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I suggested in last Monday’s report that it felt like something had fundamentally changed in the capital markets and that the massive rise in implied financial market volatility, specifically in equity markets, had clearly knocked us all a bit for six and reflective of a market that felt the central bank put was no longer in the market.
Looking back at the week with the benefit of hindsight has really solidified this view and we are seeing markets fundamentally evolve with genuine aggression, where in the past five days we can see the S&P 500 falling 5.2%, while the DAX, the ASX 200 and the China CSI 300 fell 5.3%, 4.6% and 10.1% respectively. From the highs on 29 January, US equities, along with many other global indices, have now technically corrected and what’s more, on four days last week we saw intra-day ranges of 4% or more and we really have to go back to August 2011 to see anything like this. A massive buildup in market leverage has been partially unwound in the blink of an eye and what started as systematic funds selling out of equity and futures positions, as implied volatility headed higher, has morphed into something far more broad-based incorporating many other market participants.
That said, Friday's session would have given the bulls hope. With a specific focus on the S&P 500, we can see the buyers stepping in to defend the 200-day moving average, for the second time that week. The move off the 200-day subsequently resulted in a 3.6% rally from 2532 to close at 2623 in the last hour and a half of cash trade and what was likely shorts covering, with the index closing up 1.5% on the day. Volumes were impressive, resulting in value some 77% above the 100-day average, while breadth was upbeat with 83% of stocks higher on the day.
The buyers have been lacking throughout the week and for the most part it was algorithmic trading that materialised, with the correlation between the bonds, S&P 500 implied volatility (or the “VIX”) and the S&P 500 itself picking up sharply. While this is subjective, one could argue that it is the US bond market that is the driving force though, and will remain so through this coming week, especially with the yield curve (the difference between 2- and 10-year Treasury yields) pushing back to 77 basis points (bp) and importantly the 10-year ‘real’ (or inflation-adjusted) Treasury yield sitting up at a multi-year high of 78bp. With January US core CPI (consensus at 0.22% mom) and December retail sales (+0.4%) due on Thursday at 00:30 aedt, markets will be hugely sensitive to these numbers and this has to be a consideration for portfolio risk in the week ahead.
This is a market that is now extremely focused on the back-end of the US bond curve and as yields head higher (both on a nominal and real basis) many are asking how on earth ballooning US deficit projections are sustainable when we have rising rates and an ever-increasing cost of servicing this debt. Not to mention that rising rates make investors question the relative attractiveness of the high valuation, high cash flow businesses many of which we know sit in the tech space, not to mention the bond proxies, such as REITs.
There will also be a supply issue to focus on this week with €23.5 billion of bond issuances from a number of key European countries and this could continue to push global bond yields higher, which invariably will likely keep implied volatility elevated too.
So the technicals are becoming more favourable here and we have seen a number of notes from investment banks talking about averaging into longs in the equity market at current levels. Perhaps this will play out well, but I would personally be wanting to see the S&P 500 close above the 5-day exponential moving average before feeling the worst is over. Let’s not forget, the VIX at 29 still suggests the S&P 500 is priced for daily moves of some 1.5%, so this suggests keeping position sizing low and being able to react should the index just head sharply lower (or higher) on no apparent news. We should also consider that the high yield credit default (CDS) swaps index closed at the widest levels since January 2017 and up 33bp on the week and this is a similar picture in Europe too, so it would be compelling to see credit spreads narrow from here.
Oil and gasoline are getting badly beaten up here too, with gasoline futures lower by 12% in the past two weeks, with much focus on US production moving to 10.25 million p/d, while Total is looking to add a further 430,000 b/d, with talk about bringing oil fields online in Nigeria and Angola this year. US crude fell 3.2% on Friday and is sitting on minor support at the November highs. The prospect of a further move lower is obviously a real risk and all eyes fall on this morning’s crude futures open, with the Baker-Hughes rig count gaining a sizeable 26 rigs (announced after market close on Friday) to 791 – the biggest one-week increase since January 2017. If crude is going lower then equities will struggle and ‘real’ yield will only go higher as inflation expectation head lower, which will act as a secondary headwind for risk assets.
So we will be watching the Asia equity open, because if the equity bulls feel the worst is past us and we have genuinely had the technical shake-out that needed to happen, then Asia will go a small step to given us this belief. Our call for the ASX 200 open currently sits at 5804 (-34 points), but this feels a touch too low and I would not be surprised if we saw S&P 500 futures open a touch higher, following on from the positive US close, which in-turn should support Asian prices. If we look at BHP and CBA ADR (American Depository Receipt), we can see these two influential names set for diverging opens with calls of -0.34% and +0.5% respectively.
Japan should open on a weaker footing too, where we currently see the Nikkei 225 open at 21,239 (-143 points), while the Hang Seng is called flat at 29,648 and we have seen a monster pin bar reversal, where a higher high in upcoming trade would be a potential buy signal.
It’s a macro inspired week and a backdrop where many are getting a sharp lesson in position sizing with the VIX at 29, not to mention how to deal with a world of high correlations, where bond yields move higher, equities plunge and implied vols tick up. Although the order of this flow is a point of debate. The strong macro overview should subtract to an extent on what is a busy week on the corporate reporting calendar here in Australia, with names like BPT, BXB, GPT, IFN, IVC, NHF,, OML, SEK and VCX on the docket today, although the influence on the broader market shouldn’t be overly pronounced. On the data side, Aussie employment data is due on Thursday (consensus calling for 15,000 net jobs created, with the unemployment rate remaining at 5.5%).
AUD/USD has found a more stable platform for the week ahead but the bulls really need a close above $0.7848 (the 5-day moving average and 38.2% retracement of the recent decline from $0.8135). EUR/AUD is interesting on the daily chart and needs a close through A$1.5771 to open up stronger upside, while AUD/JPY is finding good buyers into the November lows and this could be setting up for a short covering move should sentiment turn more positive this week. We go into the new week with interest rate markets now pricing no hikes at all in the May meeting, with 14bp priced for December. Given what we heard from the governor and the SoMP last week it’s hard to disagree with this pricing structure.
USD/JPY is another on the watch list, with price showing divergence with the oscillators suggesting potential upside in the week ahead.