It certainly feels as though something changed last week, something fairly significant and where for so long markets lacked any sign of a pulse, the idea that we are now facing a period of elevated implied volatility has knocked us all a bit for six.
It just seems so fitting that we start a new chapter at the Federal Reserve and as the page turns the macro backdrop is evolving before our very eyes. We've finally closed out on Janet Yellen’s tenure at the helm of the Federal Reserve, in which she was predominantly tasked with making the handover from Quantitative Easing (EA) to one of hiking the fed funds rate and eventually unwinding the balance sheet as smooth as possible. While Yellen has her critics in spades, and while her policies have been largely aimed at reducing financial market volatility, in terms of setting monetary policy to bolster the US and global economy, I’d debate she has done an excellent job. Take a step back and understand that Bernanke’s mission was fighting deflation, not just in the US, but on a global platform, and we see the evolution of both Bernanke and Yellen’s approach to monetary policy has in-turn created a platform for Jay Powell to focus on his objectives: to effectively reduce the Fed’s balance sheet, target financial risks, while shifting the fed funds rate ever towards its longer-term equilibrium rate.
So a new chapter is upon us and the markets are already speaking out and it feels that given the moves in the long-end of the US bond market, as well many other developed markets, the world has finally bought into the notion that inflation is coming. There is so much attention on the 10-Year Treasury, which closed Friday's trading session up a further seven basis points (bp) at 2.84%. However, importantly, the US 30-Year Treasury had an even bigger sell-off on the day, closing +8bp at 3.07% and for those who really want to focus on the fixed income markets should look at the 10’s vs 30’s yield curve (see below). For the very reason that if this steepens further from here then it should only solidify the belief that inflation is headed back towards the Fed’s target and that the Fed are currently too far behind the curve.
Equity markets will struggle as market participants question this evolution in macro backdrop and a steeper Treasury curve spells warning signs for USD bears and it’s therefore no surprise to see the USD finding buyers across all G10 currencies on Friday and notably against the AUD (with AUD/USD falling 1.3%) and emerging markets.
We have seen the growing confidence in US inflation expectations, where we can see US five-year inflation expectations (starting in five-year time) pushing to a multi-year high of 2.25%. The Fed will have noticed that, 100%. But it’s also important to understand that nominal bond yields have been moving higher far more aggressively than inflation expectations and subsequently we see US 5- and 10-year ‘real’ (or inflation-adjusted) sitting at multi-year highs of 55bp and 70bp respectively. This is a big deal for financial markets, especially for emerging markets, which are going to take a hit if we see a further continuation of higher ‘real’ yields and potential USD strength. We have to watch how the Hang Seng, H-Shares, CSI 300 all trade this coming week, as all three markets printed bearish outside week reversals (i.e. price traded above the prior week’s high and closed below the prior week’s low). So any further downside in these indices should be respected, where after such a strong run since 7 December, the bears have wrestled back control and support levels are being taken out one-by-one.
The focus on Friday was on the non-farm payrolls, where the combination of solid job creation of (200,000 jobs were created in December), with wages increasing at 2.9% - the highest level since May 2009, although, the disappointing aspect was the 10bp rise in the U6 underemployment rate to 8.2% (from 8.1%). Perhaps the most important variable on Friday though was the unwinding of short volatility structures and as the S&P 500 headed ever lower we saw the “VIX” index (or S&P 500 implied volatility) move into 17.31% and closing up 28% on the day and almost 60% on the week. For the derivative traders out there, we can also look at the implied volatility of the S&P 500 implied volatility, or what is known as the “VVIX” (effectively, a derivative of a derivative), and see this pushing into 125% (+27% on the week) – the highest level since 2015. This is interesting, as there is a belief that higher volatility could be here to stay for a while longer and that is a new phenomenon, with the institutional trade of 2017 being selling volatility of any spikes above 14%. A new Fed, a new backdrop by which traders need to operate in! I like what I am seeing…
It leads us then to understand the genuine reasoning behind why the S&P 500 fell 2.1% and what was the biggest one-day sell-off since September 2016, with the index losing $511 billion in market value, with 96% of stocks lower on the day. That reasoning being that the systematic, rules-based funds, many of whom will use implied or realised volatility (vols) in their risk models have dumped stock. As vols spiked, they unwound equity positions rapidly as their model dictates. There is talk (source: Morgan Stanley (NYSE:MS)) that volatility targeting annuity funds could have to sell a further $30 billion of stock this week and another $40 billion should realised volatility not retreat lower. The fact that systematic funds were offloading stock also seems to explain the lack of any real buying of other ‘safe-haven’ assets, although to be fair, when higher bond yields are the backbone of the concern it’s hard to feel we will see too much buying of gold, although we have seen good buying of CHF and JPY, certainly against other currencies than USDs.
I like short GBP/CHF this coming week.
The fact there we have now heard from the over two thirds of the S&P 500 and certainly the bulk of the mega index weights should make us question what is the new inspiration and what effectively stabilizes risk from here. So, in effect, US markets have hit an air pocket of sorts. The S&P 500 also printed a bearish outside week reversal and is just holding the November trend support, so the bulls will absolutely want to see this hold on Monday. The German DAX is another index on the radar, given we saw a firm close through 12,900, which has been a floor in the market for so long, losing a sizable 4.2% on the week and I see risks that we could see a period where the 9-day RSI (Relative Strength Index) could stay below 30 for an extended period. After being bullish risk assets for some time, recent price action and the currently technical set-up suggests the risks to global equities seem elevated to the downside.
(S&P 500 daily)
Another interesting aspect has been the relative outperformance of the ASX 200, with the Aussie market closing up 1.2% last week. Contrast this to the S&P 500, which fell 3.9% (the worst week since early 2016) and there are reasons to feel this outperformance could continue in the week ahead. That said, we should play catch-up of sorts with Aussie SPI Futures closing 65-points lower on Friday and our call for the ASX 200 open sits at 6056 and a 1.1% fall seems in store unless something punchy comes out in the news flow tonight. Based on their ADRs (American Depository Receipt) and without pricing in any of the weekend news, BHP should 1% lower, with CBA also likely to face stronger downside pressure ahead of Wednesday earnings. Clearly not a great day to be long bond proxies, such as REITs.
However, given the broad-based sector falls in Europe and the US it’s hard to see too many hiding places on the open, but let’s not forget it’s a huge week locally with the start of 1H18 earnings in play, with expectations somewhat elevated given the ratio of downgrades/upgrades guidance in the recent confession session. We also have the small affair of the RBA meeting tomorrow, while RBA governor Lowe speaks on Thursday (at 20:00 aedt), while the Statement on Monetary Policy is due on Friday. With the plethora of event risk due, amid the unfolding dynamic of rising real yields and a steeper yield curve, one has to have noticed the AUD/USD having an almost textbook rejection of the September and January double top at $0.8125, with rallies in the pair due to be sold given the prevailing trend, although long EUR/AUD is also on the radar for a break of the December highs.