It’s cheaper to lend the US treasury money for a month than lend to the Swiss monetary authorities for 50 years. But not only is the fixed income market benefiting from low inflation expectations and unconventional central bank policy, but we are now seeing increasing risk aversion flows. We always talk about traders missing the boat on the equity rally, but the truth is the rally in fixed income is where the real FOMO (Fear of Missing Out) trade is occurring.
The Federal Reserve will not be enthused by Friday’s US economic data, which showed the Uni of Michigan five- and ten-year inflation expectations at all-time lows, while the Fed’s Labor Market Conditions Index (LMCI) was the most negative since 2009. The yield curve is the flattest since 2007 and while narrowing credit spreads have meant borrowing for corporates is super compelling, the Fed won’t like raising rates with inflation expectations and the yield curve flattening aggressively. Two rate hikes are currently not priced into markets until April 2019, so the market is either gradually warming to the idea that we are more likely to see easing from the Fed, or a near-term hike would be seen as a policy mistake. This week’s FOMC meeting is going to be the central focus, especially after Yellen’s recent speech in Philadelphia suggesting that inflation expectations have ‘caught her attention’. Well, if she focused on the US five year/five swaps market then the Fed would never raise rates.
The other key story is the huge hedging exercise seen through markets. This has been prevalent in GBP/USD for a week or so, with GBP/USD two-week implied volatility (at 38%) now the highest ever (see Bloomberg chart below). The bookies have the probability of a ‘Leave’ vote in the UK referendum at 35%, but traders are taking no risks here and there seems to be a genuine view that we could be staring at a ‘Brexit’. Clearly the polls in the last few days suggest the 35% probability of this event is too low, but hedging UK risks at the current cost is not attractive, so we should look at other markets such as the EUR which is considerably cheaper. While I still sit in the camp that the status quo will prevail, key personnel behind the ‘remain’ camp are clearly not rallying the troops.
The move in implied volatility has now spread to the equity market where the VIX (US volatility index) has pushed into 21, rallying 55% in the last six days. Higher implied volatility as I have mentioned is absolutely key behind the trading landscape and means adjusting both risk and money management for the increased range expansion and risks in the market. To survive and thrive as a trader, we simply have to adjust to volatility.
All the variables points to a tough open locally, with SPI futures 1.9% lower than Friday’s ASX 200 cash close. In the same time, S&P 500 futures are 1.6% lower, with oil futures down 3.2%. We have the ASX 200 opening at 5215, with BHP likely down 3% and yield plays likely to be hit as investors react to higher implied volatility. China and Japanese equities are hardly inspiring either, with both markets finding strong sellers yesterday, so another day of strong selling could lead the ASX 200 into 5200, a level where we saw strong bids in late April.
The key consideration here is what happens if we do actually see a ‘leave’ vote and a sudden shock to markets. What have central banks got in the kitty this time around? The answer of course is significantly less than in prior cycles. As I have argued for some time, for risk assets to find sizeable downside means a strong loss of confidence that central banks can dictate financial markets. That is firmly in the markets’ sights and the gold bulls will be getting fairly excited at the prospect.