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We have, after what has seemed like an eternity, volatility and trends occurring in the forex market, with the JP Morgan volatility index moving up 44% from the July low. We are also seeing implied volatility in the bond market at the highest since March, although the index (I have looked at the Bank of America MOVE index) is still only 7% above the year’s average. The equity market is still seeing fairly limited intra-day ranges, but that may well change soon.
As always, we should look at the world institutional benchmark, the S&P 500, as our central guide for other global bourses. However, in turn we need to focus on the US bond market, as this is perhaps the single most influential asset class of all. We’ve seen a steepening of the US yield curve, which is aiding the USD, however I feel we need to focus most specifically on the five-year treasury given the sensitivity to interest rate expectations. Looking at the price action here, we can see the bond is on the verge of a technical breakout and a sustained break of the key 1.8% level could put it on a path to target the 2.20% level over the coming weeks.
Gold looking highly vulnerable
This would have further positive ramifications for the USD, which is simply the flavour of the month for virtually every trader out there and there is simply is no better way to hedge rising US yields and USD strength than being long Japanese equities. However, USD strength is also having negative ramifications on the likes of gold, which has broken the 2014 uptrend on September 2; a closing break of the June pivot low of $1240 would see traders target $1180.
Higher US bond yields will have negative ramifications on emerging markets and the potential for outflows from certain EM economies, especially as we have seen really strong outperformance (relative to developed markets) over the last few months. The other key issue is whether we see a continuation of the short-term unwind of carry positioning. There is generally a constant between carry structures (i.e. buying a high-yielding currency, funding the position with a low yielding one) and outperformance from emerging markets – low volatility.
The unwind of the carry trade was largely behind the collapse in the AUD over the last few days, although there would have been some sizeable hedging from money managers and corporates of Australian fixed income products as well. Recall foreign entities have been big issuers of AUD-denominated debt (aka kangaroo bonds) of late, while we know just under 70% of total Australian government bonds are held by foreigners. Naturally if we invest in foreign assets we have a currency exposure, so when you see AUD in freefall (certainly not helped by the fact that Aussie bonds have seen a capital loss of late as well) you will feel compelled to hedge exposure by selling AUDs (against your domestic currency).
A new trading range for the AUD/USD?
What’s been interesting today is we have seen AUD/USD testing the floor of the prior 0.9400 to 0.9200 range, but has subsequently found a wall of sellers after today’s Aussie jobs print. If we see the London and New York session hold below the 92 level, then it could really confirm the belief that we are ready to see a new trading range, potentially testing the 90 handle. Today’s Aussie jobs report was breath-taking - do much so that at 106,700 net jobs, no one actually believed the figure! When you hear that over 6,000 jobs have been created every business day it makes you feel that you need to be working in HR given how overworked they must be, while going long stocks like Seek or News Corp (think CarrierOne) would also do nicely if the Aussie economy is seeing that sort of job creation. Still, despite a slight increase in expectations I feel the jobs data won’t alter the RBA’s view on rates.
European markets should find themselves on a firmer platform, although the price action for the rest of the day is far from certain. Mario Draghi is expected to speak at the Eurofi Financial Forum in Milan, so naturally EUR/USD and EUR crosses will be in focus, but it’s worth remembering just how oversold the single currency is. It’s also fitting to see that the inflation expectations in the eurozone (the ECB have highlighted it looks at the five-year swap rate) are back down to 1.96%, effectively declining despite the measures announced by Mario Draghi. This suggests a healthy degree of scepticism that targeted balance sheet expansion will actually work, although many feel the actual plans to expand the balance sheet will be hard to achieve in the first place.
In the UK all eyes will be on GBP/USD and whether Monday’s gap can be filled (1.6233 to 1.6283). We saw a bullish outside day yesterday (i.e. Wednesday printed a lower low, but closed above Tuesday’s high), so follow-through buying today could be very interesting; albeit fairly brave.