Traders showing little fear in the equity market

Traders once again showed little fear in the equity market, despite US politicians showing no new signs of agreement.

- Traders looking at hedging strategies

- Potential to sell rallies in USD/JPY to 97.50

- China showing limited concern around US fiscal issues

You get the impression that if we are going to see some sort of agreement it will come at some stage next week, and therefore this weekend could contain more headline risk than usual.

Traders looking at hedging strategies

Traders once again have been looking at hedging strategies, with the VIX (US volatility index) spiking 16% to 19.4% - the highest reading since June. Coincidentally, the last time the VIX traded to similar levels, we saw a 6% correction in the underlying S&P 500. Still, as long as the VIX is rising, and thus traders are buying put (option) protection, stocks are going to see limited downside pressure.

There has also been talk or should I say hope, that Washington will act if the market pushes them into action. In 2008, after Congress first rejected the TARP (Troubled Asset Relief Programme) and US markets subsequently went into free-fall, this ultimately pushed authorities to cobble together an agreement in quicker fashion. It certainly doesn’t feel like this will happen this time and if it does, it won’t happen this week.  Still, the prospect of a default is likely to keep the USD and equity inflows modest at best.

Volatility in the forex markets is still extremely low and you can see this in AUD/USD, EUR/USD or GBP/USD three-month volatility readings, which are the lowest levels in months. The same can’t be said in the short-term debt markets, notably in the US, with the US T-bill maturing October 24, spiking six basis points yesterday to 17 basis points (bp). Recall that the yield on this instrument was negative a few weeks ago!

Yesterday’s three and six moth US bill auctions showed deterioration in the bid-to-cover ratio (the three-month auction at the lowest level since April 2010), and therefore tonight’s $30 billion auction of four-week bills will be very interesting. Again, who wants to lend the US Treasury money if you really believe it will default?

Flows in Asia have been fairly subdued, with traders keen to watch price action in China given the market re-opened after Golden Week. On the whole, Asian equities have been offered, although volumes have been low, as has the conviction. The market needs a reason right now to buy and there doesn’t seem any glaring reasons to do so; on the flip side however, there doesn’t seem to be the impetus to really see much lower prices at present.

Sell rallies in USD/JPY to 97.50

We’ve seen some short covering in JPY based positions, although I feel a move higher in USD/JPY to 97.50 looks like a potentially good entry for fresh shorts, given the short-term downtrend in play. There has also being good bias to sell into strength in AUD/USD and more so AUD/JPY after the solid NAB business confidence numbers (the highest in over three years). AUD/JPY could fall to the 90 handle in the short term, although the daily MACD is still above zero and momentum still favours buying dips.

Interestingly there were very limited moves in the JPY, despite Japan’s current account surplus shrinking to a record low in August. The surplus is now down 64% from a year earlier, and it seems logical that given the trend that we will even see a deficit in the months to come. A weaker JPY is having a major effect on businesses importing inflation (subsequently deporting deflation), and therefore we are starting to see this front and centre in its trade figures. This is a big JPY negative, and while we think the JPY (like the CHF) is expensive, the time for selling isn’t right now.

China showing limited concern around US fiscal issues

China re-opened and is trading 0.2% lower, which is hardly a market concerned about holding nearly $1.3 trillion of debt; good buying can be seen in telco and industrial names.  The HSBC services PMI print grew at a slightly less expansive level from the prior month at 52.4, although this is not a concern and should support the Q3 GDP print (released October 18), which is expected to be 7.8%. Local press in China (China Securities Journal) is reporting the Q4 GDP print should be 7.6% and again this is fairly healthy. Its worthy of note that the PBOC has conducted RMB65 billion in seven-day repos to inject liquidity after the holiday, and this seems to be supporting other risk assets.

European equities look like they will see a weaker open, with traders continuing to increase portfolio hedges. It’s interesting to see traders starting to focus more closely on the European money markets again. We feel the EMU (European Monetary Union) should grow a touch over 1% in 2014 and the last thing the seventeen-nation economy needs is a spike in borrowing rates to banks, which in turn will clearly be passed onto the customer.

Given the supply of credit is very low in Europe anyhow, borrowing rates (Euribor) are getting more focus and we should start seeing a stronger inverse correlation with the EUR. Higher rates imply an increased need for new liquidity measures (i.e. a new LTRO – Long-term refinancing operation), which in itself expands the ECB’s balance sheet, in turn weakening the EUR. Alcoa also kicks of the unofficial start to Q3 earnings, with the market expecting the company to earn 5.3 cents.

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