Markets Seem Fearless as Volatility Sinks

Stocks

Summary:

Call it the calm after the storm.

Following the pandemic-driven hurricane that battered the global economy and world markets, investors find themselves sailing in eerily calm waters.

Key measures of implied stock, bond and foreign exchange market volatility are tumbling, in some cases to levels last seen before the COVID-19 outbreak more than three years ago.

The 'VIX' index of implied volatility in the S&P 500 - the Wall Street 'fear index' - this week fell below 14.0 for the first time since February 2020. The average over the past 20 years, and since the index's launch in 1990, is just under 20.0.

A benchmark global FX implied volatility index fell to its lowest level since February 2022, and the 'MOVE' index of implied Treasury bond volatility is the lowest since before the U.S. banking shock in March. Both are well off recent peaks.

Markets Seem Fearless as Volatility Sinks_1

Despite monetary tightening cycles that have lifted interest rates in many countries to their highest in decades, markets are booming - French and German stocks just hit record highs, Japanese equities climbed to a 33-year peak, and an AI-led tech frenzy is juicing Wall Street higher.

When you consider the U.S. banking turmoil, U.S. debt default scare and liquidity withdrawal fears that dominated headlines in recent months, the slump in volatility is in many ways remarkable, and begs the question: how long can the stars stay aligned?

But it is also perfectly reasonable.

Soft Landing

The Federal Reserve is near the end of its rate hiking cycle, even if it may have one or two quarter-percentage-point hikes left in the tank. Interest rate futures market pricing has the year-end policy rate roughly where it is now, and lower in 2024.

Barring unforeseen shocks, a hawkish U.S. central bank is not something investors have to factor into asset prices over the next six months and into next year. That's a potentially remarkable period of interest rate stability.

That's especially important for currency markets. Exchange rates are driven by the concertina effect of cross-border interest rate differentials - the more stable and less volatile they are, the more stable and less volatile FX markets are.

The U.S. economy is still growing and the unemployment rate anchored near 50-year lows. While there will almost certainly be bumps along the way after the most aggressive rate hiking cycle in 40 years, the 'soft landing' narrative - in which the economy and inflation slow without triggering a recession - is gaining traction.

In a survey of hundreds of attendees at a Deutsche Bank European Leveraged Finance Conference in London this week, some 28% said the U.S. recession, when it comes, will be "inconsequential" in nature and for markets.

Gimme Shelter

In a JP Morgan client survey this week, 29% of respondents said a "soft landing" scenario is the main reason equity volatility is so low, and 35% pointed to "low investor positioning."

Several positioning surveys and data show that investors are underweight equities, in some cases holding their lowest allocation in many years. At the same time, their cash and bond holdings are the highest in years.

So with the stock market going up, investors have little need to hedge their equity positions because their exposure is so light and they are already 'naturally' hedged by being long cash and fixed income. Demand for downside protection via S&P 500 options contracts then dries up, and as the VIX index is derived from these options, implied volatility sinks.

None of this suggests investors should be complacent. Intuitively, when volatility is so low the chances of a snap higher increases, leaving a broadly unhedged investor base vulnerable.

Buy-The-Dip Bonanza

Research by Nautilus shows that when the VIX breaks below 14.0 for the first time in over a year, the S&P 500 tends to struggle. There's an 84% probability the market is down a month later, a 68% probability it's down after two months, and a 62% probability it's down three months later.

But as long as investors are in 'BTD' and 'FOMO' mode and 'buy the dip' for 'fear of missing out,' volatility can stay low and in turn limit the downside. This has been evident in short-term trading strategies recently as much as longer-term investment positions.

As Bank of America strategists note, even during last year's selloff, markets still tried to rally, only to be beaten down by Fed rate hikes - the median up day for the S&P 500 last year was the highest since 1938.

So far in 2023, 'buy the dip' strategies are having their third-best year ever as the end of the Fed's cycle comes into view. Until the 'long and variable' lag of previous tightening kicks in, low volatility could keep that going for a little longer yet. Markets Seem Fearless as Volatility Sinks_3

Markets Seem Fearless as Volatility Sinks_3

Source: ZAWYA

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Samantha Luan

Forex

USD: Jobless claim jump hit the dollar

Currency markets continue to show very elevated sensitivity to data: yesterday, the increase in US weekly jobless claims to 261k against a median estimate of 235k sent the dollar weaker across the board. Lay off numbers have been rising consistently over the past few months and we could now start to see those finally trickle through to the initial jobless claims data. We must remember that there is always a period of time between lay off announcements and the actual job being cut and often no claim can be made until all severance payments have been finalised.

The Fed funds futures curve shows that markets have only marginally scaled back rate expectations after the Bank of Canada's surprise hike triggered a fresh round of hawkish bets. There are currently 7bp priced in for June, and 19bp for July, around 3bp lower (for both meetings) compared to Wednesday. Yet, if we exclude CAD – which is trading in tandem with USD at the moment – the dollar fell around 0.7%-1.0% against all G10 currencies yesterday. It is a testament to that big FX sensitivity to data and rate expectations, and one of the reasons behind our bearish USD view for the second half of the year, when we expect both data and rates to turn negative for the greenback.

The lack of data releases in the US may offer some stabilisation to the dollar around current levels today (hovering around the 103.50 handle in DXY). Elsewhere, it's worth keeping a close eye on Canadian jobs numbers, now that a July back-to-back hike is a tangible possibility. Consensus is looking at a solid 21k headline read, but with unemployment ticking higher from 5.0% to 5.1% and wage growth cooling off marginally, in line with what we saw in the US May jobs figures.

EUR: Shrugging off the recession

EUR/USD is back around the 1.0800 handle, with the moves once again coming entirely from the USD leg. Domestically, the news of the eurozone entering a technical recession after the 1Q GDP revision was understandably overlooked by the market, and may well be overlooked too by an inflation-focused ECB next week.

There are no domestic drivers for the euro today, and in line with what we highlighted in the USD section above, we expect some consolidation around current levels in core dollar pairs. EUR/USD could stabilise marginally below 1.0800.

Elsewhere in Europe, we saw EUR/CHF come under pressure yesterday following hawkish comments from the Swiss National Bank Governor Thomas Jordan, where he highlighted how current rates are low and "it's not really a good idea to wait then have higher inflation later". The SNB will announce policy on 22 June, and we expect a 25bp hike following a similar move by the ECB. It appears however, that the market is pricing in more beyond that hike, which is not part of our baseline scenario at the moment.

GBP: EUR/GBP is undervalued

EUR/GBP has moved back below 0.8600 after a very small rebound and we estimate the pair to be trading at around a 2.0% short-term undervaluation at the current levels, which falls beyond the 1.4% 1.5 standard-deviation lower-bound.

We remain of the view that EUR/GBP will increasingly struggle to find more bearish momentum now that markets are already pricing in 100bp of Bank of England tightening and the pair is already in undervaluation territory. On the cable side, we expect some stabilisation around 1.2550-1.2600. The UK calendar is empty today.

NOK: Inflation surprise adds to the need for more tightening

We recently published an update of our Norges Bank and NOK calls, which is based on expectations for the central bank to bring rates to 3.75% or potentially even 4.0% in an effort to support the declining Norwegian krone.

This morning, inflation numbers for May were released, and surprised on the upside. Both headline and underlying inflation accelerated to 6.7%, from a 6.4% and 6.3% April level, respectively. While the rate-setting model used by Norges Bank is rather mechanical and includes other factors (like trade-weighted NOK and oil prices), higher inflation may well be due to the substantial weakening of the krone and ultimately suggests there is some urgency to bring rates higher to support NOK.

We still expect EUR/NOK to navigate troubled waters in the near term, but continue to target levels close to 11.00 by the end of the year thanks to NOK's strong fundamentals and our expectations for good sentiment for high-beta European currencies in the second half of the year.

Source: ING

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Devin

Energy

Commodity

Europe's gas storage is refilling much more slowly than usual as the drop in prices encourages more consumption by industrial users and power generators while diverting liquefied natural gas (LNG) cargoes to Asia.

Gas inventories across the European Union and the United Kingdom were +261 Terawatt-hours (TWh) above the prior 10-year seasonal average on June 6, a surplus of +48% or 1.88 standard deviations.

The surplus has narrowed from +282 TWh (+80% or +2.41 standard deviations) at the end of the traditional winter drawdown season on March 31 ("Aggregated gas storage inventory", Gas Infrastructure Europe, June 8).

Storage sites reached two-thirds full on May 24, which was 57 days earlier than the average since 2011, but that reflected the record volume of gas already in store at the end of the winter.

Since the start of the refill season on April 1, inventories have accumulated much more slowly than normal for the time of year, in contrast to the record speed of the refill this time last year.

Total inventories have risen by +165 TWh in 2023, the smallest seasonal addition since 2021 and before that 2015, compared with a prior 10-year average increase of +186 TWh.

Over the seven days ending on June 6, the most recent data available, stocks increased by an average of just 2.60 TWh per day, the slowest accumulation for at least 11 years.

Inventories are still on course to reach 1,225 TWh by the end of the refill season, with a probable range from 1,044 TWh to 1,323 TWh.

Most of these storage trajectories are physically impossible since maximum storage capacity is estimated at only 1,138 TWh.

In effect, storage will be full much earlier than normal, and the winter drawdown will have to start earlier than usual.

But projected end-of-summer storage has already fallen from 1,246 TWh (with a range from 1,102 to 1,413 TWh) on April 1.

Inventories have responded to lower prices, with front-month futures prices down by more than 90% from its peak in August 2022.

After adjusting for inflation, front-month prices are in the 52nd percentile for all months since 2010, almost exactly in line with the long-term average.

Cheaper prices are encouraging more gas-fired generation (at the expense of coal) and some heavy industrial users to restart plants idled during the price crisis in 2022.

Lower prices in Europe are also diverting more LNG cargoes to price-sensitive customers in South and East Asia for power generation.

With inventories accumulating much more slowly, the market adjustment appears well underway already.

Front-month prices appear to have stabilised around 25 euros ($26.92) per megawatt-hour for the time being, and the summer-winter calendar spread between July 2023 and January 2024 has also recovered slightly to a contango of around 17 euros from a recent low of 24 euros in late May.

Stabilising front-month prices and a slightly less-weak spread imply traders anticipate the drop in prices has been enough to prevent storage space running out before the middle of October.

Source: Natural Gas World

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Warren Takunda

Traders' Opinions

In a global financial landscape dominated by concerns of persistently high inflation, government bond yields across the globe witnessed a substantial surge as investors brace themselves for the likelihood of elevated interest rates. This surge comes in the wake of unexpected interest rate hikes by both the Reserve Bank of Australia and the Bank of Canada, adding to the anticipation of further rate increases in the near future. Traders are now eyeing a potential hike in the Fed funds rate by July, while the European Central Bank (ECB) is also expected to raise borrowing costs next week.

The yield on the United States' 10-year Treasury note, often considered a benchmark for global borrowing expenses, has climbed to 3.8%, nearing levels not observed in the past three months. This upward trajectory in US bond yields reflects the prevailing sentiment of investors worldwide who anticipate continued tightening monetary policies to counter inflationary pressures.

Similarly, Germany's 10-year Bund yield, the benchmark for European borrowing costs, has surged beyond 2.47%, signifying growing market expectations of interest rate adjustments within the Eurozone. Meanwhile, the yield on Australia's ten-year bond has surpassed the 4% threshold, reflecting the Reserve Bank of Australia's proactive stance on inflation management.

The recent interest rate hikes by the Reserve Bank of Australia and the Bank of Canada have caught many market participants off guard. After a pause in the previous meeting, these central banks' decisions to raise rates by 25 basis points indicate their concern over mounting inflationary pressures and their commitment to preemptively addressing the issue. This unexpected move has fueled speculations that central banks worldwide may adopt a more hawkish stance to rein in inflation, which has become a primary concern for policymakers.

Investors are now closely monitoring the actions of the US Federal Reserve, which is expected to make its own interest rate decision in the coming months. The market sentiment points to a potential rate hike by July, as investors anticipate the Fed's determination to curb inflationary risks. Similarly, the ECB's decision to raise borrowing costs further amplifies the global expectation of tighter monetary policies in the foreseeable future.

The surge in bond yields indicates that investors are demanding higher returns to offset potential inflation risks and adjust to an environment of heightened interest rates. This development may have implications for borrowing costs across various sectors, including mortgages, corporate loans, and government financing.

As the bond market reacts to these developments, analysts and market participants continue to evaluate the potential implications of rising interest rates on the overall economy. While higher yields may attract capital inflows, they can also increase borrowing costs, potentially dampening economic growth and affecting consumer spending.

The trajectory of government bond yields serves as a barometer for investors' expectations regarding future economic conditions. The recent surge in yields reflects growing concerns over persistent inflation and the proactive steps being taken by central banks to address these challenges. As market participants prepare for potential interest rate adjustments across major economies, the financial world watches closely to gauge the implications of these policy changes on global markets and economic stability.

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Cohen

Q1 GDP for Australia came in broadly as anticipated at 0.2%, 2.3%yr. Household spending managed to lift by only 0.2% in Q1 after a similarly weak 0.3% gain in Q4. This was despite another fall in the savings ratio from 4.4% to 3.7% – freeing up roughly $2bn in funding for expenditure – as elevated inflation, interest rates and fiscal drags eroded nominal earnings and saw household's real disposable income fall by 0.3% in the quarter to be 4% lower over the year.

As interest rates continue to rise and inflation only slowly abates, real discretionary spending capacity will remain under pressure. Regarding other areas of the domestic economy, conditions for investment were supportive in the quarter, a rise in construction work and equipment spending leading a 2.9% increase in new business investment overall. Note though, the outlook for investment is clouded given emerging weakness in household demand and global uncertainties.

On trade, Australia's current account surplus widened from $11.7bn in Q4 (revised down from $14.1bn) to $12.3bn in Q1. This was primarily driven by an improvement in the trade surplus, up $2.1bn in the quarter upon sustained strength in Australia's terms of trade which rose 2.8% in Q1. In real terms however, the lift in import volumes (+3.2%) outpaced exports (+1.8%), leading net exports to subtract from GDP growth in Q1, -0.2ppts.

The RBA's decision to raise the cash rate by 25bps this week, which came as a surprise to markets, highlight's the Board's concern over inflation risks proving persistent as well as the implications for the economy if they do. Providing more colour around the decision, Governor Lowe delivered a speech the following day, highlighting four key areas critical for the RBA's navigation of the 'narrow path'. These include, the global economy, household spending, unit labour costs and inflation expectations.

The Board still believes it can lower inflation whilst maintaining the economic gains from earlier expansionary policy, but the risks are considerable. Given their decision in June and associated communications, we now expect a further 25bp cash rate increase in July to 4.35%. Another move in August is a possibility depending on the data's evolution. Rate cuts will have to wait until 2024.

The RBA wasn't the only central bank to surprise this week – the Bank of Canada also raised its policy rate by 25bps to 4.75%, ending the pause which started in January. The stronger-than-expected Q1 GDP print of 3.1% annualised, with a "surprisingly strong and broad-based" contribution from household consumption, led policymakers to believe that a further rate hike was warranted to rein in excess demand. Strong core inflation also contributed to the decision as the bank expressed concern that "CPI inflation could get stuck materially above the 2% target". Forward guidance was scant but, having been wrong-footed in June, market participants are now pricing in additional tightening, with a hike fully priced by September and a 50/50 chance of another by year end.

South of the border in the US, the ISM non-manufacturing survey weakened to 50.3 in May – a whisker above the neutral threshold and around six points below the five-year pre-COVID average. There was a broad-based fall in the sub-indices, with 'backlog of orders' and 'new orders' falling the most. Most notably though, the employment sub-index fell below 50, signalling a modest reduction in headcount at service firms. This is consistent with the uptick reported for initial claims this week and the reduction in hours found by the establishment survey last week; however, it is a stark contrast to the outsized 339k gain in nonfarm payrolls also reported by the BLS' establishment survey.

The US trade deficit meanwhile widened to $74.6 billion in April as a result of both weaker exports and stronger imports which recovered much of the weakness seen last month. On the exports side, industrial supplies and consumer foods both saw a sizeable downshift. Exports to Germany contracted – an unsurprising result given Germany and the Euro Area overall are now estimated to have experienced a mild recession during Q4 and Q1. Exports to China also fell, but not by as much.

Reversing our perspective and moving a month forward in time to May, China's trade surplus narrowed to US$65.8bn as exports weakened and imports rose. Exports to the US have declined on a year ago basis every month since August 2022. Offsetting growth in demand has however come from Asia, momentum that is likely to be sustained through 2023. Imports are expected to strengthen further following a pick-up in construction. Residential sales have already jumped higher and starts will follow. As these projects begin, demand for key inputs such as iron ore and timber will grow. China's post-COVID consumer recovery is also likely to result in an increase in consumption of imported goods and services. This is good news for our region as Chinese visitors support tourism across Asia and Oceania.

Source: Westpac Banking

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Alex

Markets have focused on the renewed uptick in macro momentum, which has resurfaced fears of inflation turning more persistent. But we doubt the rise in leading indicators will be sustained, and see evidence of underlying inflation continuing to gradually ease.

While the May NFP surprised markedly to the upside, the underlying details were much weaker. Employment growth is heavily concentrated on sectors such as leisure & hospitality, which have for a long time suffered from labour shortages. As labour force participation is recovering, employment rises even if broader labour demand is weakening. But importantly, supply-driven employment growth is not inflationary, rather the opposite.

The number of employed workers declined by 310k, which together with labour force growth of 130k suggests that slack is finally forming into labour markets. As such, wage sum growth remains on a downtrend, and our preferred measure of underlying inflation, core services CPI & ex. housing & health care, has also stabilized in the last two releases.

We expect the May CPI, released just ahead of the FOMC meeting, to slow down to 0.2% m/m (4.2% y/y) driven by negative contribution from energy prices. We also forecast Core CPI to continue cooling to 0.3% m/m (5.2% y/y). Manufacturing PMI price indices and used car prices suggest that the April uptick in core goods CPI will not be sustained, while we also look for continuing gradual slowdown in core services and shelter components.

Markets are pricing in a larger (75-80%) probability for a hike in July. Notably, it would only require two individual FOMC participants to shift their 2023 rate projections higher to lift the median 'dot' to 5.25-5.50%, which could spark a hawkish initial reaction in the markets. We still think the bar for restarting hikes in July will be high unless inflation pressures clearly accelerate over summer, which we consider unlikely. Private consumption has so far remained markedly resilient compared to the plunge in real disposable income, but with excess savings soon depleted, we think growth backdrop will remain weak.

Negative signals from longer-lead monetary indicators combined with the risk of tightening liquidity conditions over summer will further discourage rate hikes when inflation has already turned lower. Consumers' inflation expectations have continued declining, and currently hover around 4-5%, suggesting that holding nominal rates at 5% will maintain monetary policy stance sufficiently restrictive.

We make no changes to our forecasts, and expect the Fed to maintain rates at the current level for the remainder of the year. A pause could pose near-term upside risks to EUR/USD, but we still maintain a bearish view on the cross towards H2.

Source: Danske Bank

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Devin

Forex

A 261k weekly jobless claims print, the highest since October 2021 appears to have been all it took to push U.S. markets higher on the day and rekindle the idea that the Federal Reserve would signal a pause when it meets next week.

This week's rate hikes by the RBA and Bank of Canada have muddied the waters somewhat as to what the Fed might do next week, with both central banks taking the view that financial conditions are still too loose, posing the question as to whether the Fed might feel the same way based on recent data.

Nonetheless yesterday's claims numbers prompted some U.S. dollar weakness, along with a slide in yields perhaps in the hope that this would mean that there would be enough of a data deterioration between now and July, for the prospect of next week's skip becoming a slightly more permanent state of affairs.

The danger is that we've been here before with a big jump in claims data which has subsequently been revised away, however such is the nature of market sentiment now that the markets are moving on the basis of one data point to the next.

While U.S. markets finished higher on the day, European markets underwent a rather more mixed session, with the FTSE100 and Spanish IBEX closing lower, while the rest of Europe's markets edged higher. The mixed session had little in the way of significant drivers, apart from the latest EU GDP data showing that the eurozone economy had fallen into a technical recession, at the end of last year and the beginning of this year.

The jury continues to be out as to whether we are likely to see the recent sharp falls in headline inflation start to act as a drag on core CPI, but there have been some encouraging signs, in spite of the resilience being seen in the services sector, and with respect to wage growth.

One of the encouraging signs that inflation is starting to turn into deflation has been recent economic data out of China which has shown that inflation has been slowing sharply, and that factory gate prices especially have been negative for the last 7 months.

In April we saw PPI come in at -3.6%, and this morning's May numbers were even worse at -4.6%, the lowest levels since 2016.

Headline CPI was also subdued, rising 0.2%, as the slowdown in the Chinese economy showed little signs of coming to an end, raising the prospect that this period of low and negative prices could act as a broader headwind or leading indicator for the global economy. It also raises the prospect of further easing from the Chinese central bank, although how that would help the wider economy is open to question given the reluctance of Chinese consumers to spend after 3 years of restrictions, which were only recently eased.

Crude oil prices fell back again yesterday on reports that the U.S. and Iran had agreed a deal on oil exports, a claim which was subsequently denied, but also saw oil prices slide to their lowest levels this week, and below last weeks close.

EUR/USD – rallied back through the highs of last week and needs to push up and beyond the 1.0820/30 area to kick on higher. We still have support back at the recent lows at 1.0635.

GBP/USD – pushed up beyond the highs of last week at 1.2540 and looks set to test trend line resistance from the 2021 highs at 1.2630. This, along with the May highs at 1.2680 is a key barrier for a move towards the 1.3000 area. We have support at 1.2450.

EUR/GBP – still feels like it wants to go lower towards support at the 0.8560 level and last week's lows, just above the December 2022 lows at 0.8558. While below resistance at the 0.8660 area the bias remains for a drift lower, through 0.8550 towards 0.8520.

USD/JPY – still feels toppy above the 140.00 area, but needs a break below 138.30 to suggest a return to the 137.00 area. The main resistance remains at 140.95 area.