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The Daily Fix: Markets nervous as the coronavirus spreads outside of China

Chris Weston
Head of Research
Feb 24, 2020
It’s promising to be an interesting session here in Asia, with the bears back wrestling a bit more of a say here, and gold and bond bulls feeling pretty good about their exposures.

We’re seeing AUDUSD, EURUSD and USDJPY selling off in early interbank FX, suggesting a weaker open in the S&P500, Aussie SPI and crude futures.

The focus will be on the likes of the Kospi, HSI and Nikkei 225 which will both face headwinds on open, as will the ASX 200 with SPI futures closing -47p lower on Friday. S&P500 futures should open 0.5% or so weaker, with price currently sitting on the January highs, and where a break here will take the cash index through 3332 and potentially into 31 January low of 3214 over next week or so.

Trading chart

The focus moves out of China

Last week my focus was less on the number of cases seen in China, and more on preparing for the economic data series that rolls in, specifically, China’s manufacturing and services PMI (Saturday), which gives us a chance to mark-to-market current set-ups, positioning and rates pricing, against the fact seen in the actual data flow.

However, the news flow from the weekend has changed the game somewhat, where the focus is much more on the threat of an outbreak outside of China and in this case into Korea, Italy and Iran, where we have seen the number of new cases of the coronavirus highlight some worrying trends - with Italy cancelling several marquee events and Korea, whose number of cases have pushed through 600, forcing the government to raise the concern level to the highest possible setting. A fate many had speculated could lead to some extreme containment measures which will further weigh on growth in Korea and the region.

The French finance has also detailed tourist numbers have fallen 30% to 40% following the virus outbreak.

Markets to watch

USDKRW remains one of the markets favourite risk proxies for months. Having taken out 1200 with ease on Friday, with many focused on Friday's Korean 20-day exports, which fell 9.3% when adjusted for calendar distortions. It feels highly likely that this cross will find buyers again on open and looks to be ready to take out the July highs around 1216/23. Whether this proves to be a driver of more mainstream FX pairs, such as AUDJPY and AUDUSD is yet to be seen, although AUDUSD looks the better short on the weekly chart.

USDKRW chart

USDCNH is never off the radar for long and the pair, having broken the bear channel, is now going sideways and consolidating. A kick higher (yuan weakness) today is possible and will resonate in small buying across other USD crosses, where I’d be easing into USDMXN longs, as the higher volatility seen in the VIX index (now at 17%) should see over-loved and well-owned carry longs part unwound. EURMXN has seen two solid days of gains and shorts will keen to see 20.544 holds, as this has been a decent level to fade this short-covering rally from 20.036. Slightly better EU PMI on Friday helped EUR appreciation, and we look to see if this resonates in the upcoming German IFO survey this week, but the main reason the EUR is rallying here is a carry unwind and positioning – the question is how much more is there to go?

US politics gets more clarity

The fact we have seen Bernie Sanders poll well in Nevada won't overly shock, but he’ll head into South Carolina (Saturday) and Super Tuesday brimming with confidence, knowing that he has the wind to his back. The market doesn’t seem too concerned at this juncture that he is inching closer to the White House, as expectations remain that Trump will overcome Sanders with ease. That playbook remains music to gold bull's ears, as traders look at election hedges and gold is a front runner here.

On the subject of gold, gold bulls will love the moves in US fixed income, notably in the long-end with US 30-year Treasury’s closing at 1.91% (-4.5bp) and into the all-time lows. One suspects we break here on the Treasury futures open and print new lows, such is the hunt for duration assets once more. Gold bulls like the inversion in the curve, with US2s vs 5s now -3bp, while US3m v 10yr sits at -8.7bp. Inflation-adjusted nominal Treasury’s (or 'real' yield) is headed lower, and we see 5yr real yields at -30bp and 10s -14.7bp and despite gold futures positions at quite stretched levels (see the CoT report), pullbacks will be bought and its onto $1790 overtime.

I would argue that futures positions look rich, but we are not seeing such euphoria just yet in the options market, where gold 1-month (25-delta) call volatility trades at a 2.83 volatility (vol) premium to puts. If this was closer to 4 vols I’d be fading this rally with conviction, but it's not there yet and the relative demand for gold upside has not become too extreme.

Income chart
Source: Bloomberg

It's unclear how much more juice we can see in the rates trade as fed funds futures are pricing in two cuts over the coming 12 months and that pricing feels fair on current news and assumptions. Three cuts seem punchy unless we really see evidence of an L-shaped economic environment, so it feels like US 2-year Treasury’s lacks less appeal than longer-duration bonds given its sensitivity to Fed expectations. It does concern me that US 5y5y breakevens fell a further 2bp to close at 1.63% and thus look to be starting a trend lower. That should get the attention of Fed vice-chair Richard Clarida this week, as it has Lael Brainard.

No central bank wants to see falling inflation expectations and it's their job to get in front of this, affect the psyche of business and the consumer and engineer animal spirits. Central banks are back in play and if you are giving a glass-half-full outlook here the market will start to take you to town. Higher vols are the by-product.

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