Keep an eye on volatility as markets enter a critical period

Financial markets are entering a critical period, including interest rate decisions in the US and Japan and the UK’s referendum on continued EU membership. It promises to be a volatile time, and that opens up potential trading opportunities.

Japanese trader
Source: Bloomberg

Financial markets are entering a critical period, and it kicks off next week with the meetings of rate setters at the US Federal Reserve and the Bank of Japan (BOJ). There’s also a possibility that MSCI could include mainland-traded Chinese stocks, known as A-shares, in the MSCI Emerging market index, there’s a raft of Chinese economic data, and the Brexit debate will remain in focus.

The key market to watch is the Volatility index (see chart below), as this is central to the macro backdrop in markets. Low volatility, inspired by various central banking actions, forces investors into yield and effectively they are paid to be in a position. A rise in volatility would see this trade being unwound rather quickly and this is where we can look at shorting equity markets with greater conviction. 

The chart below from Morgan Stanley highlights the MSCI world (equity) index moving inversely with developed market bond markets. Again, a pick-up in market volatility would change this dynamic, in so much that money would continue to flow into the bond markets, but equity markets would face strong headwinds and high yielding and commodity-focused currencies such as the AUD and CAD would likely be sold. 

The Bank of Japan meeting and selling strength in USD/JPY
The BOJ meeting will bring back bad memories for some of the April policy meeting, where it took no action and the Japanese yen strengthened 3%, the most since 2010. I again see the BOJ doing little at this meeting, as central banks across the world wait to see how events such as the UK referendum unfold. I do expect further policy easing in the July meeting and this should keep USD/JPY supported.

Trade idea: My preference is to sell strength in USD/JPY. A move into the ¥108.50 to ¥108.80 specifically looks attractive. Stops could be placed on a close above ¥110 for a move into ¥105.50.

This chart from Morgan Stanley shows the relationship between USD/JPY and the inflation adjusted bond spread (US vs Japan). The correlation suggests we could see short-term upside in the pair, but my bias is to sell rallies. The trade would benefit from any pick up in risk aversion and of course higher volatility. 

The meeting of the US Federal Reserve’s policy makers
The June meeting of the Federal Open Market Committee is clearly the highlight of next week. The interest rate markets are now assigning a zero probability of a hike, so the focus will be on how punchy the accompanying statement is and whether they are looking specifically at tightening policy at the July or September meeting.

The likelihood is we see a repeat of Janet Yellen’s recent speech: that they want to put up rates, but it purely depends on the outcome of potentially destabilising events, such as the UK referendum. The Fed will be happy to raise with corporate credit spreads narrowing, but the US yield curve is a clear issue at 91 basis points. Falling inflation expectations are a huge concern, not just for the Fed but many other central banks.

The probability is we see a slight downgrade to their growth forecasts for 2016 and 2017, with a shift lower in their view on where interest rates are likely to head in 2017 and 2018. Recall, interest rate traders are positioned significantly more negatively than the Fed’s own projection, so there is a chance we see a modest USD rally.

Spot Gold – The yellow metal will naturally be sensitive to USD moves around the Fed meeting and as things stand the current set-up looks bullish on the daily chart and looks destined to head into the recent high of $1300. My Preference is to buy pullbacks into $1260, with stops below $1240.

Silver - Silver looks even more attractive than gold. Here the weekly chart needs a little explanation.

The daily chart has seen the price close above the 61.8% retracement of the May to June sell-off, so the bulls are firmly in control. The RSI’s (Relative Strength Index) are elevated, but this is a sign of the strong move higher. I really like the fact we saw such aggressive breakout in price action through the May downtrend (highlighted in the pink circle).

The gold/silver ratio is looking progressively bearish. A falling ratio suggests silver is outperforming and traders will often trade the ratio through a pair’s trade i.e. short gold/long silver (for more information on pairs trading see: A break on the ratio of 72.33 would suggest silver is likely to be the better long over gold. 

China data drop
There’s a raft of economic data due out of China on Monday, including industrial production and retail sales. Economists expect industrial production to have risen 6.0% on the year in May and 5.9% annually year-to-date, according to consensus estimates. Retail sales are expected to have risen 10.1% on the year.

Naturally the Australian dollar and resource stocks will be in focus, but so should high grade copper. Interestingly, copper price movements look increasingly bearish, with the price closing below the bottom of the range. The risks now are for a move into 20,000, where a break opens up the January lows of 19,500.

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