This coming week may very well be one of the most important weeks of the year. There are a number of events that individually and collectively have the potential to spur significant moves across the capital markets. These events include the Scottish referendum, FOMC meeting, and the launch of the ECB's TLTRO facility.
In addition, the Swiss National Bank meets, and it has indicated that negative rates have not been ruled out to help defend the currency cap. In Spain, Catalonia's parliament will decide whether to push forward with a non-binding survey/referendum that has been rejected by the national government. Some observers have attributed the under-performance of Spanish assets (after a period of out performance) to the idea that the strong showing of the Scottish nationalists has some bearing on Catalonia's independence.
Given the potential for these events to drive the capital markets, and that the volatility of volatility, if you will, has risen, an overview of the technical condition of the capital markets may be particularly helpful now. At the risk of oversimplifying, the US dollar is in a strong uptrend against the major currencies and most of the emerging market currencies. Speculative positioning in the futures market has been concentrated in amassing significant short euro and yen positions. The market was net long Australian and Canadian dollars, but the recent price action suggests a substantial position adjustment took place, and more than what is captured in the position report for the week ending September 9.
There has also been a sharp reversal in US yields. The U.S. 10-Year Treasury yield was near the lows for the year in late August, below 2.35%. It briefly poked through 2.60% before the weekend. It has now satisfied a Fibonocci retracement (38.2%) of the yield decline from January through August. The next retracement target is near 2.68%. Barring a shock, the yield can climb into the 2.75%-2.80% in the coming weeks.
Yields around the world have risen with US Treasuries (which is why political scientists rather than investment advisers formalized the hypothesis of a G-zero world). European bond yields have risen less, and several emerging markets and Australia experienced larger increases in yields. Generally speaking, in a rising interest rate environment, one would expect the credit spreads to widen, with lower credit yields rising more.
The S&P 500 set record highs on September 4, but the technical tone has deteriorated in recent sessions. The development is somewhat reminiscent of the topping pattern carved out in the second half of July, when the S&P 500 also registered record highs. It is as if investors are happy to take profits on rallies. Perhaps this reflects a mistrust of the equity gains or belief that the environment that facilitated them will change soon. We note that the five and 20 day moving average are set to cross, and this cross-over has done a good job in recent months of signaling the trends. The poor close before the weekend warns of follow-through losses in the coming week. Initial targets are in 1970 and then 1958; It takes a break of the 1940 area to signal a test on the August low in front of 1900.
Most equity markets also fell last week, but let's look at the exceptions first. The weakening of yen may have helped encourage the 1.8% rally in theNikkei. Soft Chinese CPI underscores the scope for potential easing of policy, and this may have helped the national markets rise 1-2%. The MSCI Emerging Markets equity index recorded its 3-year high on September 4, while the S&P was making its record high. It fell each session last week, and the five and 20 day moving averages have crossed. All of the Fibonocci retracement objectives have been surpassed, highlighting the risk that the index 1045-50 area (~1.5%-2.0% decline).
Commodity prices have fallen sharply. The CRB Index is off more than 10% since late June, and 4% this month alone. The momentum is too much and some signs of consolidation were seen toward the end of the week in which twice the index gapped lower. Of note for American drivers, gasoline prices at the pump are at six-month lows (average price in the US, according to AAA). Oil prices themselves staged a potentially important technical reversal last week. The move through $96 would indicate a low of some significance was likely in place. The price of Gold is at an eight-month low. Raising interest rates increase the opportunity cost of holding gold, and the rally in the dollar may deter other buyers.
Taking a closer look at the foreign exchange market, we share four points. First, the euro's record long losing streak of eight weeks ended with a firm close before the weekend. The $1.3000 level has psychological significance, while the retracement of the ECB-induced slide is $1.3010. It may take a move through the $1.3045 area to encourage short covering.
Second, the dollar has made new highs against the yen for eleven consecutive sessions. The rise in US yields, and the official jawboning, took place after the move was well under way. The advance in the dollar has met no resistance. The diversification of Japan's public funds, the increased portfolio outflow, and speculators are among the featured yen sellers. With ECB officials talking the euro lower, Japanese officials may detect a greater sense of flux, and have welcomed the yen's decline, and recognizing the fundamental economic considerations behind it. The dollar finished last week near its highs, and further near-term gains are likely. The JPY108 level beckons, but the real target seems to be closer to JPY110.
Third, the gap that was created at the start of last week's trading, in response to the YouGov poll that showed the Scottish independents with a lead, has not been fully filled. A small gap still exists between $1.6277-$1.6283. We think that nearly every one really expects the "no" vote to carry the day and the speculative positioning in the sterling futures market bears this out. There is a sense that sterling has been oversold, but the risks are great, and the cost of hedging (implied volatility) is high. It takes a break of $1.60 to signal something important. It is likely to remain intact until the referendum. A "yes" victory would wreak havoc. Sterling would sell-off sharply, and likely drag down short-term rates. The market would price in a political and economic crisis. At the same time, a "no" victory would allow the market to focus on favorable UK fundamentals and a pound that has lost 12 cents over the past two months. On an as-expected "no" vote, our target for sterling is $1.65-$1.66.
Fourth, a negative attitude to the European currencies and yen are not new. The new thing that has taken place is that the dollar-bloc currencies have also now fallen out of favor. The Australian and New Zealand dollars were the weakest of the majors last week. The yen barely eclipsed the Canadian dollar to take third place. The technical indicators warn of further losses ahead. In addition, the take-away from the recent price action in the other major currencies, is that this is not the kind of dollar market that one has been rewarded for fading breakouts. Both the Australian and Canadian dollar have broken out of their previous ranges. Technically, there may be scope for another 2% decline in the coming weeks.
Observations based on speculative positioning in the futures market:
1. There were two significant (10k+ contract change in gross positions) position adjustment in the CFTC reporting period ending September 9. First, short-covering reduced the gross short yen position by 14.8k contracts to 118.0k. The yen has continued to sell-off and new shorts were likely established since the reporting period ended. Second, the bulls went shopping in sterling. They extended the gross long position by 13.8k contracts to 81.3k. It was the most buying in five months. It is also larger than the euro, yen and Swiss franc gross positions combined.
2. The other twelve gross currency positions we track were adjusted by less than 5k contracts. Generally speaking, this reflected the position squaring in the sense that most of the currency futures (but the Swiss franc and the Australian dollar) saw a small reduction in gross short positions. Outside of sterling that we discussed above, there was virtually no buying of the currency futures during the reporting period. Combined, the euro, yen, and Swiss franc saw an increase of 2.5k gross long contracts. Gross longs were reduced in Canadian and Australian dollars and the Mexican peso. The out-sized losses in these currencies in recent says suggests were longs have been liquidated.
3. Speculators in the US 10-year Treasury futures bought into the decline through September 9. During the week they added almost 58k long contracts for a gross position of 440.2k contracts. The gross shorts edged a little higher. The 8.4k contract increase brings the gross short position to 473.5k contracts. The net short position fell to 33.3k contracts from 82.7k. An important question is when will the longs capitulate? We think that the yields are a little more than half way to what may be a new equilibrium (~2.75%).
