We are in the eye of the storm, with the US volatility index (VIX) up to 24% (+19.3% on the session), ultimately pushing US financial conditions into the most restrictive since September 2015. There has been a rush for portfolio protection, but has it gone too far and are we at a point of peak bearishness?
The comments from George Soros that we could be seeing a re-run of 2008 is a concern I share. While I do not necessarily think a long protracted bear market in developed market equities starts now, there is absolutely the potential for a deep move lower in 2016 or early 2017. For now though, we need to look at the fact that the VIX is elevated, the S&P 500 is three standard deviations from the 20-day average, and the percentage of stocks above their 20- and 50-day is a lowly 15%. The prospect of some sort of mean reversion is high, with the nine-day RSI also getting to a level that contrarians would be eyeing, although it’s by no way at extremes. Would I advocate a very short-term long in the S&P 500 cash and futures today? Yes, but given the trend and fear in markets I am keen to keep positions size very small and would be keen to reverse the trade into any good strength.
It’s very interesting that despite the rampant selling in developed equities, there has been such a limited reaction in fixed income. The US ten-year treasury dropped a mere two points yesterday, which is incredible given the fact the VIX spiked and equities hit hard, on volumes 36% above the 100-day average! We’ve come to the crux of the issue, which is emerging market central banks drawing their FX reserves to help stabilise capital outflows, with many holding these reserves in bonds (ie having to sell government bonds to get access the currency). In times gone by (and when markets fell on different thematics), we would have seen huge moves lower in developed market bond yields, but the US ten-year dropping two basis points highlights that emerging market central banks are aggressively selling out of US treasuries to access the USD’s needed to put the reserves to work. This offsets any rampant buying in US treasuries from risk averse funds who sense lower inflationary forces.
The concern here is when US treasury yields pullback sufficiently, it pushes the equity market to a compelling level on a relative basis. That isn’t happening now and that is key. Central banks are drawing down reserves and the impact that is having on liquidity conditions is huge. The fact that we saw China’s FX reserves fall a record $108 billion in December will only add to the worry.
The craziness in the coming 24 hours
- China have removed the recently imposed circuit breaker mechanism. Today’s open of the Chinese equity market is anyone’s guess, although Bill Gross has suggested he sees the Chinese market opening 5-6% lower. We should see the market open for more than 15 minutes today, but it promises to be a wild day in China.
- The China A50 futures markets actually suggest we are going to see gains today.
- USD/CNY closed at 6.5929, which suggests another weaker fix of the CNY mid-point today at 12:15 AEDT. The 12:15 fix has become arguably the biggest source of volatility for markets and there are no signs today will be any different.
- Long EUR/CNH has been a brilliant trade. Stay with the trend here, the pair is going higher in my opinion. For European companies, that source revenue in China (think autos) and repatriate, this exchange rate is hurting big time.
- Long EUR/AUDhas been and is a brilliant trade. Everyone is covering EUR shorts as the carry trade unwinds and leverage themselves to the Europe’s current account surplus.
- Our call for the ASX 200 is 4950 (-1.2%). Any stocks that thrives in a low volatile world is going to get sold fairly hard on open. Think yield. But if my short-term S&P 500 call materialises then I would expect a modest bounce in the Aussie market. From this perspective, how things shape up after 10:30 AEDT are key. My deep preference is to work orders into the 4900 area though given the strong support seen in September and December, but again it feels as though I am catching a falling knife and any upside seems likely to be temporary.
- Watch ASX oil stocks today. While many will point out oil is down on the session, both Brent and WTI are higher from yesterday’s ASX cash close. Gold stocks continue to work from here.
- US non-farm payrolls could be a short-term catalyst tonight, although it’s going to need a perfect storm of large employment and wage growth (consensus +2.8%) to encourage the bulls. While this week’s ADP payrolls was very strong, as Citigroup point out over the last 17 years, the initial December print has been above 200,000 – a mere three times and averaged 157,00 over the last five years.
- Will AUD/USD go through 70c today?