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S&P and Dow Jones futures have opened the day on a soft note and our European opening calls are following in its wake, so traders seem to have started the week with a modest degree of concern. This is backed by the bid in Australian and US treasuries on open, suggesting that this is a genuine risk off move. EUR/USD and EUR/JPY have seen good selling and it will be interesting to see if EUR/USD can hold $1.1200 and instinct tells me it won’t.
It’s interesting that EUR/USD one-month implied options volatility is at 13.68%, the highest level since December 2011 and looking set to break out to the upside. The backdrop does have the same hallmarks of 2011/2012 with all the headline risk in play, although we are not getting the 400 pips daily ranges in EUR/USD like we did then. But certainly we are seeing markets moving in response to narrative from the key players in the negotiating process, some of which most traders have never heard of anyhow!
The Greek negotiating team are still optimistically pushing for continued inclusion in the Monetary Union, while at the same time pushing for debt forgiveness and maintaining government. This is simply not going to happen but it is important to note that both the Greeks and the Creditor nations have common ground, in so much that they are both agreeing on a 3.5% primary surplus by 2018. It’s the pace and how they get there in the years leading into this that are a major point of contention.
Whether there is agreement this week is up for debate, but if not there is the EU council meeting the following week, which comes just before the scheduled bundled payment to the IMF on 30 June. Coincidently, 30 June is also the same day as when the four-month bailout extension expires. Still, a missed payment doesn’t necessarily constitute an outright default and there would be a lengthy administrative process after this.
Were this to occur most traders will look to sell EUR’s and European equity markets, but the best trade in my opinion will be long German bunds, short Italian and Spanish bonds. We are already seeing this trade work well with the yield premium Italian bonds have over 10-year bunds at 137 basis points, up from 88 basis points in early March.
Asian equity markets have seen modest selling, although the selling is more significantly pronounced in China where it seems traders are selling out of positions to take part in the 25 IPO’s coming to market. Talk is we could see over $1 trillion rotating out of the market to pay for what is effectively seen as free money for Chinese institutional traders, who actually qualify for the descent discount to the public offering. Retail investors only get the opening price as way of a rule in China. The regulator (the CSRC) has also banned all margining financing, leverage and collateral arrangements which is big news, although probably expected to a degree given the measures already put in place. Chinese equities could be vulnerable in the short-term.
The ASX 200 fell below 5,500 at one stage as simply no one was buying. Energy stocks have fallen sharply with some reasonable percentage moves in the sector and have been the big underperformer today, although the moves in oil certainly haven’t warranted the scale of the selling. The volume through the broader market has been poor to say the least and investors and the market looks set for another sub $5 billion day.
As mentioned, the other key event risk is this week’s Fed meeting. There is no chance whatsoever that the Fed will target a higher funds rate but the prospect of using the event to signal one is coming is high. Whether this will this be the trigger for a further $9 billion outflows from emerging market funds is yet to be seen but there is a strong prospect that the signal will be provided to markets.
To me that signal comes if the Fed leaves its projection for the fed funds rate at 62 basis points. Looking at the fed funds future (December contract), the market has an implied yield of 38 basis points, so there is clearly a strong scepticism around the magnitude of future policy moves. Their growth forecasts are also likely to be cut from the current estimate of 2.5% (set in the March meeting) to closer to 2%. However, if we hear that the Fed’s projection on where the fund rate will be at year end remain at 62 basis point then we should see the USD bought, with the two-year treasury likely to head towards 80 basis points. With Greece and the FOMC meeting in play EUR/USD is by far the most interesting currency pair to watch this week.