Friday, January 15, 2016

ECB Meeting: Front Running

There are expectation in certain quarters of further actions from ECB next week. While this is possible, I think it is not likely. The question is less about whether they "should" and more about if they will. ECB historically never did strong actions back to back, based on their premise that it needs time to see the effect of the last action. A back to back action in current situation might as well signify a certain amount of crisis perception at the ECB. In retrospect we will be wiser if indeed we are in a crisis or not, but it is highly unlikely the ECB will be willing to send out any such message yet.
The opening of the year has seen some wild actions across markets. However the underlying macro stories remains more or less the same, although admittedly towards the downside. The US is holding up strong on employment. The inflation weakness, when looked at the US only is reminiscent of the recovery from early 90s recession. On the GDP side there has been considerable revision (for example Atlanta Fed GDP now is considerably revised downward, so are the PMIs). Euro area itself has also undergone GDP downward revision, but the PMI has been quite strong and steady. Nevertheless the inflation expectation has remain stubbornly low. And China has hogged the headline in recent times, but that is arguably more because of policymakers actions than data surprise. The capital outflows continue and the economy remains in a need for rebalancing. In fact most of the Chinese Economic Surprise index ticked upward in recent times (see for example Citi Economic Index).
But nonetheless, the markets have been really shaky, especially in equities. The chart below shows volatility skews implied from index options across markets. They shows a strong return of fear (although much less than last August). Note the right hand chart plots the ratio of average skew to average absolute deviations, a measure of average fear as implied from the options market.
The technicals and price actions may well be in the bear zone, and probably we are poised for further corrections from here. For some markets, the January move is reminiscent of what happened in 2008 in January and then what followed. But however there are reasons not to worry about a large crisis like crash in risk assets. For one, we see no evidence of mass euphoria in equities as we saw in case of both early 2000s and also in 2008 among retail investors (left chart below), and speculative position is far more cautious.

Also, this is confirmed by flow data from ICI. The equities flows have turned a new negative early last year, after the high yield lost its charm in 2014. Lately even fixed income has seen a turn in the sustained positive flows. Similar flows can be observed for emerging markets funds. This is definitely risk averse positioning rotating in to presumably more cash.

Given this back-drop, it is less likely to have some fresh actions this meeting from the ECB. On that front, the expectation is further depo cut and/ or increase in QE. We already have some political misgivings on this, so any action perhaps have to wait. Euro rates are so low it is difficult to push it significantly lower - compare the reaction of the 2014 QE expansion from BoJ, where the initial reaction of around 20bps in 10y rate was unwound in the space of a few months. On top, given the political situation, sudden sell-off is perhaps equally likely and but with better risk-reward outcome. In fact the top risks in Europe is not disinflation. That is pretty much global (and will be more so if Chinese deflation export increases following sustained CNY devaluation). The top risk is the refugee crisis which has distorted the focus on integration of Euro area as a whole. On top we have un-resolved Spanish situation, and the distant, but no less real, possibility of Brexit. The underlying theme of global rate convergence cannot be indefinitely put off by outperformance of the US economy! When Japan had the so called "lost decade", it was pretty much alone (apart from, may be, an internal unraveling of the erstwhile Soviet Republic).
Technically, long term technicals on USD rates suggests most rates are range bound, with last bearish signals around 2014 to 2015, the long end being the last to be fired. On the slopes, 2s5s is poised for a steepening quite strongly unless there is a change in the macro story. So is the 5s10s30s fly.
long term technicals on EUR rates are similar to USD, most rates are range bound, but has a smaller tendency to revert back. Also most slopes are near the higher area of trading range, especially 10s30s and also 5s10s. Sterling rates signals are mostly bland with few long term signs.
On shorter term, USD Rates long end shows a poise for comeback from recent rally and a strong steepening in 2s5s. Euro rates has weak signals of an impending sell-off in 30y and also in 5s10s30s fly (belly sell-off). Sterling rates shows some poise for a steepening in the front end (2s5s area) as well, along with a flattening of the 5s30s and 10s30s
Cross markets technicals supports the story of USD slopes steepening vs. Euro slopes.
Trades here:
1. USD steepening 5s30s outright or conditional (EDIT: vs. EUR, changed from 2s5s to 5s30s for leverage on 1st Feb)
2. BP Box of 2s5s10s30s (2s5s steepening vs. 10s30s flattening)
3. USD EUR long term rates convergence in limited size.
EUR/USD will most probably remain range-bound. Any large move without any action to fade.
In many ways, the current global situation looks like the long recovery in the 1990s (see here for example). We had a similar balance sheet crisis of sorts, and late in the recovery we had Russia and Asian Crisis doing the China now. That signified the bottom of a bust in commodities then. After that, a frenzy of dotcom stocks and a boom in globalization and commodities ended up in a sustained rally in risk assets. Although we have arguably a technically focused start up frenzy around now, they are mostly outside the scope of the general equities market (see the over-exposure to manufacturing in equity indices, compared to the economy from a recent Goldman reports). And the commodities are doing the reverse this time.

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