Equities fragile, FX volatile
- Fed may have left left rate hike too long
- Expect volatility in sterling trade
- Euro outlook still broadly negative
By Neil Staines
“Q2 picture is incomplete” — Lael Brainard
On Friday we stated our expectation that the US headline payrolls number would disappoint, but not by enough to prevent the unemployment rate itself from falling further. A significant drop in the participation rate, however, meant that both the payroll number and the unemployment rate fell more than anyone expected (with downward revisions to the previous months’ payroll gains) and employment slowed to 1.7%, year-over-year.
While disappointing it may, in conjunction with a Q2 GDP rebound, boost productivity – something hat has been curiously absent so far in the global economic recovery.
Herein lies the dilemma. The "data-dependent" Federal Reserve left it so long before pulling the normalisation trigger – despite chair Yellen's recent admission that “a rate hike in coming months may be appropriate” – that the data are starting to show signs of losing momentum.
Last night, Yellen pointed out that she sees “the economic positives outweighing the negatives” and, in being “cautiously optimistic that overseas headwinds are now fading”, she believes the US is “now close to eliminating labour market slack”.
However, the Fed will need to be sure that the May unemployment report was a one-off, which means that a June hike is all but off the table. July and September remain possibilities, but they are now dependent on a resumption of labour market stability (strength) and a smooth passing of the Brexit referendum and its impact on global economic confidence.
And then there are the US Presidential elections...
The "taper" (after the tantrum) and the first US rate hike both eventually came in December after a whole year of expectations and speculation. Putting our views as to how far the Fed are already behind the curve to one side... this year may not be any different.
“The 50:50-90 rule: Anytime you have a 50-50 chance of getting something right, there is a 90% probability you will get it wrong” — Andy Rooney
Now that the prospect of a June rate rise has all but been put to bed, there is one dominant focus for financial markets for the next couple of weeks: Brexit.
Last night’s price action in GBP was a timely reminder that volatility and liquidity risks will become increasingly heightened as we approach the ballot on June 23. This morning's 1% rally, which arrived without any obvious trigger, also serves as a warning that the directional risks to GBP are not singularly to the downside.
Furthermore, from a technical standpoint it is important to consider the activity in the options market and its implications. Due to the potential severity of the impact of a Brexit on the value of GBP, coupled with the advance warning, it is unlikely that any corporate or exposed individual would consciously leave any exposure unhedged.
The simplest (not necessarily cheapest) way to achieve this is through the options market. If we then consider that those options purchased as protection (insurance) against an adverse move in GBP will not likely be hedged (prior to the event in any case) then this leaves those who have sold these derivatives (market makers) net short of gamma (and volatility) as the only "hedgers".
This is important, as hedging a short option has a "negative gamma" or the need to buy when spot rises and sell when spot falls. In essence, this dynamic will increase the volatility of GBP.
“Fragility is the quality of things that are vulnerable to volatility” — Nassim Taleb
The risk of a sharply higher volatility state for GBP is rising significantly. In the broader asset space, the likely implications are a reduction in speculative exposures (or a closing out of popular trades) and a likely rise in volatility across broader financial markets.
In our view, in FX, downside exposure to the EUR offers better value than GBP at the current juncture, as the situation for the Eurozone is not good in the event of a Remain vote from the UK referendum, and really not good in the event of a Leave.
Equities retain far too high a level relative to our valuation metrics, and from our perspective do not factor anywhere near the risk premium of a Brexit that we would have expected this close to an event, particularly given the fact that the polls are roughly 50-50.
Despite their recent buoyancy, we continue to view equity markets as "fragile".
— Edited by Michael McKenna
Neil Staines is head of trading at The ECU Group