The Daily Edge

Nov 7: Risk sentiment model: US mid-term election special

Authored by Ivan Delgado, Head of Market Research at Global Prime. The purpose of these institutional-level chart studies 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.

Risk sentiment model:A risk rally poised for more legs

At first glance, the flows seen in equities, US yields, and the DXY, reveal a picture that should be fairly constructive to bid up risk currencies while keeping FX majors supported.

Our risk-weighted index has come under pressure in recent hours, but that’s mainly due to the larger percentual decline in US yields, hence why we are required to break down the dynamics further by looking at both order flow and market structures. Even if the correlation coefficient of the RWI (Risk Weighted Index) against risk proxies such as the AUD/JPY is extremely high, it’s at times like this, when we might get an erroneous reading of risk conditions if not deconstructing the anatomy of the present risk conditions.

Let’s first touch on the US mid-term election results. For a change, the actual projections in the street appear to have come true, with the Democrats set to win back the House, while Republicans will easily retain control of the Senate.

This means a divided Congress, which may see the start of an impeachment process (chances of President Trump leaving almost null)which may divert attention from further easing measures. Under a divided Congress, further fiscal easing or an infrastructure spending plan is low in possibilities, which is one of the reasons that is resulting in the US Dollar weakness post results.

In terms of the Fed, it would still keep the course on its rate hike campaign short-term, while some debt ceiling issues may arise come next year. Overall, short-term, this scenario is one that should cause limited changes to the context we had seen leading up to the midterm election, even if it creates headwind risks for the political stability in the US.

According to TD Securities, these are the four scenarios to consider how a divided Congress and the White House may interact.

As depicted in the chart above, we have transitioned into an environment characterized by a debilitating USD across the board, both from an order flow (arrows) and structure view (black lines). As I mark in the bottom right chart above, whenever we find ourselves in this 6th column scenario of USD weakness, look for the equity market to provide the missing piece of information on whether or not risk is expected to be buoyant heading into Wednesday’s trade.

As one can notice, the S&P 500 futures are trading at the highs of its up-cycle, which constitutes a bullish picture for risk, as flows and the structure align. At the same time, the midterm election outcome has taken its toll on the 30-yr US yield, which is now on the cusp of validating a new cycle low after the breakout of 3.42. Similarly, the selling flows in the DXY are re-anchoring to the down-cycle dynamics, sowing the seeds of what’s a USD weakness environment, within a context of risk appetite as per the performance of equities.

What this equates to is an environment where the currency majors are expected to perform well against the US Dollar. The Japanese Yen, meanwhile, is likely to remain under pressure against the likes of European or commodity currencies. Just be aware that the S&P 500 has yet to confirm a new cycle high as it so far fails to find acceptance above its previous validated swing high at 2,766.00. Any retracement back towards 2,735.00 would confirm the transition into a range, in which case, the ‘risk on’ outlook, from a structural standpoint, would hinge on the ability to resume the uptrend.

One observation that reinforces my view on the extension of the risk rally is the fact that even with USD weakness, gold remains pressured lower. This constitutes a solid hint that the market has no interest to resort to the allure of gold as a risk-off play. If gold is lower even on USD weakness across the board, that’s a clue about the rather friendly conditions we may find ourselves in.

Another interesting development that is helping to firm up my conviction on the USD weakness theme is the fact that EM FX continue to charge higher across the board. See the top left chart, where we have now broken outside a 3-week range and printing back-to-back bullish rejection candles in the process.

One scenario that would invalidate this constructive premise is renewed pressure in equities to the extent that the structure reverts back into bearish territory. If that’s the case, a setback in JPY crosses is likely. If this scenario were to materialize in coming days (equities back down), and assuming the USD weakness remains in place, short-side business in USD/JPY is a play to favor, although be reminded that such a campaign would be in stark contrast to the bullish outlook based on the correlations and cycles exhibited.