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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 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.
Following the overstretched pessimism in which we started the year, the short-term relief rally in financial markets keeps on going. A combination of factors keeps supporting the overall risk. The constructive headlines coming out of the Sino-US trade negotiations remains an important development stimulating the risk on tone, with further signs that both parties aim to find a more protracted compromise after the confirmation that the Chinese Vice Premier plans to visit the US by month-end. More to latch on for risk seekers?
The lingering positive effects on the back of the dovish tu at the helm of the Fed continues to play out in favor of risk as well. The wait-and-see narrative is feeding through, sustaining risk. The immediate consequences ever since Fed’s Chairman Powell caved in to the market’s demand for a pause in the normalization process has been to drive the US Dollar lower as the expectations for a long pause in the Fed rate hike cycle and a potential adjustment of its shrinking balance sheet is being factored in the markets.
Besides, there is no doubt that all Fed members are now undeniably on the same camp, pinning words such as patience, flexibility, prudence, on top of their minds when addressing the press. A market-imposed unifying view.
The latest shoe to drop for the dovish rhetoric to go full circle came courtesy of Fed’s Vice Chairman Richard Clarida, who recognized the need for a sustained pause, the moderate improvements in global growth, the tightening of financial conditions or the possibility of shifting course in the Fed’s balance sheet strategy should it be warranted by market events.
Risk appetite conditions have therefore solidified even if we are far from being out of the woods. It’s become obvious for quite some time now that our risk-weighted index has been commanded higher mainly by the recovery in the S&P 500 as the correlation indicates. That’s why one must be mindful that the ES is fast approaching the key make or break point that led to the liquidity event last year. It implies that should sellers find enough value to create a supply imbalance off this area, risk off conditions looks poised to deteriorate again. The behavior in Gold prices also promotes the notion that the market has scaled down its fears, even if the poor performance in the US Dollar means that the bullish trend is far from experiencing a technical compromise. The yellow metal has taken a pause on its bullish momentum after reaching its 100% projected target ahead of $1.3k.
Some critical technical cracks in the US Dollar index (DXY), the EUR/USD as a proxy or the Chinese Yuan have manifested as a consequence of the dovish tu by the Fed even if the Euro has shown a lack of impetus beyond 1.15. The run in economic data out of the Eurozone has been atrocious, and it has become blatantly clear that it’s the countries at the core of the Union (Germany, France) that no longer can hide their miseries either as recently shown by the appalling industrial production figures, which adds to the existing weakening trends in the manufacturing sector. Throw into the mix the revolts in France by the yellow vest protesters, now in the hundreds of thousands, and the outlook gets even gloomier for Europe.
ECB’s Draghi is due to testify on the ECB’s 2017 Annual Report before the European Parliament, and one wonders, with the obvious economic data, if he could walk back his over-optimism. As in the case of the Fed, it seems only a matter of time until the ECB adopts a more realistic view of present market conditions, which may further undermine the outlook for a late-year rate hike. Once the ECB starts to highlight the risk in the EZ from ‘broadly balanced’ to ‘titled to the downside’ in coming meetings, that’s when the market will get the evidence it needs to price out a 2019 normalization.
If we were to witness further weakness in the US Dollar, especially if it comes combined with an increase in volatility in financial markets via renewed selling in global equities, a theme that we must pay very close attention is the reduction in USD-denominated carry-motivated flows. US money markets have seen a massive increase in foreign holdings via EUR, JPY funding to take advantage of the rate differentials. If the volatility resumes again, the reduction in the carry trade exposure could keep pushing the USD into new lows, acting as an accelerant of the structural weakness present.
A risk to be aware of that may eventuate in further USD fragility due to the prolonged US govement shutdown since this Saturday officially the longest in history. According to Fox Business, Trump is looking to end the impasse with a govement emergency declaration soon. There are many legal question marks on whether or not this move would be even lawful.
Andreas Steno Larsen, Senior Global FX/FI Strategist at Nordea Markets, commented on this underlying risk for the USD in Q1 last week:
“The likely upcoming debt ceiling excess liquidity surge is interesting, as liquidity developments will then be at odds with Feds balance sheet trend.” The increase on liquidity due to the adjustments required by the Treasury may translate in USD weakness.
The run-up in the Chinese Yuan is critically important to monitor too, as it only makes the need for China to reach a trade deal with the US a more compelling outcome to achieve in order to address its economic slowdown. The entire world is keeping a close eye on how the talks evolve as calls for a global recession, make no mistake, do come driven by the significant loss of momentum in China. All countries are dependable of the initial psychological/sentiment impact and the subsequent potentially positive economic ramifications that a Chinese trade deal with the US would exhibit.
The Chinese govement, via its different state-control arms, has enacted a new set of stimulatory policies, including a 1% cut in its banks’ reserve requirement ratios to try to stimulate the economy, which remains in a state of disarray as the trend in the Chinese QoQ economic indicators indicate (vehicles sales, industrial productions, fixed asset investments, trade activity).
There are a number of reasons to expect higher volatility this week. Firstly, UK PM May is set to finally face the meaningful vote of the Brexit deal, with the prospects of a defeat running very high. It’s been reported that over 200 MPs may oppose to the drafted deal negotiated with the EU.
The question, therefore, becomes what next? Judging by the performance in the Sterling, there seems to be a growing line of thinking that is buying into the notion that the UK will eventually manage to negotiate an extension of article 50, even if at this stage, with the EU not willing to cave in to further concessions, it means simply delaying the inevitable. One could argue that some glimmers of hopes over a 2nd referendum on Brexit, even if misplaced by the lack of any evidence, have been priced into the latest GBP run up. If the idea of an article 50 extension starts to dissipate to instead resolve the current conundrum via a hard Brexit by late March, the Sterling should suffer.
Another volatility accelerant this week includes the US eaings season getting underway, with traditional banks the highlights, including JP Morgan, Bank of America, Goldman Sachs to name a few. If we were to focus on other events to drive sentiment, today’s China’s trade balance offers an excellent opportunity to keep assessing the state of affairs in China.
The breakout of the saturated range structure last week has so far failed to find follow through. My bullish bias and long exposure remain undeterred nonetheless, as the trade ticks enough boxes to remain committed to the long-bias. On the daily chart, we can clearly observe that the bullish resolution comes in line with the divergence in the German vs US bond yield spread, which argues for any retest of the previous area of resistance (on a closing basis) at 1.1440–50 an exceptional area to consider engaging in long-side business. By drawing the volume profile, clear symmetries emerge, allowing us to identify the POC of the multi-month range at 1.1375 area with the extremes at 1.1307–1.1448, hence why it’s so vitally important to hold the latter for the uptrend to resume. This constructive outlook comes in stark contrast with the European fundamentals, but as I’ve argued, this is a movement led by broad-based USD weakness. Also notice, last week’s close beyond 1.15 achieved the creation of a fresh bullish cycle high, with the extension from Jan 3rd low to the recent high greater in magnitude (260 pips) than the previous leg up of 207 pips. This bullish structure has emerged on the back of a debilitating bearish structure seen from Oct to Nov of 2018.
Friday’s bullish outside day has shifted the focus towards further upside. The breakout occurs despite the weakness present in the EUR/USD in the last 2 days, clearly implying that this GBP-centric move is predicated on the hopes that a positive Brexit outcome may emerge this week in the form of an extension of the article 50. On the lower windows, you can observe the decoupling of the GBP/USD with the EUR/USD in a magenta line. The bullish breakout of the sticky resistance at 1.28 (POC November) alongside the rising UK vs US bond yield spread does reinforce the view that short-term bullish risk exists, even if one must be mindful that vol is set to pick up substantially from Jan 15 when the UK parliament is set to move forward with the Brexit meaningful vote. Any setbacks now face 3 critical macro areas at 1.28–2785, followed by 1.2712 ahead of the Dec POC at 1.2650–55.
Again, this is a market where market symmetries can assist us to determine our short-term bias. Ever since the recovery above 108.10 (100% proj target), the daily price action has provided enough evidence of this area being actively traded by market makers and short-term momentum accounts looking to adjust valuations. The upward slope in the 5-day moving average is another positive input I am personally factoring in. The last 2 daily prints, trapping volume to the downside while achieving bullish closes is a clear reminder that upward risks are building up as long as the risk environment remains sustained. I am personally holding a near-term long bias in this market, as the achievement of the projected target of 100% has been backed by price action and sustainable risk. I remain very versatile to change my views to bearish if we can achieve a close sub 108.10 with a deterioration in the risk tone. If this scenario eventuates, a potential resumption of the downtrend is on the cards.
* 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).
Find below today’s implied / historical vol levels.
* 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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