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The Daily Fix: A new level of panic

Chris Weston
Head of Research
Mar 10, 2020
It’s clear we are in a new, incredibly worrying phase in this crisis. While we are watching the coronavirus case count, the focus has switched lanes and we are watching funding channels and credit spreads – financial contagion is hitting risk for six and is breeding a new level of panic.

The volatility (vol) through all assets classes is staggering, and while most are focusing on the vol in EU and US equities, crude and certainly US Treasuries, we can’t go past FX moves too, where USDJPY 1-week implied volatility has shot up to 32% the highest since 2008.

In fact, if we look we can see USDJPY 1-week put volatility trades at a 7.5 vol premium to calls, which is just incredibly high. It seems that the options market is positioned for a break of Y100 soon enough and the BoJ are almost powerless to stop this, without selling JPY in the market and that would not go down well.

USDJPY has been at the centre of FX traders thought process, with price hitting a session low of 101.19, before shorts covered, taking the pair back to 102.50. USDJPY has a lock on the S&P 500 futures today though, which are pushing 2% higher through Asia, with WTI futures +4.3% - there is some covering of short risk positions ahead of Trumps news conference, where he is expected to announce a payrolls tax cut.

Will the Fed go shock and awe next week?

US rates markets are pricing in a 75bp cut at next week’s FOMC meeting, with additional measures such as lowering charges for its swap lines, even cash lending to smaller banks. The rate cut will get the attention though and one suspects the Fed will not want to make a bad situation worse by not meeting the market, so it will take the fed funds rate ever closer to zero. From here we have to consider the next policy actions, which of course will be fiscal (from a government) and, or more pertinently a liquidity event from the Fed.

Tactically, it would not surprise to see traders cover risk (such as equity) shorts into the FOMC on 18 March, with the view that the Fed will give a signal that they are having a more intense discussion about changing the Fed’s legal framework for buying corporate debt and equities. With so much pessimism in the price, should the market hear this narrative it will promote a short-term relief rally in equities and I would not want to be short equities if the Fed are on the other side of the trade.

That said, it raises so many moral issues – what levels on the S&P 500 and credit indices will they target, what credit rating tranche do they focus on and what factors of equity will benefit - will it even create inflation? The trade here will be selling volatility.

FX markets are moving wildly

It's been a while since we have seen a near 7% move in a major currency pair, but MXNJPY has just about achieved this and at one stage it was even 12.8% lower. AUDJPY has seen sizeable volumes, where at one stage the pair hit 64.37 and lower by nearly 8%, although buyers have stepped back in and the pair closed 3.6% lower on the day.

EURUSD pushed for a test of 1.15, although we’re seeing better sellers emerge and the dynamics below must start to impact the EUR – That said, if you’ve been bearish EURs you’ve expressed it against the JPY and CHF. The USDX closed the session 0.9% lower, but has found a bid into the January lows of 94.60, so if this goes expect the USD to take another leg lower.

So, in an environment of growing financial contagion, what should we really be watching?

Daily chart
  • We are watching EU banks, where the EU Stoxx bank index has fallen to an all-time low. What can the ECB do this week to assist here?
  • We are watching a blow out in EU credit-default swaps (CDS) and the cost to insure against a credit default event
  • We see Italian 10-year BTPs yields widen 50bp on the day against German bunds to 227bp - to command the widest yield differential since August and this is causing the Italian MIB to nosedive. This should only get worse, as Italy have announced they are extending travel ban and increasing the restrictions nationwide
  • We watch the US 3m FRA-OIS spread, a measure of credit risk, pushing to 52bp (the highest since 2011) and this despite the NY Fed increasing the max rep take up to $150b)
  • We watch the US and EU financial conditions indices, which are in free-fall despite nominal and real bond yields moving ever lower. Central banks can’t control this with interest rates
  • And we watch crude as a further decline will only exacerbate the worry about the cash flows of energy names and weigh on credit markets.
US financial condition index
Financial condition chart

So, a lot to focus on and all the while we ask how much further this drawdown in risk has got to go. In most normal circumstances I’d argue that when it truly feels like the worst thing in the world is to buy, then we are nearing a bottom and it almost feels like that days is upon us. This is not a normal circumstance however and it feels like there is more to come. That said, these markets are incredibly over sold and under loved and the risk of the ECB, the Fed and various governments going on a volatility subduing campaign seems high. So the kitchen sink approach looks likely to come into fruition. Whether this will be enough to stem the falls and cause a lasting sentiment shift is yet to be seen, but it could inspire a more prolonged short covering trading rally.

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