The Daily Edge: An Expensive US Dollar Loses Its Shine Even As Risk Deteriorates
By: Global Prime Forex
Tags: Economics

The Daily Edge is authored by Ivan Delgado, Head of Market Research at Global Prime. The purpose of this content is to provide an assessment of market conditions. The report takes an in-depth look on market dynamics, factoring in fundamentals, technicals, inter-market, futures and options, in order to determine daily biases and assist one’s decisions on a regular basis. Feel free to follow Ivan on Twitter & Youtube.

Summary — Dec 18, 2018

The lay of the land in the US equity space went from bad to worse on Monday, as the S&P 500 imploded by falling over 2% and in the process, the old Nov-Dec range is now being stared from the rear mirror. As per the US Dollar, it finally saw an intraday move in alignment with its expensive macro valuation, and rather than appreciating in a treacherous risk aversion context, it followed equities lower in locksteps as the rush to go ‘cash’ accelerated.

There was an absence of fresh macro drivers. Even if we had had a clear catalyst, that focus would soon be fading as on the back of everyone’s mind is this week’s FOMC meeting, which is going to set out the outlook for monetary policy heading into 2019. Will the Fed err on the side of caution by sounding more dovish? Judging by imp vols, it’s going to be a wild ride…

Looking at Monday’s data, it was a bitter/sweet day for the likes of European fundamentals, as the final EU CPI reading undershot below the ECB mandate of 2% by a small margin (1.9% in Nov), while the imports/exports activity out of the Eurozone offered signs of optimism as strong activity continues. The reading raises the risk of retaliation by the US Trump administration, who won’t be too delighted on the widening EU-US trade surplus. Meanwhile, fundamentals out of the US were simply bitter (housing, manufacturing).

Today, all eyes will be fixated in the German IFO. Remember, fundamentals out of Europe matter more than ever, as the ECB has shifted from expansionary auto-pilot policies into a more data-dependent stance.

Brace yourself for what looks set to be another bumpy ride as it looks like the S&P 500 may find fresh selling. When factoring in the spike in option ‘Put’ premiums in the benchmark index, the increase in sell-side volume + open interest, or a VIX borderline of 25.00, these are all indications that warrant a high degree of prudence as the picture is really ugly out there.

In this type of environment, the likes of the Japanese Yen (25 delta RR higher) and gold are set to benefit. The Euro performance will be subject, in part, to the release of the German IFO, even if judging by the high interest to buy low delta options at the extremes of the range, impl vol, and the CoT, all suggest the pair should continue to exhibit a rotational profile. Watch any potential breakout in EUR/JPY as it may lead to a directional acceleration.

Lastly, today’s shout out goes to Miad Kasravi, who goes by the handle @ZFXtrading in Twitter. Miad is the Founder of www.speculatorstrading.com. I discovered him back in August. He is an active commentator on the #fintwit community and someone you should follow.

Market Drivers

Equity bears are blaring the trumpet after finally achieving a solid close sub 2,600.00 in the S&P 500 in a move driven by substantial sell volume.

UK PM Theresa May confirms that the next Brexit meaningful vote will take place during the third week of January. As the conundrum stands, there doesn’t seem to be an easy way out as the EU pledges that the deal on the table is the only one possible.

Italy looks to be on track to reach some type of compromise with the European Council in its 2019 budget after last week’s revisions. The coalition government has reportedly finally agreed on the figures and contents and the new draft sent to the EU. Italian yields trade stable.

France’s Finance Minister Bruno Le Maire is set to convene with his EU counterparts to discuss the country’s budget deficit, which is aimed to be as close to the 3% limit as possible. The German vs French yield spread still communicates high unrest by bond traders.

Ahead of the FOMC later in the week, President Trump continues to attack the independence of the Fed with a Tweet that read “It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!” .

Fundamentals

After ticking up since mid-2018, the latest revision to the EU CPI for Nov y/y undershot at 1.9%, which is below the ECB’s mandate of 2%. This development can’t possibly be a positive input for a Central Bank that must reconcile a slow down in growth and depressed price pressures.

to the EU CPI for Nov y/y undershot at 1.9%, which is below the ECB’s mandate of 2%. This development can’t possibly be a positive input for a Central Bank that must reconcile a slow down in growth and depressed price pressures. The tendency of lower trade surpluses in the EU continues for the month of October after figures revealed a paltry reading of 12.5b vs 14.2b exp. However, it occurs on the back of a fresh spike in both imports and exports, which is a solid sign of healthy trading activity. The trade surplus with the US expanded to 114.8b euros as of year-to-Oct 2018 vs 96.1b euros during the same period in 2017. These figures run the risk of worsening the trade narrative via US President Trump. Find out the details in the Eurostats website.

website. In the US, the NY Empire State Manuf index came downbeat at 10.9 vs 20.1, the lowest reading since July 2017. Could this be more than just a one-off anecdote? The US continues to sail through a late business cycle and this type of data may suggest the first cracks within the context of a still solid economic status. The data tends to be a leading indicator of economic health and market conditions. The 6 month forward estimates still came quite optimistic.

came downbeat at 10.9 vs 20.1, the lowest reading since July 2017. Could this be more than just a one-off anecdote? The US continues to sail through a late business cycle and this type of data may suggest the first cracks within the context of a still solid economic status. The data tends to be a leading indicator of economic health and market conditions. The 6 month forward estimates still came quite optimistic. The NAHB Housing Market index in the US dropped by 4 points to 56. Above 50 still indicates a favorable outlook on home sales, mainly over concerns over housing affordability. Since peaking in January this year, it’s been a one-way street down for the indicator.

Events Ahead

A key release for today is the German IFO Business Climate, expected to come worse-than-expected at 101.8 vs 102 prior. After a bleep higher in August, the index has accumulated 4 consecutive months of declines, which is not a good augur. This release will be critical to assess the current economic health in Germany and wider EU economic conditions. We are in an environment in which the ECB has transitioned into a data-dependent mode, hence it’s in economic indicators of this caliber that the Central Bank will be basing its monetary policy decisions heading into 2019. The backdrop of slower growth in the EU poses risks.

Out of the US, we will get an update in housing stats in the form of building permits and housing starts. Both indicators tend to be strongly correlated. Market economists are calling for a stable number compared to the previous month’s readings.

Risk Model

An ugly picture after our prop risk-weighted index (RWI) lost nearly 4% of its value overnight. The sell-off in US equities, the extension lower in US yields came combined with a weaker US Dollar.

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The whole financial world has been keeping an eye on the make-or-break level of 2,600.00 in the S&P 500. We had a first go that failed last week, but with Monday’s resolution below, it’s now off to the races for further declines unless the Fed can come to the rescue by stopping the bleeding.

Note, the S&P 500 is a market running an implied volatility (VIX) of nearly 25.00 points, which would always increase the risk of directional moves amid the absence of gamma scalping on the edges of key levels. The close near the lows of the day at 2,560.00, the collapse in the HYG (junk bonds) all seem to indicate that there might be more pain ahead for risk assets.

The sell-off in US yields does not carry the same substance as equities, judging by the volume out of the 10-year US bonds (ZN contract). If we factor in that the instrument is resting at a macro support around the 2.85% vicinity, I anticipate that any further pressure on high beta assets should emanate from follow through sell-side bets in equities.

Forex Majors

EUR/USD — Unattractive Levels to Engage in Buy Campaigns

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If we only had to base our trading decision on the divergence between the pricing of the pair and its true valuation via the German vs US yield spread, we’d be talking about a Euro worth 1.16–1.17usd. Especially with the Italian premium also coming down big time in recent weeks. This is precisely the thesis that has made me, and still does, make me a Euro buyer sub 1.13. My long was filled at 1.1290.

You can find last week’s explanation of my bullish views in this video.

However, there are obvious impending factors that should limit any recovery above the 1.14–1.1450 mark until the FOMC, and we are getting much closer to these levels now, which implies that being a Euro buyer heading into Tuesday carries significantly higher risks.

The disastrous French PMI last Friday, accompanied by the clear deterioration in the EU manufacturing indexes, poses significant risks for the ECB to keep its rate hike commitment in 2019.

As a result of the heightened concerns out of France, the German vs French yield spread has come into strong focus as the new barometer to measure economic risks in France and in the EU. The levels it trades at still casts a long shadow for the Euro to gain any momentum outside its range.

For the next 24h, the pair still faces the risk of supply dynamics to kick in as it retests the origin of the mark-down in prices from last Friday (area highlighted in blue). Note, it’s also finding further confluence by coming into contact with the 3rd test of a descending trendline. Additionally, the recovery off the lows does not carry sufficient volume activity.

GBP/USD — Short-Term Recovery Amid Macro Selling

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With the high-stakes of a Brexit meaningful vote put on the back burner until January, the Sterling has been trading as an expression of USD performance, as the magenta line (DXY) exhibits. Judging by the new cycle high in the UK vs US yield spread, there should only be one way to engage in this market, and that’s to the upside. However, that’d be preposterous to say the least, as we must contend with the political risk swing emanating from the Brexit negotiations, which makes trading the Pound intraday incredibly challenging as algo-led gyrations become the norm.

If we take a step back, however, we can observe the forest with more clarity. The weekly has confirmed a key breakout through 1.27, and that should precisely be taken as the most macro signal to approach the Sterling. In other words, we have transitioned into a technically bearish phase for an ultimate target of 1.2140 based on a simple 100% projection target. What this means is that any re-test of 1.2680–2700–2720, where I’ve marked the areas of most liquidity, offer selling opportunities. In the hourly, the constructive upcycle phase is still active, which makes the prospects of further upside in the next 24h a short-term technically conducive outcome.

USD/JPY — Sellers Catching Up With Macro Reality

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After the $81b inflows into US Money Market funds last week, which kept the pair anchored, short-term buyers have finally been slapped with a reality check. As I’ve reiterated, the strength in the pair was always meant to be temporary amid the huge macro divergence with our risk-weighted index (in red) and the US vs JP yield spread (both highly correlated).

Moreover, yesterday’s study of the latest CoT positioning reflected an upside run mainly driven by a removal of liquidity with large specs not participating in the move up. On the daily, we still remain in a range between 112.30 and 114.00, however, the last failure to test 114.00 opens the doors for a retest of 112.30 and it this level fails to hold, a breakout of the daily range may ensue. This scenario may well play out upon the outcome of the FOMC later this week. Any precipitous attempt ahead of the high-risk event may see a market aiming to play a rotational role back into the mean.

For now, the hourly chart suggests selling on strength as the ideal strategy. The only caveat is that at current levels, only momentum and fast algo-led strategies may capitalize on enough risk-reward plays. If you are a swing trader, I’d much rather for the rate to at least pay 113.00 up towards 113.20 to start considering sell-side business intraday. Remember, I always mark the areas where I expect the highest concentration of liquidity.

AUD/USD — Trades Into Macro Support, Risk-Off May Weight

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The Aussie is a market trapped in small ranges, lacking sufficient interest. By analyzing the weekly chart, the outlook is far from promising, after back-to-back bearish price action (engulfing bar + long tail rejecting higher liquidity levels). Technically, it places the risks to the downside.

But, this week is all about the FOMC, therefore, it will soon be time to press the reset button and reassess the valuation of the Aussie based on the Fed outcome. The correlations one can obtain via the Yuan, Hang Seng and the Aussie vs US yield spread do promote a relief rally of sorts.

On the downside, sellers would be trading straight into a massive support area at 0.7160 (previous daily swing high), which has already held last week’s impulsive sell-off.

Meanwhile, any recovery in the Aussie finds nearby intervals of liquidity which makes any higher adjustments in the rate a slow grind technically wise. As one can notice in the hourly chart, 0.7180 is a clear example, having contained any attempts to explore higher levels of liquidity.

Futures — Open Interest & Volumes

The preponderance of evidence to stay short equities just keeps piling up. The CME data confirms that Monday’s breakout in the S&P 500 carries the largest jump in open interest in quite some time, after an increase of over 135k+ contracts. The Japanese Yen also saw richer liquidity even if the volume was lower-than-expected. The rest of asset classes monitored exhibited poor liquidity, with moves characterized by a removal of liquidity.

* By tracking open interest, we can gauge the addition or removal of liquidity in a market. Since open interest involves the total number of outstanding contracts in a particular instrument, we can therefore accept as true that an increase in open interest means there is more liquidity available, in other words, participants are adding business by opening new positions. On the contrary, if a market sees a decrease in open interest, it means that liquidity is shrinking. Similarly, an increase in volume expresses higher activity or commitment to participate in a particular direction, while the opposite means a lower involvement in participation, which tends to ultimately lead to exhaustion.

Options — 25 Delta RR & Vols

There are quite a few developments that immediately jumped at me when crunching today’s 25 delta risk reversals and vols. The options market has turned less bearish on EUR/USD as reflected by the 10% increase in the 25 delta risk reversal, which is a normal dynamic following the pair’s recovery. The same picture can be observed via the USD/JPY changes. The pair that shows a major change in the pricing of calls vs puts is the Aussie, with the market now demanding a higher premium to buy calls. The percentage change is very significant and it harbingers potential upside ahead.

How about the Canadian Dollar? Despite its rise, the options market has lowered the cost of buying calls, which would not occur unless the expectations for higher upside were downgraded. Another instrument that screams trouble ahead is the S&P 500, with the premium to buy puts going through the roof, while at the same time, the implied volatility (ATM strike) has jumped in accordance. It continues to communicate that option traders are betting for lower targets ahead in the ES.

Source: http://cmegroup.quikstrike.net (RR settles are available ~1am UK).

* The 25-delta risk reversal is the result of calculating the vol of the 25 delta call and discount the vol of the 25 delta put. A positive risk reversal (calls vol greater than puts) implies a ‘positively’ skewed distribution, in other words, an underperformance of longs via spot. The analysis of the 25-delta risk reversals, when combined with different time measures of implied volatility, allows us to factor in more clues about a potential direction. If the day to day pricing of calls — puts increases while there is an anticipation of greater vol, it tends to be a bullish signal to expect higher spot prices.

Options — Ratio Imp/Hist Vol

By analyzing the ratio of implied / historical vol levels, up to 1 month forward, the markets that run the risks of trading slippier based on the current values include the NZD/USD, EUR/JPY and Gold. I obviously ignore the perky Sterling, which continues to trade with vol levels of its own. Notice, the EUR/USD, USD/JPY, AUD/USD run slimmer chances of seeing protracted directional movements as the low ratios from 2 weeks forward still indicate plenty of gamma scalping present.

* If implied vol is below historical vol, represented by a ratio < 1% in the table above, the market tends to seek equilibrium by being long vega (volatility) via the buying of options. This is when gamma scalping is most present to keep positions delta neutral, which tends to result in markets more trappy/rotational. On the contrary, if implied vol is above historical vol, represented by a ratio > 1%, we are faced with a market that carries more unlimited risks given the increased activity to sell expensive volatility (puts), hence why it tends to result in a more directional market profile when breaks occur. The sellers of puts must hedge their risk by selling on bearish breakouts and vice versa.

Bonus Insights- What Are You Missing?

I’ve been pointing out for a while that the ratio of implied vs historical vol continues to run dangerously high in EUR/JPY. Besides, Monday’s price action, with a long tail rejection to the upside heralds danger ahead for a retest of the range low. It could get ugly below 127.70 on short vega strategies hedging, which may set into motion a cascade of induced selling.

The ING Economics Team has put together this visual in which it breaks down the camp where each Fed member stands. The radar still seems to point towards a slight risk of the Fed not sounding as dovish as some market pundits expect. While the US economy faces more headwinds heading into 2019, further rate hikes continue to exhibit enough backing, which is predicated on the fact that the economic activity in the US continues to be fairly strong.

In this weekend’s ANZ research report, the economics team highlights as the chart of the week the tighter liquidity that is set to contribute to a more challenging environment for risk appetite in 2019.

As the ANZ Economics Team notes: “A more cautious outlook for the Fed and a likely pause in rate hikes should cap bond yields in the US and New Zealand. However, the US market could become a more important source of market volatility. When US rates were exceptionally low, investors sought yield from other assets. This proved to be a boon for credit, with debt issuance high around the world. Moving forward, the backdrop for credit markets looks less appealing. The corporate leverage cycle is advanced, while global liquidity is expected to diminish as central bank balance sheets continue to contract. Funding markets look set to be tighter, with the risk of wider spreads.”

In its latest research report, Morgan Stanley highlights Monday’s Euro Summit. From a macro level, this meeting sets a positive precedent, as it found the principles of an agreement to achieve deeper fiscal integration in the Euro area while strengthening the European Stability Mechanism. Arguably, if more progress is made in this front over the months ahead, the Euro area could be better prepared to cope with future financial or debt crises.

Today’s Twitter Shoutout

Miad Kasravi, who goes by the handle @ZFXtrading in Twitter, is an avid trader and founder of www.speculatorstrading.com. I had the pleasure to jump on a couple of calls with Miad earlier this year and I can frankly say he is a very passionate trader. You will find his tweets on all things financial markets, tends to be very switched on, and I like the fact that he resorts to the study of volume and Intermarket studies to rationalize his decisions.

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Important Footnotes