Dow Rebound and VIX Retreat Not Confidence-Inspiring Return to Form
- The S&P 500 closed out its best week in four years, it just took an extremely painful market rout to foster the move
- Risk trends from US to global shares, junk bonds to carry trade will not revert back to the calm complacency before January's spill
- Ahead, protectionism will be a broad them as will monetary policy for the Dollar, Euro and Pound in particular
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A Rally in Risk Trends Put In Context
Context is always important when analyzing opportunity and risk. If we were to evaluate the broad performance of 'the market' this past week without reference to what had preceded it, the scales are impressive. Most assets pursued for greater capital and yield gain were on the rise with impressive percentage and notional advances. In particular, the US equity indices performed remarkably well with the Dow and Nasdaq posting their best weeks since late 2015 while the S&P 500 put in for a percentage gain that doesn't find a match until the very end of 2012. Yet, this performance was not the continuation from an uninterrupted bull trend nor a breakout following a period of consolidation. It was recovery from a deep decline suffered over the preceding two weeks. And, while a good portion of the losses were covered, we have yet to retrace all of what was lost. What's more, we are unlikely to recover the inherent conviction in a passive advance in sentiment astray of traditional valuation even if we were to return to record high prices.
Volatility as Signal and Exposure
One of the foundations of blind conviction in progress of high risk assets was the inordinately low level of expected (implied) volatility registered by the market's favorite 'fear' measures. The VIX was at the top of the list and its incredible dalliance below 10 through the second half of 2017 suggested the intermediate future was virtually risk free. Of course, few mindful investors really believed that to be the case, but that didn't stop them from joining the feeding frenzy for high cost and low return investments. The explosion from the VIX the week before struck the kind of fear in investors for which the gauge was initially billed. Beyond just a remarkable increase for a closely observed indicator, the direct speculative exposure in VIX futures and ETNs dealt a painful blow to some of the most extreme of the 'risk' defined trades. We can see this in the dramatic reversal in the COT net speculative figures and implosion of products like XIV. It is unlikely that we simply see this measure once again deflate to or below 10 again; but if it does, it will bring with it a far more conspicuous degree of anxiety than anything we've seen before - and that makes it overtly unsustainable.
Protectionism and the Dollar
As we look ahead to the drivers directing sentiment for the broader financial system or individual moves for specific assets, there are a few themes that stick out. A release from the US Commerce Department revived the not-long dormant discussion of protectionism. Just a few weeks ago, the Trump administration brought the 'America First' agenda to Davos and the impression was distinctly an isolationism view. Yet, the protectionist push was still abstract with the shopping of that policy. It was made material however on Friday when the group headed by Secretary Wilbur Ross produced its findings and recommendations following an investigation into certain trade practices with key partners. It is no surprise that they concluded that a number of countries - lead by China - were finding advantage at the expense of the US through their steel and aluminum exports. In turn, the group recommended three different options, the first of which sums up the spirit of their approach nicely in a 24 percent tariff on foreign steel. If adopted, expect 'trade wars' to be a frequently used term moving forward; and the impact to general risk assets and the Dollar can be quite significant - especially after recent bouts of volatility.
Monetary Policy and the Majors
There are few currencies that stand to lose more systemically than the Dollar in the event of a trade war that centers on the United States. The probabilities of the world's most liquid currency remaining immune or benefitting from retaliatory policies looking to circumvent it are virtually nil. Yet, as we keep tabs on the market's recognition for this theme - and the erratic ebb and flow of 'risk' - we also have monetary policy as a theme that can impact the Dollar and the other majors. A range of Fed speakers, the FOMC minutes and the Fed's semi-annual monetary policy report to Congress are all on tap next week. Interestingly, the Dollar at lows and its futures open interest at multi-year lows, but interest rate expectations and Fed Fund futures open interest are at decade and record highs respectively. I don't expect that gap to remain forever. For the Euro, the EU and Eurozone Finance Ministers and Leaders meetings will take a back seat to the ECB's minutes (recall the surprise dovishness of the central bank at its July meeting). Then there is the Pound which will have key BoE members speaking alongside UK jobs and the return from recess for the Commons to take up Brexit again. We discuss all of this and more to prep for trading next week in this weekend Trading Video.
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