Currently, there are only two indices that have upside momentum – the US and Japan on its falling yen. The last quarter of trade has seen the USD become the trade of choice and, with the dollar index up 7.7% (3.8% in September a lone), Q4 is likely to see some of the heat in the currency come out as it has been so loved and so overbought. Some will take profit, although we see this as an opportunity to buy the dips.
The US markets have still not broken their uptrend, despite their best efforts. The S&P was only down 2.7% for the month and has managed to consolidate around the uptrend line in the past three days. The futures market has yet to have a pullback of 5% or more. Currently it is 2.7% off since the September high and remains well bid on dips. This is almost a year-long trend.
These trends remain my indictors for the beginning of the proper sell-off in the US markets. With sentiment wavering and the Fed funds rate now well and truly in play, this momentum is going to be tested in the coming six months – the question that is going to cause volatility is when.
I also believe that Q3 showed that the record-low volatility in the market was too big a danger to ignore. The VIX rose 60% in the quarter (34% in September) and, at 16.3, this remains within historical norms. However, if the US market breaks down and the uptrend is finally cracked as we suspect, two things are likely for Q4:
Firstly, the VIX will continue to march higher and past normal levels. Risk aversion and put protection will only increase in times of sustained downward pressure. You only have to look at what has transpired in the ASX over the past four weeks to see how volatility leads to increased trading in hedging strategies.
Secondly, the increased pressure from the US slide will put increased pressure on the rest of the world and is likely to see Q4 going the way of Q3. The US is the lead market – increased selling in the US will lead to risk-off strategies in the rest of the world, particularly emerging markets.
The interesting to dilemma here is that RBS has found that AUD, emerging markets and volatility are all perfectly correlated when overlayed. The correction shows very clearly that selling in emerging markets corresponds to selling the AUD and vice versa – which in turn sees volatility increasing. Weakness in the equity markets, increases in USD and uncertainly all spell downward trending markets for emerging markets and the ASX.
Ahead of the Asian open
Today is National Day in China and the celebration spans over the next two trading days, so Hong Kong and Shanghai will be offline till Friday. This will take a reasonable amount of funds out of the Asian trading session over today and tomorrow, and may lead to slightly sporadic trading.
Japan is due to release its Tankan data this morning. Expectations are for further slides in the business numbers, and that again will bring selling in the yen leading to upside on the Nikkei. The inverse correlation is still iron-clad. The rise in the Nikkei over the past three months is down to the slide in the yen. It is currently at seven-year highs.
The ASX finished the quarter off 1.9% for the month. It shed 5.9% - the largest monthly decline since May 2012. We’re currently calling the ASX 200 down 33 points to 5259. Having bounced yesterday, the slide in the ASX still looks to be intact and I remain tactically bearish in the yield trade as the AUD continues to slide. There will be an opportunity for a short-term bounce in the ASX as it will overshoot. However, we are not there yet.