The Daily Edge—US Rates Roil Markets, Curve Inversion Main Talk.

The Daily Digest is authored by Ivan Delgado, Head of Market Research at Global Prime. The purpose of this content is to provide an assessment of the market conditions for the next 24h of trading in order to assist one’s decisions on a regular basis. Follow Ivan on twitter.

Summary - 6 Dec 2018

The psyche of the market has been severely damaged after an intense sell-off in risk assets on Tuesday. The synchronized Monday’s run-ups in the S&P 500 and US bonds were a rare occurrence poised to not to last. It was just a matter of which one would give in. Ultimately, US bond vigilantes kept a steady hand and equity holders caved in, letting sellers take full control and play the needed catch up with bonds. Can we blame the full-blown crisis in risk sentiment to what is perceived to be a vague and non-committal US-China trade truce? I’d say partially as the market is not buying into both superpowers finding sufficient common ground to arrest concerns over more punitive actions next year. Trump’s latest tweet storm, calling himself ‘tariffs man’ or the lack of follow up details can’t possibly be helping the case near term.

Can we attribute the sea of red to the sudden change in the Fed’s communication? Judging by the dramatic flattening of the US yield curve, you bet. As the lay of the land stands, if the Fed has any intentions to raise rates in 2019, the market is unambiguously telling us ‘better press the brakes and re-consider the normalization path’. By the end of business at 5pm New York time, the textbook risk-off aversion climate led to the usual suspects (Gold, Yen, bonds) being bid to the boots while risk-on linked currencies and stocks suffered badly.

Quite a painful way to start one’s day if you’ve been stuck with a risk-seeking mentality on the aftermath of the temporary truce reached by US President Trump and China’s President Xi. The market has called the meeting bluff and with it, a sea of red has taken over. Judge by yourself…

Market Drivers

• The flattening of the US yield curve continues to be a major concern for financial markets. The sharp decline in the 10y-2y & 10y-3m (Fed’s favorite measure) heralds impending dangers ahead for the outlook of the US economy, even if it feels somewhat off from the current robust state. It implies the Fed is getting ahead of itself rising rates into 2019, the question to dominate in the trading floors ensues. Will they listen?
• Most worrisome? The Fed, judging by its NY office President, Mr. Williams, may not take the foot off the pedal for quite some time. Williams said that “at some point, it will be less obvious for the Fed to raise rates”, which implies in the short-term, seems non-debatable. After all, you can’t blame the Fed at a time when the rude economic health is still prevalent as reflected by the country’s unemployment figures and manufacturing data.
• Eventually, the Fed’s actions cut no ice with a market that sees a long-lasting tightening cycle as non-viable and probably a policy mistake that may have to be backtracked. However, the slippery laws of economic cycles are all too clear in hindsight but tricky to make the right judgment calls at times. In other words, it’s somewhat inevitable that for now, the Fed keeps adjusting its policy rate settings to whatever conditions they are faced with, even if that leads to a misjudgment of its own making in the future.
• The market has spoken and the verdict is that the truce agreed between China and the US falls well short and fails to check all the boxes necessary for a long sustained relief rally. US President Trump may have mastered the art of the deal, but when it comes to China, some of the sticking points that both sides should give up to (ie/technological transfers) are a non-starter as the battle is far beyond trade, it’s about global dominance.
• China is so far playing a ‘silence game’, which has the US expectant on their ability to live up to the expectations placed after the Xi-Trump G20 meeting. Reflective of the current uncertainty were comments from US secretary of commerce, Wilbur Ross, who spoke to CNBC, saying “we shall see what China commits to.”
• A UK parliament motion, through a contentious vote which resulted in 312 vs 299, determined it will hold more power to vote on the various scenarios available in Brexit. Essentially, what this means is that if the UK PM May’s Brexit draft agreement is defeated in parliament, as it’s expected it will, then the parliament will have a greater say in the alternative on the table. These options include to re-negotiate a Brexit deal with the EU, the call for a general election (most likely) or a new referendum (least likely). Moreover, we learned via an EU court aide that Britain will be in a position to revoke Article 50 unilaterally without asking permission from other countries; even if it has no bearing in the very short-term, the mere thinking of a no Brexit is a ‘buy’ for algos.
• Italian officials, headed by the economic minister Giovanni Tria, and the European counterparts, have finally come to terms that the only way to unravel the current standoff in Italy’s budget is to sit down and talk. That’s precisely what they began doing on Tuesday, with Tria highlighting the need to not worsen the situation by avoiding EU procedures. For now, all the dialogue is non-committal and too generic in nature, even if it the headline reads catchy and fits the storyline by pledging the reduction of the deficit from 2.4% to 2%. If history is any indication, this is how it may play out: Italy will keep promising unattainable and overly optimistic budget targets so that waters can calm down in hopes the EU will buy into their bluffing. This will allow for some further can-kicking for all to benefit. As a consolation for the interest of Euro bulls, the German vs Italian 10y yield spread is strikingly stable at 2.86%, highest since early Oct.
• Based on the latest comments from the Saudis, it looks as though an agreement on production cuts out of tomorrow’s OPEC meeting is far from being baked in the cake. At this stage, while the comments sound worrisome, there has been enough evidence via key actors to think that some type of compromise to alleviate the downward pressure in Oil will be agreed upon. Will it be enough to create the circuit breaker?

Fundamentals

• The RBA left its exchange rate unchanged at 1.5%. The Central Bank remains in its own ‘sweet spot’ by comfortably holding rates steady as the economy moves along. Remember, the next policy meeting is not scheduled until Feb. There were minimal changes in the statement. One could read very familiar lines such as “low rates are supporting the economy” or that gradual progress is still expected in unemployment, which seems like a fair judgment call. What appears overblown is the RBA’s over-optimistic stance on inflation, expected at 2 ¼ in the next 2y, which feels very overcooked judging by the latest indications via the Melbourne Institute inflation survey.
• One must keep a very close eye on the Chinese Yuan after an aggressive fixing by the PBOC on Tuesday. The Central Bank strengthened the Yuan to 6.893 vs 6.943, which marked the highest Yuan setting since June 2017. Was this a move meant to show the US their commitment to improving trade relationships? Are they interested to increase imports?
• In spite of being a clear sideshow, the UK construction PMI came upbeat, mainly driven by residential housing. As an anecdote, a London-based contact recently told tell me he keeps seeing London flooded with cranes all over the places.
• The latest dairy auction in New Zealand came at 2.2%, which adds to the Kiwi’s positive sentiment following negative reads in the auctions since mid-June.
• A few minutes ago, we just learned that the Australian economy grew at a paltry 0.3% in Q3, which falls dramatically short from the 0.6% expected. By breaking down the data, one can observe sluggish consumption at 0.3% q/q, with saving rate at the lowest since Q4 2017. Sooner or later, the RBA’s light bulb should go off. Once that moment comes, they should start revising its overinflated inflation calls.
• Later today, ECB’s President Draghi is due to deliver opening remarks at an ECB conference on bank supervision in Frankfurt. As usual, be on alert in case of any EUR moving headlines cross the screens, although one should not hold his breath.
• The Bank of Canada is expected to maintain its rate-setting unchanged after raising it by 25 basis points to 1.75% in October. The Central Bank, in its last meeting, sounded constructive by highlighting the inflation and economic outlook as robust. Moreover, the Nafta 2 trade deal is an uncertainty out of the way, which should promote investment and trade. On the flip side, the Central Bank must contend with dramatically lower Oil prices, although when all factors considered, the solid economic data should still warrant further hikes in an economy that is running near full capacity. The senior Deputy Governor Carolyn Wilkins has been a proponent of higher rates by signaling that the neutral policy rate is still higher than the current rate and further hikes should be in store.

Risk Model

Our prop risk-weighted index (RWI), by hitting the lowest reading since mid-August this year, embodies the dismal picture in risk conditions. Find an illustration below.

Ever since the peak on the RWI reached at the open of markets on Monday, risk-seekers have certainly been hit by a reality check, as it reflects the sharp fall of nearly 9% in the index. The immediate thought that comes to investors’ and traders’ mind is to stay much more defensive in equities plays, consider currencies the likes of the Japanese Yen, to a lesser extent the USD, while being extremely vigilant if you are looking to endorse commodity-linked currencies.

The flows have clearly reverted back into unambiguous extreme ‘risk-off’ conditions and the velocity of the sell-offs must not be ignored. No conjuncture can be drawn between the intense sell-side flows and market cycles (structures) just yet, with the S&P 500 still in an hourly upcycle off the Nov 26 low even if the technical outlook is now severely damaged due to the extreme velocity of the move down.

The deterioration behind the RWI can be mainly explained via the implosion suffered by long-dated US rates, with the 30-year risk sensitive US Treasury exhibiting a dramatic fall. However, with the price now leaning against a macro weekly support at 3.14%, I can’t help but think those bottom pickers will show up aiming to capitalize on the over-extension of the US rates rout.

What I personally find most perturbing for the interest of the US Dollar and risk conditions in general, is the outperformance in gold prices. The metal has, once again, decoupled from its 2018 relationship as a function of US Dollar performance, and is trading much higher. The notion of acting temporarily as a safe harbor amid the reduction in diversification options out there is back in vogue.

In times of financial stress, US bonds, Yen and gold are the ultimate shelters to find refuge, and that’s precisely what we saw on Tuesday. Be on high alert!

Forex Majors

EUR/USD - may be destined for higher Dec valuations if risk eases

I remain of the view that the EURUSD is setting the stage for higher valuations in December based on various factors, such as the completion of 3 legs down (each weaker in magnitude) , a major divergence vs German-US yield spread/Italian premium, and a bullish outside day at decision level 1.13. Capitalizing on weakness does make sense sub 1.13. In the last 24h, the bearish reversal does suggest that another attempt down towards the round number is on the cards. Any test of liquidity areas at 1.1285 and beyond do represent genuine long opportunities based on valuations. From an hourly perspective, the impulsive move from levels above 1.14 has set into motion a potential downward extension to retest 1.1319 liquidity area ahead of the critical 1.13.

The increase in sell-side volume on the way down backs the case for lower levels. The sharp pullback has also invalidated the hourly upcycle as the price discovery matures into a potential intraday downcycle. However, I am still expecting plenty of buying interest, especially if risk off can ease. A major demand area (highlighted in green), the deteriorating outlook for US rate hikes heading into 2019, higher valuations, all support the notion that sub 1.13 should represent genuine value to engage in buy-side campaigns if risk permits.

GBP/USD - on the cusp of a key breakout at 1.27

The bearish price action ahead of the key support at 1.27 enhances the prospects of a potential breakout. While Tuesday’s candle close held the level, the full reversal candle (V-shape type) tends to be a sign that increased downward pressure is likely. If it serves of any consolation, the UK vs US 5-year yield spread does not justify a breakout, but with risk off at full steam and the lay of the Brexit land is still very muddy, one can certainly find enough triggers that would lead to an eventual resolution south-bound. The hourly chart shows a clear range with 1.27-1.2840 the lines in the sand drawn by market participants.

The second attempt at 1.27 on Dec 4th, which followed the tepid one the prior day, has been greeted by a huge absorption candle, which makes a retest of 1.27 a potential exit for those trapped shorts on the breakout. This means we may see intraday upward pressure into Dec 4 POC at 1.2740. Only a break and acceptance above would then increase the prospects of a range extension. When trading ranges, pay attention to the side in control of the mid-point of the range at 1.2770.

USD/JPY: Bearish cracks, focus shifts south

The daily chart communicates more trouble ahead. The close near the day lows after an outlier move of nearly 2x the average range in increasing volume ticks all the boxes. The price action is a reminder of the current disconnect that has existed and still does between the pair pricing and hammered risk-off conditions / US vs JP yield spread. A break through 112.50 daily liquidity would expose the next key decision point at 112.00 round number ahead of 111.70.

The hourly chart has confirmed a fresh downcycle, with an amplitude of extension exceeding the previous leg down, which bodes well for the interest of shorts. The selling volume has been very steady throughout the move down, which reinforces the sell-side outlook. The key areas to engage as a seller for the most attractive prices include 113.20 ahead of 113.39.

AUD/USD: Correction within 3 legs upcycle

The Aussie is on a 3rd leg upcycle. Whenever a 3-sequence interval completes, it makes the prospects of further headways challenging. For now, the daily liquidity at 0.7330 has been chewed up by increased interest to sell risk and a dismal Aus GDP in Q3, placing the focus back into 0.73. If that level gives in, it’d be most likely the turn to test the next cluster of bids at 0.7270 ahead of an ascending trendline circa 0.7245/55. Also, be aware that both the Aus vs US yield spreads and the Hang Seng index as a proxy for the Aussie, are both rolling over.

By analyzing the pair’s anatomy in the hourly chart, the Aus GDP print secured an additional 50+ pips to the downside as the pricing adjusts to the fundamentals. The breach of the ascending trendline is one technical bastillon out of the way, as it’s the fact that the structure has now reverted into a downcycle, confirming a double top in the process. Overall, it makes propositions to be a seller on strength near term a more appealing concept to consider.

Options Market

We’ve seen Gold futures (GC1!) bought with impetus since last week. Ahead of the Trump-Xi G20 summit, the market was aggressively buying 'Out of the Money' (OTM) Puts as cheap insurances in what appears to have been an anticipation of a bullish price action in the front month (Dec) contract. The latest activity saw participants trailing up OTM Puts purchases up to $1,200. What’s more, the latest leg saw over 8k new contacts added on Monday, which supports the notion of buying into weakness, especially as the US10Y-US2Y curve makes fresh lows.

Last Friday's options activity in Oil (WTI) saw aggressive buyers of IM Call ~1.5k contracts, backed up by nearly 2/1 ratio of OTM Puts/Calls. Accounts buying options for a ST buy-side move also made sure to protect the downside via $50 strike OTM Puts

Did you notice Monday’s campaign to pile into long US bond contracts? Check this out. We had aggressive ‘In the money’ Call buyers circa 119,50, which was backed up by a surge in ‘out of the money’ puts to the tune of over 20k contracts. There were certainly some players betting for a short-term directional move in US rates. And gosh, did they get it right this time.

This week’s Aussie turnaround in fortunes makes the perfect example on why monitoring implied volatilities can be an important extra consideration. On Monday, the 1-week implied volatility in the Aussie open of 0.7313 stood at just over 81 pips. Guess where the market found the double top? Precisely after an 81 pips run-up. Will it always be this accurate? Absolutely not. Nonetheless, implied volatility is definitely a dynamic blueprint to anticipate measured moves. When combined with other confluent factors, it adds another layer to account for.

Remember, if implied vol is below historical vol, the market tends to seek equilibrium by being long vega (volatility) via the buying of options, which is when gamma scalping is most present to keep positions delta neutral by covering one’s risk. On the contrary, if implied vol is above historical vol, we are faced with a market with unlimited risks given the increased activity to sell options. Other than GBP, which runs a far greater implied vol than any other currency, one should not be oblivious to the downside risks in EUR/JPY based on the current ratio above 2%, which means a market significantly short vega (volatility), as such, a follow through acceleration move through 127.70/80 may be on the cards amid the absence of gamma scalping.

Bonus Charts - What Are You Missing?

Today, I want to bring to your attention a tweet by Otavio Costa, Crescat Capital global macro analyst. He ruminates on the recent anomaly of the synchronized rise in both the S&P 500 & US bonds. Since stats & history should serve as a means to measure probability in outcomes, Mr. Costa’s tweet should definitely provide some food for thought as an early warning signal. So far, judging by the moves in equities on Tuesday, he is definitely ‘on the money’.

Courtesy of Holger Zschaepitz, market analyst, comes another chart, one that has been doing the rounds to become the market’s central focus. I am talking about the first shoe to drop in the US yield curve. The inversion of the 5y-3y is now a reality as illustrated in the chart below.

What about the Yuan? USDCNY has found equilibrium sub 6.87. The breakout below its previous daily swing low represents the very first transition into a bearish structure since Jan'18. Combine this price action w/ a hammered US yield curve. I stand by the vision of risks for a lower USD.

Oil technicals show the price bouncing off May'16-Nov'17 POC & 100% proj target. In terms of fundamentals, Dec 6 OPEC meeting looks to address the oversupply issues with expectations for cuts on the agenda. Interestingly, "Managed Money,” which is the group that most correlates with the price covered more shorts than they decreased longs + longs as % of OI at extremes.

Intelligence Gathering

Morgan Stanley stands by its perma USD bear calls. In its latest research report, the bank reveals that it has added a new long play in EUR/USD for an ultimate target of 1.18. As I argued above, Morgan Stanley sees the downside resolution in USD/CNY as a potential catalyst to unravel further weakness in the US Dollar. EUR shorts in money markets may soon run to the exits, the bank believes. Find an extract of Morgan Stanley’s research below:

Sacha Tihanyi, Deputy Head of Emerging Markets Strategy at TD Securities, put together his thought on what could go wrong for China in 2019. Risks of China under-delivering on growth expectations? The massive 40%+ decline in its stock market this year is a reminiscence of a country in trouble, hard to argue against that bit of evidence. The analyst argues that next year’s underperformance may lead to greater monetary and fiscal support for the economy, exacerbating China’s debt burden and as a result, may see the Chinese Yuan under downside pressure as capital exits. Read TD Securities research extract below:

Quote of the Day

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." - Warren Buffett

Important Footnotes

• Risk model: The fact that financial markets have become so intertwined and dynamic makes it essential to stay constantly in tune with market conditions and adapt to new environments. This prop model will assist you to gauge the context that you are trading so that you can significantly reduce the downside risks. To understand the principles applied in the assessment of this model, refer to the tutorial How to Unpack Risk Sentiment Profiles

• Cycles: Markets evolve in cycles followed by a period of distribution and/or accumulation. The weekly cycles are highlighted in red, blue refers to the daily, while the black lines represent the hourly cycles. To understand the principles applied in the assessment of cycles, refer to the tutorial How To Read Market Structures In Forex

• POC: It refers to the point of control. It represents the areas of most interest by trading volume and should act as walls of bids/offers that may result in price reversals. The volume profile analysis tracks trading activity over a specified time period at specified price levels. The study reveals the constant evolution of the market auction process. If you wish to find out more about the importance of the POC, refer to the tutorial How to Read Volume Profile Structures

• Tick Volume: Price updates activity provides great insights into the actual buy or sell-side commitment to be engaged into a specific directional movement. Studies validate that price updates (tick volume) are highly correlated to actual traded volume, with the correlation being very high, when looking at hourly data. If you wish to find out more about the importance tick volume, refer to the tutorial on Why Is Tick Volume Important To Monitor?

• Horizontal Support/Resistance: Unlike levels of dynamic support or resistance or more subjective measurements such as fibonacci retracements, pivot points, trendlines, or other forms of reactive areas, the horizontal lines of support and resistance are universal concepts used by the majority of market participants. It, therefore, makes the areas the most widely followed and relevant to monitor.

• Trendlines: Besides the horizontal lines, trendlines are helpful as a visual representation of the trend. The trendlines are drawn respecting a series of rules that determine the validation of a new cycle being created. Therefore, these trendline drawn in the chart hinge to a certain interpretation of market structures.

• Correlations: Each forex pair has a series of highly correlated assets to assess valuations. This type of study is called inter-market analysis and it involves scoping out anomalies in the ever-evolving global interconnectivity between equities, bonds, currencies, and commodities. If you would like to understand more about this concept, refer to the tutorial How Divergence In Correlated Assets Can Help You Add An Edge.

• Fundamentals: It's important to highlight that the daily market outlook provided in this report is subject to the impact of the fundamental news. Any unexpected news may cause the price to behave erratically in the short term.

• Projection Targets: The usefulness of the 100% projection resides in the symmetry and harmonic relationships of market cycles. By drawing a 100% projection, you can anticipate the area in the chart where some type of pause and potential reversals in price is likely to occur, due to 1. The side in control of the cycle takes profits 2. Counter-trend positions are added by contrarian players 3. These are price points where limit orders are set by market-makers. You can find out more by reading the tutorial on The Magical 100% Fibonacci Projection

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