QE is clearly working in Europe

Mario Draghi basically gave fixed income traders the green light to carry on with the radical position adjustment in the German and French bond markets yesterday, with talk that traders should expect higher volatility in this asset class.

Source: Bloomberg

The central bank also has no plans to intervene here and I wouldn’t be surprised to see the German 10-year bund testing the September highs of 1.10% soon and, judging by the moves of late, perhaps even next week! A 40 basis point move on the week is outrageous and testament to the reversal in positioning and lower liquidity. Those who bought European fixed income in mid-May would have been hoping for reassuring words from Mr Draghi, but alas they were not heard. This ultimately leaves us at a spot where now only 20% of European debt has a negative yield, down from 35% in April. The good thing here is it means the European Central Bank could be buying at more compelling levels, but what’s more it really feels that the QE program is actually working!

Our own client flow has been fairly two-way on EUR/USD today, although 71% of total open positions are now looking for a move lower. I would be loath to short the pair while the German bund (price) is in free-fall and judging from the daily chart the June futures contract is not yet oversold and momentum suggests that rallies will be sold into. On a cautionary note though the oscillators haven’t printed a lower low (divergence), so we could be seeing signs of an impending reversal, so it promises to be a key session. There is limited data from Europe, so my bias is certainly to be short the German bund (June contract) even here.

EUR/AUD looks like the much cleaner trade and after breaking through good supply today, looks destined for a move to the February highs of a$1.4800. The AUD in general has been hit hard today, courtesy of a poor April retail sales report (+0.0% mom versus +0.3% expected) and a record trade deficit of A$3.888 billion. Naturally, there are negative implications for Q2; GDP and is a small piece of the puzzle the doves will cling to that may influence the Reserve Bank, who are openly data dependant. Of course, there is still much water to flow under the bridge, but it is clear that the market feels this could start a trend in the data and whether or not this is the case is yet to be seen, but there is certainly some worrying trends.

AUD/USD collapsed from $0.7773 to $0.7708, and a break of the five-day average (at $0.7705) which effectively contained moves during the May sell-off, would see a retest of the 1 June swing low and onto the key support zone of the series of March to April lows.

What hasn’t been so clear have been the moves in the ASX 200. At an index level there has been a sharp pick up in volatility and you can see this with the ASX volatility index moving higher as the cost to buy put option protection increases. Price action at an index level is looking much shakier and the 200-day moving average (at 5,590) has been convincingly broken. There are now some 40% of ASX 200 companies below the longer term average now and bear in mind this stood at 29% a month ago.

Some are attributing the weak data to the strong rally off earlier low of 5,526 for the ASX 200, but I am unconvinced of this and it looks like it was driven by the SPI futures. SPI futures started to rally at 11:20, ten minutes prior to the retail sales and trade balance and subsequent move lower in Aussie bond yields and AUD. There seems to have be someone trying to defend the 7 May low of 5,559 and while the futures contract did rally after the poor data (which is simply nuts to me) they were already rallying into the release. This changed though as we entered the final couple of hours and the sellers in both futures and cash market ramped up. Trend resistance is seen at 5,600 so I would ease back on shorts on a break above here, but there is no denying that things are looking a little ugly out there right now and the banks are right at the heart of it.

Still, the moves in Australia pale into insignificance to China, which is already playing into Bill Gross’s second ‘short of a lifetime’ trade; well at least the Shenzhen market. The CSI 300 market dropped 2.5% in 20 minutes with talk a large brokerage house (GuoSheng Securities) had halted all margin financing on the ChiNext (small cap, high growth, high P/E) index. Bear in mind this market is one, if not the most popular markets for retail traders as they focus on momentum, which when you see that the market has risen 165% year-to-date you know there is plenty in here. The question now is will this be a trend among the brokers for a complete cut off in the use of margin debt in the ChiNext market and from here into the larger markets such as the CSI 300.

Could this be the trigger for a more pronounced and prolonged correction in Chinese markets? It is too early to answer, but the prospect has absolutely increased.



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