Rising volatility and a strong USD

Volatility seems to have risen somewhat over the last couple of days, although the VIX at 16.7% doesn’t really portray a major risk-off feel.

Source: Bloomberg

In the FX space, implied volatility is still subdued, and although EUR/USD has no friends in the world, one-month implied volatility is only at 11.36%, although this seems to be rising. A pick up in FX volatility will naturally negatively impact EUR/JPY, and this pair looks destined for lower levels over the coming weeks.

Having closed below the year’s low of ¥130.15, the pair is eying a move to the falling trend support at ¥128.60, although traders are seemingly nibbling away at profits on shorts today.

EUR/USD and ultimately the US dollar index are the key talking points though, and there seems to be no stopping the move. It has to be said the short-term price action is grossly oversold. But we have seen conditions like this on at least four other occasions since the 23% decline (from $1.3993) started in May 2014, highs and the strongest counter trend rally was 3.9% in October. So, while there is an ever increasing risk of a short-covering rally, traders will sell into it.

The question is what will cause a reversal of the USD juggernaut? Its fate seems to be lying in the Federal Reserve’s hands in next week’s central bank meeting. US two-year treasury yields found buyers yesterday, so the moves in the US dollar index seem a function of weakness in other currencies. The falls in yield have also given Asia-based traders some reason to feel that the world is not about to end and we have seen calmer heads prevail this side of the world.

The USD strength is clearly a major negative for US markets, especially stocks that earn 60% or more of their revenue from Europe. However, there are of course many sectors that benefit from a strong USD and this extends to various global markets as well. Japan has weathered the storm well today, although the JPY has benefited from the pullback in the S&P 500. China is seeing a good rally, although we shouldn’t be surprised as mainland traders don’t seem to follow overseas leads and the modest declines in the Hang Seng are a better refection of sentiment.

US futures have seen some signs of life, although it is never good to see a market close on its low, with 93% of stocks lower and on good volume. Perhaps traders may take some inspiration that Asia is seeing stability and our European opening calls are looking more optimistic.

The ASX 200 fell to a low of 5748, but the bulls have dominated as the day wore on with strong buying in financials and consumer names on good volume. The 3.5% decline in home loan data and 0.1% drop in lending for investment purposes will please the Reserve Bank somewhat, but the 1.2% decline in March consumer confidence won’t be taken well. No central bank wants to see consumer confidence fall shortly after easing policy, and this will beg the question of the effectiveness of interest rate cuts. We have seen increased talk of direct intervention from the RBA into the FX markets, in turn pushing AUD below what the bank feel is ‘fair value’. There is merit here, especially with the ‘Aussie’ looking vulnerable to further losses both against the greenback and on a trade-weighted basis. I am sure the RBA would be loath to undertake this course of action and it seems unlikely that this will cure all ills in the Australian economy.

The more radical standpoint would be for an expansion of base money, potentially buying sovereign debt to the tune of 2% of GDP a month. Naturally this will cause bond yields to fall heavily and spreads relative to other sovereign bonds to narrow, with the AUD likely to come along for a rather steep ride. It seems logical that the RBA would have to buy bonds from foreign banks to achieve the set targets, which would probably not be open-ended like Europe, Japan and the US. Aussie banks will be awash with liquidity as their balance sheets are already in great shape - healthy relative to European banks at present. The key here is the AUD would be smashed and the ASX 200 will fly; then you have a very, very confident consumer. Housing would be a huge issue though and APRA would have an impossible time controlling the money being pro-actively lent out to borrowers.

Clearly we are nowhere near that point and we would probably need to see unemployment closer to 8%, inflation below 1% (and falling) and a stock market heading below 4500. However, we live in a world where central banks are going all-in and inflation expectations and consumer confidence is not reacting as it should.

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