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The Top Three Risks Facing Global Markets Right Now

The Top Three Risks Facing Global Markets Right Now

Talking Points:

- While much of the world is watching the Fed for that first hike in Nine years, liquidity and geopolitical risk may present more complicated quagmires for investors to contend with.

- Geo-political and liquidity risk can be difficult to time, so it behooves the investor/trader to manage their exposure in these conditions should an adverse situation arise.

- Should we make it to mid-December unscathed, the upcoming Fed decision could present a game-changing scenario to markets that exacerbates other, more incalculable risks.

What a difference a month can make…

Only three months ago, we saw China’s ‘Black Monday’ envelop financial markets with fear of a global economic collapse. Nearly a month later, after markets had recovered a bit, but at the September Fed meeting Ms. Yellen vexed markets by backing off of the rate hike that the bank had been promising markets for years, but accompanied that hold with a hawkish statement that pointed to the fact that a hike was still coming in 2015, despite the pressures being seen in China, commodity markets and the recently re-triggered deflation now showing up in Europe.

Markets sold off again after that confusing September FOMC meeting, only to find a bottom near the end of September. We spent much of the month of October rallying higher: From September 29th to November 3rd, the S&P 500 rallied 12.55%... in a little over a month. And while this is a huge return number, it has nothing on what we’ve seen out of China, where the Shanghai Composite is up nearly 20% over the same period, while the Shenzhen Composite it up a whopping 34% since the lows at the end of September. These are eye-popping numbers in even the healthiest of markets, but for an environment riddled with risks; this type of return is confounding.

But as we came to an end of October, we saw the Federal Reserve move back to the 2015-rate-hike theme, and a blowout NFP report to kick off November made the prospect of a December hike look considerably probable; and since then most stock markets have faced challenges in setting new highs. Even though three months feels like a long time ago, we’ve basically seen a mini-crash turn into a glorious rally; and we have a litany of risks sitting in front of us so it can be difficult to determine which of these themes will reign supreme in 2016.

In this article, we’re going to look at the top three risks facing markets going into the end of 2015. We’re going to prioritize these based upon perceived order of importance, but this can change at a moment’s notice, much like the changes that we’ve seen across markets over the past three months. None of these themes develop in a vacuum, and domino/butterfly effects mean that one theme developing could considerably modify others. This is what makes trading so difficult and yet so much fun at the same time: There is no perfection, but in trading, perfection isn’t needed: You just need to win more capital than you lose (regardless of how often you’re winning or losing, to learn more, read our Traits of Successful Traders research series).

1) Biggest Risk for Markets: Liquidity

Who likes to take losses? I don’t, and if you’re reading this – you probably don’t either (considering you’re intelligent enough to obtain/own a computer and read about trading and financial markets). Well, banks and liquidity providers REALLY don’t like taking losses. It’s their entire business NOT to lose. And if you’ve turned on the financial news over the past year, you’ve probably heard about fines and fees and penalties and all other types of nefarious actions that governments are taking against banks and financial institutions.

So, if you’re in an uncomfortable environment as a trader and you continually and constantly keep hitting runs of bad luck in which your setups don’t work out – what are you going to do? Are you going to turn the volume up, increase your trade size, and go for even bigger moves? I sure hope not; because if that’s your response you probably won’t be trading for too much longer.

When an environment gets, let’s call it ‘unfriendly,’ professional traders are supposed to pull back on their risk. As in, if you have a lower probability of winning on an individual trade, you simply risk less so that the cost of ‘being wrong’ isn’t as high. Professional traders aren’t the only one with this idea, because banks do this too (and considering that banks employ many professional traders, this can have a cascade effect across markets).

When banks and liquidity providers pull risk that means that there is less liquidity in markets because banks and institutions aren’t going to be as active, and it’s this lack of liquidity that is utterly terrifying. Liquidity acts like a buffer above and below price action, and you can think of this really simplistically as sitting stop and limit orders. With a bunch of stop and limit orders setting above and below price action, when news comes out, there are many orders to fill surging or falling prices. Unless the news is really ‘big’ and brings a ton of new buyers or sellers in the market, prices should stay confined to support and resistance.

But if we decrease those buffers to just a couple of sitting stop and limit orders, the most innocuous of catalysts can create a price movement that will break right through those buffers as prices spike.

Now, I know what you’re thinking… price can spike in my direction and that can be a great trade! Not so fast: first and foremost, these spikes can happen against you, but even if they happen for you – it’s not necessarily a great thing, and the reason goes right back to liquidity. Let’s say you have a 100k lot of GBP/NZD and you get a 300 pip-spike in your favor. As soon as that +300 comes in, really quickly, you hit close, close, close to try to exit the position. But you wait in dismay as you watch prices fall back against your position, and on the way down you eventually catch a fill. The reason for this is because price spikes often don’t carry much liquidity behind them. That tick at +300 may have been for a single 10k lot, which means even if you did catch that fill, you’d have 90k remaining. But more likely, you won’t get that fill, because that happens on a FIFO basis and you clicked after the spike. Odds are someone is in line in front of you that will catch that fill, and you’ll end up with slippage on your exit.

The reason that this is the top risk facing markets rather than a refugee crisis, or conflict in the Middle East or even the Fed is the fact that this problem could significantly exacerbate any of those other issues. And perhaps more to the point, this problem is already happening. We’re but one exogenous shock away from a gigantic mess that the world may have a hard time ‘fixing.’

All of the problems that we’ve been discussing in these market talks over the past few months are concerns that banks and liquidity providers are watching as well. And given the huge trove of data that we have on the docket for December, many of these banks are rightfully cautious. And given that many of these banks have been in the headlines quite a bit over the past year, it’s logical to reason that they’d want to avoid any additional negative publicity for being caught on the wrong side of Oil, or Treasuries or the US Dollar.

The end of the year is normally an illiquid period across markets, but this year is expected to be far worse on the liquidity front given this series of concerns. David Rodriguez discussed this in his weekend article, ‘Three Factors Warn of Perfect Storm in FX Markets – Caution Advised.’

How to Counter This Risk: Stick to liquid markets. The smaller and less-liquid the market, the more dangerous it will likely be. In FX, this means that cross-pairs can be especially dangerous, markets like GBP/NZD, EUR/AUD, or AUD/CHF are usually illiquid so if we hit a period like we’re in, what little liquidity they do usually have can dry up very quickly.

Major markets usually stay fairly liquid, and this can open up opportunity. If you do want to take a short GBP/NZD stance, then you can do what a bank would do if they want to take a similar approach: Trade GBP/USD and NZD/USD individually. In most cases, banks and liquidity providers don’t want to trade in these synthetic cross markets for themselves because of the risks we just looked at (liquidity), so if they do want to take a short GBP/NZD stance, they’ll merely sell GBP/USD and buy NZD/USD.

You can do this too.

2) Geopolitical Risk/Risk of War: We just got a fresh reminder of geopolitical risk this morning when Turkey downed a Russian fighter jet over Turkish airspace. This is a little more difficult to forecast given the wide range of players involved, but if history is any guide, the United States and Russia taking separate sides in an internal, 3rd party conflict has rarely ever worked out well for the world. Given the terrorist attacks in Europe coupled with the fear and threat of additional attacks on the continent, we likely, and unfortunately, haven’t seen the end of this theme yet.

What makes this really troubling is the pure lack of predictability. To be sure, this is a ticking time-bomb of risk. It’s not likely that we’ll wake up one morning and the global war on terror will be over. More likely, and unfortunately, we’ll wake up to bad news eventually that may cauterize a more-global effort on the war on terror.

This will likely tank risk assets if it happens. We can look at the way markets opened after the November 20th terrorist attacks in Paris. The initial response was rough, as global stocks sold off only to catch their footing later in the day. But if something like this were to happen when markets were open, we’d likely see banks and liquidity providers pulling their bids/offers, and as liquidity dries up prices begin swinging wildly and violently.

I don’t want to speculate on any additional possibilities here because I truly hope that nothing more negative happens. But as a trader, I have to be a realist, and I have to build my approach around probabilities as opposed to feelings. And the probability is, we haven’t seen the end of this situation.

How to counter this risk: This is a risk that cannot be completely off-set, unfortunately. But this risk can be addressed in the portfolio by managing exposure. As in, areas like the US Dollar or Treasuries or Gold may see flows on the back of a ‘flight to quality’ should geopolitical unrest increase. And while being invested in these areas can be utterly unattractive during strong, bubbling markets, the goal of managing exposure is to diversify one’s assets so that they have a piece of the portfolio that ‘plays’ in a variety of conditions.

Think of this like asset allocation in an investor’s portfolio. If they invest 100% bonds, they’ll have horrible returns, but if they invest 100% in stocks, they’ll have massive swings that essentially amount to gambling one’s portfolio. The best answer is the right ‘mix’ of stocks and bonds based on the investor’s risk tolerance, outlook, timeline, etc.

It’s like this with trading. Hedging can offset or address portions of risk in the portfolio, and traders should avoid being ‘completely in one direction.’

One way that a trader can look to do this is by managing exposure in the US Dollar, which we discuss in the article/strategy, The USD Hedge.

Created with Trading Station II; prepared by James Stanley

3) The Fed

I’m going to try to keep this one as simple as possible: The Federal Reserve has become the centerpiece of the global economy, and this first rate hike in nine years is an unprecedented event. There are a lot of stats being thrown around ‘markets do this after lift-off’ or ‘the fed never hikes when x and y happen,’ and I urge you to qualify all of those statistics. Most of these ‘studies’ or ‘ideas’ suffer from a massively small sample size, so looking at historical events here to transpose what will happen when the Fed finally does kick rates up is even less than speculation, its pure banter at this point.

Right now, the expectation is for the Fed to hike in December, but in the back of many traders’ minds is the fact that every time that the Fed has looked at ‘less loose’ policy since the Financial Collapse has ended with the bank stepping back. If they do hike, we’ll likely see some volatility follow as investors brace for a higher-rate environment in 2016. This can be troubling, and we’ve begun to see banks already put in negative forecasts for stocks and risk-based assets around this premise.

But if they don’t hike, they may do more damage than even the worst case scenario would do if they did hike. As in, they may lose even more confidence from markets, and in a period in which Asia, Europe and Latin America are all looking weak, the global economy may devolve if the Fed losses confidence.

After all, markets are built on confidence and if that confidence goes away, then investors have no reason to stay invested in stocks or bonds or any other asset classes: At that point, cash in brown paper bags tucked under the mattress sounds like a pretty good idea, and that’s what creates financial depressions.

Further to the point, should the Fed lose control, that will exacerbate the concerns in the prior two risks,, increasing the probability for a negative ‘geopolitical event’ while also decreasing liquidity as banks and liquidity providers get more ‘risk averse.’

- Written by James Stanley, Analyst for

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.