting that the market is currently paying more attention to the DXY as the main proxy to assess the precious metals intrinsic value as opposed to US yields. That said, under the current negative backdrop in risk, interest to flock into Gold should only rise. As the RORO model stands, not only microflows have permuted towards a textbook ‘risk off’ phase, but the macro flows, which depict the weekly trend, are also in agreement to play the ‘true risk off’ trade.

We can even look at alternative measures to analyze risk with ‘red flags’ all over. For instance, the VIX (vol index for the S&P 500) just saw its largest 1-day increase since Dec 24, around 16.5. Another sign of stress in financial markets can be observed off US credit, where the ratio HYG (US high yielding corporate bonds aka junk bonds) / LQD (ETF tracking US investment grade corporate bonds) dropped sharply to its lowest level since early January. The lower this ratio goes, the more yield the market demands to buy corporate debt perceived as the least safe with the poorest cash flow. If we shift our focus to emerging markets, the EEM / SP500 index is also edging lower towards a retest of it's yearly low, while emerging markets-based currency ETFs such as the CEW (Wisdom Tree Trust) show a triple top, with a break below the previous swing low to confirm the price formation.

Summary: Intermarket Flows & Technical Analysis

EUR/USD: Sell-Side Bias Main Scenario

On the back of the dismal German PMI data, the market has adjusted EUR value in accordance. The volume profile exhibits a double distribution down on Friday, with most of the volume transacted around the 1.13 round number in what should be perceived as a sell-side continuation pattern. The endorsement of the short bias is only reinforced by the breakout of the ascending trendline, but also by the magnitude and speed of the removal of liquidity, which led to the 2nd down-leg in this ongoing hourly bearish cycle to surpass the previous downward extension on March 21. What’s more, the fact that the initial withdrawal of liquidity post German PMI was followed by another impulsive hourly bearish candle off 1.13 breaking into new lows, it translates in the round number acting as an area that sellers will be taking as a reference to extend the bearish momentum, hence the risk of shallow pullbacks. Interestingly, the German vs US 10yr bond yield spread still points to a buying bias, so at the bare minimum, it should act as a counterbalancing effect preventing major overextensions. Remember, by far, the best case is to align intermarket + technicals. Whenever there is a conflict of signals, a more cautionary approach reading price action as the ultimate truth is warranted.

GBP/USD: Critical Resistance Overhead Amid Brexit Mess

The Sterling has put on a stellar performance in the last 24h of trading, even challenging the aggressive buy-side flows going through the books in the Japanese Yen, on the basis that kicking the can down the road a few more weeks/months in the Brexit saga removes an immediate uncertainty. However, with Theresa May facing its toughest hours and her days as PM potentially numbered, this creates yet another source of uncertainty for markets, as the range of scenarios widens, even if judging by price action, the market seems to see a replacement for May as not increasing the tail risk. We are at peak noise in Brexit, which means, trading intraday price action becomes a more difficult exercise of reading the flow and be prepared for whipsawing price fluctuations on a headline by headline basis. Friday’s volume profile formation, despite it shows a P-shaped bullish structure, it is headed straight into the stickiest horizontal level of resistance in the chart, which carries the risk of the recent breakout of a descending trendline being a bull trapped. On the way down, there is now the extra support of a newly formed ascending trendline, making 1.3245-50 all the more relevant. The intermarket analysis is a mixed bag of conflicting signals for now, with DXY inverted heading lower and the UK-US bond yield spread looking to retest recent highs.

USD/JPY: ‘True Risk Off’ Invokes Concentration Of Offers

With the US yields and the VIX experiencing its sharpest moves this year, no wonder offers largely outnumbered any buy-side attempts as the pair continues to move in lockstep with the deteriorating risk profile in the markets. Regardless of the analytical measure utilized to get a pulse of the market, the end result is unambiguously bearish, and it could even get worse if the free-fall in US yields is accompanied by weakness in the DXY, which is not expected for now as the EUR implodes. From a volume profile showing a triple distribution down, the formation of a descending trendline, the intensity and extension of the 2nd led down, the actual leg count of the hourly cycle (missing one to complete a typical 3 legs move) or intermarket studies (‘true risk off’). What this translates into, is a market likely to lean on the obvious areas of resistance to keep selling unless flows revert. Also note, the breakout of the 110.00 round number is psychologically yet more technical damage inflicted.

AUD/USD: Ascending Trendline Breached, Negative Bias

Intermarket flows transitioned into a sell-side bias in the Aussie since March 22nd in the European session, as per the 2:1 ratio of lower DXY + Yuan (both inverted), accompanied by the collapse in European and US equities. The bullish turnaround in the AU-US bond yield spread plays little role to support this market as long as the rest of crosscurrents in intermarket remain negative. What this means is that any opportunity to sell on strength is expected to payoff in larger rewards vs buying. The breakout of the ascending trendline off March 14th manifests these worsening dynamics. The area highlighted in a black rectangle circa 0.7050 is definitely the next sticky support to challenge. A break below would most likely expose the critical 0.70 round number. On the way up, any shift in technicals hinges and is contingent to the ability of buyers to find acceptance above 0.71 POC.

USD/CAD: DXY + Oil Re-Invigorate The Uptrend

The recovery in the DXY alongside the sudden reversal in Oil prices as a response to the ‘true risk off’ environment has taken its toll on the exchange rate, which looks decisive to target 1.3460 resistance. The bullish momentum has the backing of last Friday’s volume profile double distribution up, an ascending trendline but as mentioned, also the intermarket flows (US-CA bond yield the exception). Any weakness in the rate before meeting the upside target should be considered, conditioned to a spontaneous setback in the constructive flows, a buy-side opportunity at advantageous prices.

Gold: Balance Area Within Bullish Context

Buyers are likely to circumvent the current state of stagnation in prices by pushing further up if we take the intermarket crosscurrents as our reference. Despite the rise in the DXY is attracting offers, the annihilation of US bond bulls via a collapse in US yields in music to the ears of buyers here. Add into the mix the weakness in the S&P 500, with the largest spike in the VIX this year, and we have a recipe for a buy-side bias, especially if the strength in the DXY moderates in the slightest. This prognosis can find its promotion via technicals, with market structure printing higher highs and higher lows since the week-long consolidation phase (accumulation) through the first week of March.

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. The Ultimate Guide To Identify Areas Of High Interest In Any Market
  • 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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