A confluence of factors are raising anxiety levels among investors, and it is being expressed in heightened volatility. The S&P 500 was turned back yesterday from the key 1945 level, and global equities are falling today. The over-production of oil is set to continue to Saudi Arabia denies intentions to cut output, and the Iranians scoffed at suggestions of freezing output. API reported another large rise in US crude stocks, which points to upside risks on the consensus estimate for 2.4 mln barrel build in today's official Department of Defense report.
Sterling's slide remains the continuing feature in the foreign exchange market. Brexit fears dominate. It has convincingly broken the $1.40 level and is trading near $1.3915. It has lost about 3.4% this week already. In terms of economic impact, sterling's trade-weighted performance is key. The Bank of England, effective exchange rate measure, has fallen 8.7%, of which 5.4% has been recorded this month alone.
UK officials are likely more concerned about the pace of the move than the direction. The pass-through to inflation may take several months provided it is sustained. To the extent that there is a trade advantage, it likely takes even longer to be seen.
Not only is sterling being sold in the spot and forward market, but some investors seek protection in options market. Implied volatility is rising, which suggest puts being bought rather than calls being sold. Three-month implied volatility is near 11.5% today, up from 8.7% at the end of last year and 8.9% at the end of January. Last April, three-month implied volatility spiked to 12.5%.
In the options market, puts and calls equidistant from the forward strike should be similarly valued. To the extent they are not reflects a market bias. Three-month sterling calls are selling at a 1.5% discount to puts (risk-reversal). This is the biggest discount since last May. Last April the discount was near 3%.
The takeaway from the options market is that the pace of sterling's decline and the market's anticipation of further declines, as reflected in the risk-reversal, do not show sterling at some kind of extreme, even though the market is stretched. In the spot market, sterling is trading well through its lower Bollinger Band (~$1.4025), which is set two standard deviations below its 20-day moving average. Three standard deviations from the 20-day moving average is near $1.3850.
What Churchill said about the Americans, that they can be counted on to do the right thing after exhausting the alternatives might apply to the UK now. The event markets and many polls still point to the UK staying in the EU. However, because of the significant potential impact of Brexit, sterling exposure is being pared and hedged, and based on discussion with numerous market participants, we suspect that it is too early to try to pick a bottom in sterling (against the dollar and crosses).
The euro is being dragged down by Brexit fears, though to a lesser extent than sterling. The euro is off 1.3% this week. Today's losses have seen it fall back below $1.10 for the first time since 3 February. While the UK may suffer on Brexit, there is some concern about the fallout for the eurozone. There have been some reports warning that Brexit, which would be the first departure from the EU, could be a catalyst for others leaving, or injecting uncertainty by holding their own referendum.
The euro area has challenges outside of the UK and Brexit. The refugee crisis is proving intractable. The flash PMI warned of weaker output, orders, and prices. While Draghi is talking a tough game, the scars from the market's disappointment with the move in December are still fresh. While participants are paring back euro exposure, they do not seem to be piling into shorts as they did last November.
The euro's push below $1.10 has extended to almost $1.0975. We pegged the initial target near $1.0950 yesterday, but see the risk of a return to the lower end of the previous range which is found near $1.08.
The yen seems to respond to market developments in an asymmetrical fashion. The earlier gains in equities and US yields did not exert much downside pressure on the yen. However, the weakness in share prices and the pullback in US yields have given the yen a bid. The dollar eased to JPY111.65, slipped marginally below the low on February 12, and bringing the February 11 low, just below JPY111.00, into view. We have suggested initial scope toward JPY110.50 and recognize the psychological significance of JPY110.
We remain impressed by the low level of verbal intervention by Japanese officials and the absence of material intervention. On a trade-weighted basis, the yen has appreciated by about 7.5% this month, which is a substantial shock. It is tantamount to some degree of tightening, and when coupled with the 10.3% drop in the Topix, it is even greater. It would seem to add pressure on the BOJ to cut rates further as early as next month.
The US economic calendar features the Markit’s preliminary service and composite readings and new home sales. The reports are not typically market-moving. Three Fed officials speak: Lacker, Kaplan, and Bullard. It is widely recognized that a March Fed hike is very unlikely, but many, including ourselves, think it is premature to rule out a June hike.
The S&P 500 is set to open lower, following yesterday’s poor session. We note two downside gaps. How the S&P 500 trades around these gaps may offer important insight into the technical condition. The first is the gap created by Monday's (February 22) higher open. The gap was entered yesterday but not closed. The lower end of the gap comes in near 1918.80. The S&P 500 also gapped higher on February 17. That gap is found between roughly 1895.75 and 1998.80. Indeed, the risk today is a gap lower opening which would be a particularly negative development if it is sustained, leaving a two-day island gap in its wake. Yesterday’s low near 1919.45 is as important as the lower levels cited here.