Volatility remains elevated this week as a correction threatens the dollar

Macro Outlook

Following a volatile first trading week of January, early impressions are that 2015 may be another difficult year. A long list of causes of the volatility include factors such as a consistent lack of growth, continued downside pressure on oil prices and structural fears in the Eurozone over a “Grexit”. However, in the past few days, fears over continued disinflation and deflation have come back in focus. The Eurozone has moved into outright deflation and despite the blame being put at the door of falling oil prices (which will begin to filter out of the numbers in Q3) the pressure is ratcheting up on the ECB to act with full blown QE. If Draghi does not (or cannot) pull the trigger at the next meeting on 22nd January, then there will need to be at the very least some pretty solid foundations laid, otherwise there could be a significantly negative reaction by a market that is increasingly pricing a move in. However, markets were then bashed by the disappointment that US average weekly earnings growth fell by 0.2% in December, taking the year on year figure back to just 1.7%. Whilst this bolsters the doves on the FOMC and should ensure the Fed maintains loose monetary policy, it seems as though the US is not as far down the recovery road as previously thought. Market sentiment has taken another hit.

Must watch for: European Court of Justice decision over the legality of the ESM

Impact: The European Stability Mechanism is effectively the process of the European Central Bank bankrolling sovereign nations. Or at least that is the case for the prosecution. If this is judged to be correct then the ECB will be effectively in breach of its mandate. This would mean that it would be incredibly difficult for the ECB to then pull the trigger on its big bazooka of full blown quantitative easing. That means that the euro could be volatile on Wednesday as will Eurozone equity markets (DAX and CAC) and peripheral bond yields would spike higher.

Foreign Exchange

After the lack of wage growth contained within the Non-farm Payrolls report disappointed the market, the chances of an early rate hike by the Fed have been reduced. After such a strong run higher in the dollar, could this now mean that we are close to a near term correction. On Friday, the Dollar Index shied away from a test of the key November 2005 high at 92.63. This came as the RSI (a technical momentum signal) had reached an incredibly stretched level of 90. Now despite the incredible strength of the prevailing trend, the overstretched level of this indicator in addition to the resistance of the next key multi-year high means that the dollar could be ripe for some profit taking and suggests that the prospect of a near term correction is now high. This could show in a rebound in Cable (which had lost 550 pips in just over a week) and the euro which is also oversold. Watch out for the Kiwi too, which has been one of the better performing of the majors in recent months and is also threatening to break a 3 month downtrend.

WATCH FOR: Despite quite a light calendar this week there are still some huge events. Sterling traders will focus on UK inflation on Monday, whilst a raft of minor US data leads up to CPI on Friday. However Wednesday’s ruling by the ECJ will be dominant this week as it could rule ECB QE impossible and significantly impact the euro.

Indices

Trading in equity markets since the New Year has certainly started with a bang, and not necessarily in a good way. With a net weekly loss of just around half a percent, the S&P 500 closed either lower or higher by over 1% on almost every day last week. Despite the sharp rally on equity markets in the middle of the week, the bulls can hardly be described as being back in control yet. Once again, volatility in equity markets is a key issue. After a couple of days of retracement, the VIX Index of S&P 500 options volatility spiked higher again on Friday. I have said previously that whilst the VIX remains elevated it reflects high demand for portfolio protection and this will be not only a drag on equities, but result in huge volatile swings in the indices. Do not expect too much reduction in volatility this week with an ECJ judgement on the ESM. If it is deemed to be illegal then it makes the job of the ECB incredibly difficult and there is likely to be sharp downside pressure. The technical outlook on major indices is also varied. As measured by longer term trend indicators, the S&P 500 remains in a bull market, the DAX Xetra is more neutral, whilst the FTSE 100 and the French CAC 40 look negative.

WATCH FOR: Watch volatility indices (such as the VIX) for how fund managers are using options to hedge their portfolios, with a negative correlation to indices. The ruling on the ESM on Wednesday will have a significant impact on the prospect for QE implementation and subsequently on Eurozone indices.

Other Assets: Commodities & Bonds

The oil price decline remains headline financial news. Despite an element of support that has come in during the last few days there is still the likelihood that a bottom has not yet been reached. There have been reports of record supplies coming out of Russia which have failed to curb the supply glut, however the problem is also on the demand side. Recent PMI data suggests there are still problems with global growth and therefore the oil price has suffered. Until there is concrete news over lower supply or improved demand it is difficult to see a sustainable low being posted for oil.

The fear of deflation (now a reality in the Eurozone), a lack of growth and subsequent safe haven asset flows have all contributed to consistent downside pressure on sovereign bond yields. A slight retracement has been seen as investor sentiment has improved in the last few days resulting in a bounce on Treasuries, Gilts and Bunds. However, with the Eurozone falling into deflation expect yields on Spanish, Italian and Portuguese debt to remain under pressure. This week could be volatile though with the ECJ ruling on the ESM. A ruling of it being illegal could cause a spike in Eurozone yields.

WATCH FOR: Gilt and Treasury traders will be watching for UK & US inflation data this week, but the major focus for Eurozone debt will be on the European Court of Justices on Wednesday.