- Markets take fright as speculation that Fed might move this month grows
- ECB already indicated it can't do much more on liquidity support
- Friday selloff shows market had become too complacent
- So-called risk parity bet has exacerbated scenario
- Dollar strengthens as AUDUSD heads back towards 0.7500 zone
The selloff Friday caught traders unaware after speculation on a
rate-hike move in September mounted once again. Photo: iStock
By John J Hardy
Global markets were already nervous last Thursday after the European Central Bank failed to support the long-in-the-tooth theme of central bank liquidity supporting carry trading and risk seeking in all corners of asset markets that has prevailed since asset markets bottomed out in early February of this year.
The acceleration in the asset market selloff on Friday shows that the market has been caught in a very complacent state, a state that is aggravated by both bonds and stocks moving in the same direction. That situation has been made worse by the popularity of so-called “risk parity”
, the idea that investments balanced across a variety of markets diversifies risk and therefore the assumption that the overall portfolio risk from a combined exposures in stocks and bonds (and other investments) will be at least partially offsetting in good times and bad.
But the trillions of dollars piling into these strategies in recent years is an extremely dangerous backdrop as both markets recently have started to move in the same direction. As the portfolios fail to function as intended, the risk rises of broad position reduction and risk exposure must simply be reduced at all costs.
Equities are lower because central banks are hesitant to commit to further easing, and bonds are selling off for the same reason, but also because of the Bank of Japan’s clear recognition that the long end of the yield curve needs to be sufficiently high to allow banks to earn money in the borrowing short and lending long strategy.
So in times like this, as long as the energy level remains high, correlations across markets tend to be very high and traders should be aware that diversification is extremely difficult. In currencies, a further meltdown in equity and bond markets is likely to see a stronger JPY, EUR and USD and a weaker everything else, if to varying degrees. And intraday two-way volatility is likely very high as market nerves fray and if, for example, today’s Fed speakers drop a dovish turn of phrase.
The Aussie’s fortune has churned higher and lower over the last couple of weeks, with the Friday collapse in risk appetite undermining the fragile case for a rally that was built on the assumption of strong support from global central banks.
From here, the technical downside catalyst looks like perhaps the 0.7500 area that held the previous selloff.
AUDUSD rally was held together by assumptions of global central bank support
The G-10 rundown
– has received considerable support after Rosengren’s rhetoric on Friday
, which helped to kick off the meltdown in risky assets. All of the attention on the Fed and the monetary policy theme will see extra focus on today’s trio of Fed speakers. US data this week includes retail sales Thursday and CPI on Friday.
EUR – Euro has been relatively firm after the less accommodative/than/expected ECB last week and the knee-buckling selloff in risk assets drives the unwinding of carry trades. If EURUSD is ever to do anything, we’ll be watching the 1.1200 area for signs of a capitulation.
JPY – again, the G3 currencies are the strongest here on the unwinding of carry trades and perhaps as the market fears that the BoJ will complete the global markets’ fear that central banks are giving up on monetary policy. Two-way risks for the JPY here.
GBP – positive data from the UK has boosted sterling, but the currency may fail to pull higher if the predominant focus is on the general meltdown in asset markets.
CHF – higher rates are perhaps a headwind for the Swiss franc, as was the lack of dovish guidance from the ECB. Watching whether EURCHF can pull into the higher range above 1.1000. USDCHF remains an interesting test case for whether the traditional safe/haven status of CHF outweighs the higher theme.
AUD – AUD one of the worst positioned currencies in this environment and could see pronounced weakness against the G3 currencies as long as this environment extends.
CAD – Risk off and a whiplash turnaround in oil prices has the CAD offered versus the USD – can we pull to the 1.3150-1.3250 zone and finally get back in the higher zone_ Still, we like CAD relative to the recent pro-carry trade themed highflyers like the NZD.
NZD – New Zealand Prime Minister John Key missed an opportunity to talk down the kiwi as he makes a series of blasé comments on NZD strength that keep AUDNZD offered. Kiwi longs will soon feel more pressure if conditions worsen further.
SEK – SEK a shade weaker, likely for the usual reasons that investors head away from less liquid currencies and into the more liquid ones. If we revisit 9.60 again in EURSEK, it may not hold a third time.
NOK – EURNOK rebounding back higher since Friday and a strong close today would neutralize the downside momentum the pair tried to build last week.. Weaker oil prices and more defensiveness in risk appetite could have us suddenly looking toward the 9.50 resistance again.
Upcoming Economic Calendar Highlights (all times GMT)
- 1205 – US Fed’s Lockhart to Speak
- 1700 – US Fed’s Kashkari to Speak
- 1715 – US Fed’s Brainard to Speak
- 2230 – Australia RBA’s Kent to Speak
— Edited by Martin O'RourkeJohn J Hardy is head of forex strategy at Saxo Bank