A World Searching for a Recession

It’s hard to go past the US ISM manufacturing print, as the recent regional manufacturing data points had given us a belief that the national print would at least be in the expansion. However, that wasn’t the case and the reality of the index dropping to 49.1 – the first contraction since August 2016 – is that the idea of the US economy is the shining light and an island onto its own has been questioned.

We know manufacturing is highly cyclical, but we can see that every sub-component in the index is below the 50 expansion/contraction level, and that is a worry. Just take a look at the correlation with the Goldman Sachs current activity indicator, with manufacturing PMI data a major contributor to the read.

The world searching for a recession

The ‘recession’ word has crept into the narrative yet again, and one way I can visualise this is to search using Google Trends for keywords. Or, I can look at the story count on Bloomberg. Here I have scanned for the story count for ‘recession’ (white) and ‘currency war’ (orange). It seems Bloomberg editorial has been putting pen to paper and focusing on the currency war angle, which is a reflection of readers interest.

Of course, the aforementioned news flow has benefited the usual suspects, gold, silver, JPY, implied volatility (the VIX index closed at 19.66%), rates and bonds – it’s all one big correlated trade. With small-caps underperforming once again (the Russell 2000/US2000 closed -1.5%) and the S&P 500 is eyeing a re-test of 2900. Asian equities are holding in ok, and while the ASX 200 is lower by 0.8%, the Hang Seng and Nikkei 225 are flat.

I would also add that overnight we heard from St Louis Fed President James Bullard, who changed his call to a 50bp cut (from 25bp) in the September FOMC meeting and as a result we’ve seen buying across the fed fund futures curve – with the market now pricing a 25% chance of 50bp cut. This has taken US 2-year Treasury’s -5bp lower to 1.44%, with small selling in the USD.

The message from Dr. Copper

Take a look at high-grade copper. If copper has a PhD in economics, then maybe this is telling us a message.

The USD index (USDX) has failed to close above trend resistance, and for those trading EURUSD (given the EUR contributes a 57% weight to the USDX basket), we’ve seen a pronounced pin bar reversal on the daily, and a higher high through today’s trade would be interesting given the love for the USD. We react to price moves.

Fed speakers to focus on

One key aspect will the upcoming Fed speaker fest. The highlight will be NY Fed President John Williams, who some will recall was so dovish in the lead-up to the August FOMC meeting, that the NY Fed had to put out a statement shortly after his speech, to walk back his view. Clearly, the market will be looking to see how he sees the world and whether his communication with the market improves.

It does feel to me as though there is further USD upside, at least in the short-term, and aside from the manufacturing data and woeful University of Michigan consumer confidence report last week, we are yet to see fragility feed into CB consumer confidence report (red line), consumption statistics or service sector reads. One suspects this will presumably be more affected should cracks emerge in labour market reads. It makes this week’s US ISM services and payrolls report just that bit more important and expect markets to be sensitive to these reads.

Silver is flying

As mentioned, there has been some love for precious metals, and there has been a focus away from gold (to an extent) towards silver. If this hasn’t come across your radar, take a look at the daily chart of silver (USD denominated), it’s flying.

Just look at the gold/silver ratio, it’s getting chopped up, and that is usually a bullish sign for precious metals.

Staying in FX, we’ve seen a renewed bid in the AUD, largely as a result of a less dovish-than-feared RBA meeting, but todays Q2 GDP print, while in-line with estimates at 0.5% QoQ has seen a further position adjustment from AUD shorts. AUDCAD has had a strong move, putting in a sizeable bullish outside day reversal, with price eyeing a move into the 0.9050 and the top of the trading range it’s formed since late July.

Consider we have the Bank of Canada meeting tonight (00:00aest), and while the market puts a 6% chance of a cut, CAD traders will feed off the tone (and the level of flexibility reserved for a cut in the October meeting. One to watch.

Of course, GBP has been well traded with better GBP buyers emerging, notably on the run below 1.2020. Even though there has been a small bid in the sterling, I don’t think it necessarily surprised that parliament passed a motion facilitating an extension of the Brexit timetable, which should be formally approved on Wednesday and will then require the blessing of the EU. There is much to write on the subject, but the thought turns to a snap election called for 14 October and whether Corbyn accepts this challenge or refuses, with the view to battle a GE early in 2020.

The US session keyed off with a Trump tweet and yet another defiant message that gave us no indication the respective Xi-Trump camps are anywhere near to forging a deal. But the tweet set a risk-off tone in markets, and this was then given additional tailwind by a shocker of an ISM manufacturing print in the US, but also in Canada.

It’s hard to go past the US ISM manufacturing print, as the recent regional manufacturing data points had given us a belief that the national print would at least be in expansion. However, that wasn’t the case and the reality of the index dropping to 49.1 – the first contraction since August 2016 – is that the idea of the US economy is the shining light and an island onto its own has been questioned.

We know manufacturing is highly cyclical, but we can see that every sub-component in the index is below the 50 expansion/contraction level, and that is a worry. Just take a look at the correlation with the Goldman Sachs current activity indicator, with manufacturing PMI data a major contributor to the read.

The world searching for a recession

The ‘recession’ word has crept into the narrative yet again, and one way I can visualise this is to search using Google Trends for keywords. Or, I can look at the story count on Bloomberg. Here I have scanned for the story count for ‘recession’ (white) and ‘currency war’ (orange). It seems Bloomberg editorial has been putting pen to paper and focusing on the currency war angle, which is a reflection of readers interest.

Of course, the aforementioned news flow has benefited the usual suspects, gold, silver, JPY, implied volatility (the VIX index closed at 19.66%), rates and bonds – it’s all one big correlated trade. With small-caps underperforming once again (the Russell 2000/US2000 closed -1.5%) and the S&P 500 is eyeing a re-test of 2900. Asian equities are holding in ok, and while the ASX 200 is lower by 0.8%, the Hang Seng and Nikkei 225 are flat.

I would also add that overnight we heard from St Louis Fed President James Bullard, who changed his call to a 50bp cut (from 25bp) in the September FOMC meeting and as a result we’ve seen buying across the fed fund futures curve – with the market now pricing a 25% chance of 50bp cut. This has taken US 2-year Treasury’s -5bp lower to 1.44%, with small selling in the USD.

The message from Dr. Copper

Take a look at high-grade copper. If copper has a PhD in economics, then maybe this is telling us a message.

The USD index (USDX) has failed to close above trend resistance, and for those trading EURUSD (given the EUR contributes a 57% weight to the USDX basket), we’ve seen a pronounced pin bar reversal on the daily, and a higher high through today’s trade would be interesting given the love for the USD. We react to price moves.

Fed speakers to focus on

One key aspect will the upcoming Fed speaker fest. The highlight will be NY Fed President John Williams, who some will recall was so dovish in the lead-up to the August FOMC meeting, that the NY Fed had to put out a statement shortly after his speech, to walk back his view. Clearly, the market will be looking to see how he sees the world and whether his communication with the market improves.

It does feel to me as though there is further USD upside, at least in the short-term, and aside from the manufacturing data and woeful University of Michigan consumer confidence report last week, we are yet to see fragility feed into CB consumer confidence report (red line), consumption statistics or service sector reads. One suspects this will presumably be more affected should cracks emerge in labour market reads. It makes this week’s US ISM services and payrolls report just that bit more important and expect markets to be sensitive to these reads.

Silver is flying

As mentioned, there has been some love for precious metals, and there has been a focus away from gold (to an extent) towards silver. If this hasn’t come across your radar, take a look at the daily chart of silver (USD denominated), it’s flying.

Just look at the gold/silver ratio, it’s getting chopped up, and that is usually a bullish sign for precious metals.

Staying in FX, we’ve seen a renewed bid in the AUD, largely as a result of a less dovish-than-feared RBA meeting, but todays Q2 GDP print, while in-line with estimates at 0.5% QoQ has seen a further position adjustment from AUD shorts. AUDCAD has had a strong move, putting in a sizeable bullish outside day reversal, with price eyeing a move into the 0.9050 and the top of the trading range it’s formed since late July.

Consider we have the Bank of Canada meeting tonight (00:00aest), and while the market puts a 6% chance of a cut, CAD traders will feed off the tone (and the level of flexibility reserved for a cut in the October meeting. One to watch.

Of course, GBP has been well traded with better GBP buyers emerging, notably on the run below 1.2020. Even though there has been a small bid in the sterling, I don’t think it necessarily surprised that parliament passed a motion facilitating an extension of the Brexit timetable, which should be formally approved on Wednesday and will then require the blessing of the EU. There is much to write on the subject, but the thought turns to a snap election called for 14 October and whether Corbyn accepts this challenge or refuses, with the view to battle a GE early in 2020.

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Chris Weston, Head of Research at Pepperstone.

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A Huge Day of Event Risk for Traders

This suggests a tight open, in what is due to be an action-packed economic data day, amid our calls for a weaker open in HK and Japan.

The focus in the equity world remains on the set-up in S&P 500 futures, where we see the market stuck between the 50-day SMA (2945) and the 200-day SMA (2814), and this is confining the cash index into 2945 to 2822. A break of these levels should define the ensuing trend, not just the US markets, but could have a bearing on risk in FX markets, and commodities too, with the VIX index so influential on broad portfolio management.

Strong gold flow

Our biggest flow has been in gold, and there seems to a view that the yellow metal takes out the 1550 supply zone soon enough. Friday’s low of 1517 needs to hold otherwise we pullback sharply into trend support at 1502. At 00:00 aest tonight we get the US ISM manufacturing report, with the consensus calling for an unchanged read at 51.2. We watch for the sub-components, such as new orders and new export orders, but with this tier one data point correlated to bond yields, this is a clear event risk for traders.

With a 19% chance of a 50bp cut priced into the fed funds futures for the September FOMC meeting, and the speculative community running a record net long position of 2,127,352 contracts (see histogram below), if the manufacturing report comes in above say 51.5, with improvements the forward-looking components, then a number of the rates bulls will do a quick assessment.

That could keep the bullish momentum in the USD rolling on, where sentiment among institutional traders is already sky high and could cause a reasonable sell-off in front-end bonds, bear flattening the curve, with gold sellers in the mix. Of course, we could see a weaker ISM manufacturing print (than consensus) and the reverse kicks in, although the trend in the regional prints suggests upside risk to ISM print, with better numbers seen in Chicago, Dallas and NY, while Kansas was poor.

UK election risks are ever-rising

GBPUSD has been well traded too, with the pair breaking the bear flag pattern (on the daily) and the eyes fall on the 12 August low of 1.2015, where a break takes us to the 16 January 2017 low of 1.1986. It won’t surprise that implied vols have picked up in all the GBP crosses, with GBPUSD 1-month implied vol now at 11.78% and the highest levels since April. We look at GBPUSD 2-month options, and the skew of put volatility over call volatility. While most will look at the weekly Commitment of Traders report and see a near record 89,028 short GBP futures position, the skew in the demand for bearish downside structures vs bullish (calls) tells me a lot about semantics too, and right now the options market is paying up for downside, but its by no mean extremes.

Let’s see how that goes, but the wheels are in motion as parliament resumes in earnest today where a cross-party group are looking to pass legislation, which would require Johnson to extend A50 until 31 January. If this passes, and that is going to be hit and miss, as recall The Copper Bill, which facilitated the March Brexit extension only passed by a single vote, then Johnson has vowed to call a snap election for 14 October. There is no certainty he’ll even get the blessing here to hold an election, as he needs two-thirds of MPs to agree and that will require Labour to be on board.

Trading GBP is for the brave

Trading UK assets is for the brave, as we are fighting headlines and that is always a tough ask. The market is obviously discounting a lot already, and a decent element od no-deal Brexit risk even if it is impossible to model.

Eyes on the CNH and AUD

Staying in FX land, as we head through the session and, we continue watching USDCNH with the bull trend continuing and a break of 7.20 looking like a matter of time. The CNY fix has been a source of volatility suppression and inspiration for a couple of weeks now, with the PBoC lifting the USDCNY mid-point by far less than the streets models time-after-time, and risk assets have taken heart in that. As long as the PBoC don’t bring the ‘fix’ into the mix then vols don’t spike. We will also be focused on all thing Aussie today, and while we have kept a beady eye on moves in USDCNH, it’s the domestic side of the external/domestic debate that will see AUDUSD test key support into 67c or moves back into the middle of the 68-67c trading range it’s held since 1 August.

Overnight AUDUSD implied volatility sits at 12.6%, but that should move higher as the session grinds on, as this vol reading is only 47th percentile (over the past 12 months), so it’s not overly high. The market is pricing a 38-pip move (with a 68.2% degree of confidence) on the session and that accounts for a whole plethora of event risk. First up, net exports, which are expected to contribute 30bp to tomorrow’s Q2 GDP, and after yesterday’s inventory data, one wouldn’t be highly surprised if the consensus of 0.5% QoQ is now closer to 0.2% to 0.3%.

The implied move also accounts for July retail sales (also 11:30aest), with calls for a 20bp increase here. We also watch for the Q2 balance of payments print, where the consensus is we see a surplus of $1.5b, which it will not only be used as a political accolade but for those who model currencies long-term valuation, current accounts do matter.

The RBA meeting (14:30 aest) is the central focus though, even if the market places a 12% chance of a cut, and the bigger driver of the AUD will likely be the statement and whether it is dovish enough to meet the 54bp of cuts priced in over the coming six months, or 62bp of cuts over the coming 12 months.

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Chris Weston, Head of Research at Pepperstone.

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Daily Fix – The USD Breakout Continues

I’ve focused on positioning, where I have looked at the weekly Commitment of Traders (CoT) futures report. Skew, which is the demand for put option volatility over call volatility, which, for me, is the best guide around sentiment – the more negative the number the greater the expected move to the downside and vice versa. And volatility, where I have looked at both realised and implied volatility, which I use for risk management and position sizing. For more instruction, do watch the webinar recent conducted as part of TraderFest –

It’s the USD that interest us most this morning, as the rate of change is moving into the top of its range, and it’s attracting just as much attention from the US President, as it is momentum-focused traders.

JPY the place to be on open

At this stage, we can key off the FX open, where the USD has weakened 0.2% against the JPY, but this is not the USD finding fault, as the greenback is up against the higher beta AUD and NZD, and finding buyers against the CNH, although todays CNY fix was far stronger than the street expected – a risk positive function.

The move into the JPY a reflection that Trump’s 15% tariffs have formally kicked in on around $110b of Chinese exports (to the US), and we’ve seen China come back placing tariffs up on $75b of US exports, and one questions if there was an element of the market expecting the implementation of tariffs to be put on ice, given the positive noises from both camps of late. It seems not.

The news flow from Hong Kong would not have gone unnoticed, and we watch to see if there is an increased response from the Chinese authorities. A Chinese manufacturing PMI print of 49.5 (vs expectations of 49.6) has also been a consideration for AUD and NZD sellers here, where we see NZDJPY and AUDJPY lower by 0.6% and 0.3% respectively. It won’t surprise then the S&P 500 and NASDAQ futures have re-opened and currently sit 0.5% and 0.7% lower respectively, with Asia markets down smalls. Here, we see the ASX 200 -0.1%, Nikkei 225 -0.3%, and the Hang Seng -1%.

EURUSD moves in focus

Despite a whole barrage of ECB speakers last week, including somewhat hawkish commentary from Knot, Lautenschlager and Weidmann, throwing some uncertainty into the” kitchen sink” approach expected from the bank at the 12 September ECB meeting. The focus has been specifically on the break of 1.10 in EURUSD, and certainly, it was significant enough to garner the attention of Trump, who said the EUR is dropping “like crazy, giving them a big export and manufacturing advantage”. Let’s see how things stand on Wednesday when ECB chief economist Lane speaks in London (21:00aest), and he could really move the dial in a market which currently places a 47.7% probability that the ECB’s deposit rate is taken to -60bp and 52.3% to -50bp. The argument, like it is in many other nations, seems to be a growing call on fiscal policy as a support driver for economic fragility.

The fact Trump said the USD is the “strongest in history”, highlights the weight he puts on the trade-weighted USD, which sits at 130.66, and at an all-time high. We trade the USD index (DXY) though and whether we are looking at the feel and structure on the daily or weekly timeframe the set-up looks so bullish.

The interesting aspect is, that while we will likely to see a better feel to this week’s US ISM manufacturing print, amid robust payrolls data, on Friday we saw a huge drop off in Friday’s University of Michigan consumer sentiment report, with around a third of respondents highlighting concerns around trade tariffs. If the soft data goes lower, then the Fed will try and get ahead of the curve. Let’s hear what NY Fed president Williams and Chair Powell make of the data this week, with keynote speeches due.

USD intervention grows a touch

However, with the USD strong and Trump making more noises on his disdain here. The question is, at what stage do we genuinely start to consider US Treasury intervention? The US really is the missing link to higher FX volatility, and if the US Treasury team, perhaps alongside the Fed, intervene then we can start talking currency wars with increased conviction, and this is where gold and silver go wild. And, not just because these metals are a clear hedge against negative real or nominal rates, but would stick out as a currency in its own right, with EM FX also working well in this environment.

We are not there yet, and the first port of call would be Steven Mnuchin putting intervention on the radar to scare off speculators. But for now, we look at the trigger points, and a trade-weighted USD 3-5% higher, with an increased rate of change, or, a USD index above 100,00 and eyeing a test of the January 2017 highs of 103.82 would raise FX vols. These levels would suggest we see the EUR/USD into 1.0500, with USDCNY into 7.25 and that would not go down well at the White House.

EURUSD

EUR/USD is tracking a few pips lower this morning, but, for now, the pair is holding below the 1.10 handle and the 1 August low of 1.1027. The technical traders are focused on the 1.0960 area, representing trend support drawn from November 2017 low, and a move through here would only encourage the market to increase short exposures.

Trading the range in the S&P 500

The futures open will offer insights, and the lack of any inspiring news flow over the weekend offers no real bullish catalysts in a market which saw the S&P 500 close unchanged, with the market, yet again finding sellers into 2940/5 zone. The 2945 to 2822 range is clear and defined, and when this breaks, it will get great attention.

US Treasury’s found small buyers in the front-end, and 10s and 30s unchanged at 1.49% and 1.96% respectively, but we expect a stronger move lower on the re-open. The 2s 10s curve remains inverted, and that suggests staying cautious, even if we are coming into a seasonally strong period for risk, with the S&P 500 historically working well in the period up to 19 September, where we tend to fade the strength into options exportation, with gamma sellers and corporate buy-back blackout a driver.

Here, I have aggregated all the moves over the past 10 years into one index, to best show the seasonality of the index. The (small) white circle where we are today.

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Chris Weston, Head of Research at Pepperstone.

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Daily FX -GBP Crowned as The Wild West of FX Again

Where, it feels as though volumes will track just below the 30-day average, with volumes through the S&P500 some 18% below this average.

The S&P500 closed +0.7% higher, where we can also see a +0.3% net change in the S&P500 futures from 16:10aest (the official ASX200 close). So, while Aussie SPI futures are down 6p from the cash close (hence the flat ASX200 call), we can look to the US and see the index giving us some belief of support at the open. Although, I am really clutching at straws here and would obviously want to see price looking more constructive before hitching a ride. It’s also positive that we’ve seen US small caps outperform with the Russell 2000 closing up 1.2%, and breadth has been pretty good, with 82% of stocks (in the S&P500) closing higher, with the only sector lower being utilities (-0.3%).

Yield curves suggest a sustained bullish move in risk is limited

There have been limited moves in the fixed income world, although we’ve seen a slight outperformance from the front-end, with 2-year US treasury’s closing -2bp at 1.50%. This has created a slight steepening of the 2s vs 10s US Treasury curve, but when this is still inverted by 2.6bp, the message we continue to hear from the yield curve is hardly one that suggests the S&P 500 is going to see a topside break of the 2943 to 2822 range, where price is currently in the 53rd percentile.

As I have suggested before, perhaps the best curve to focus on is the US 3-month vs US 5Y5Y forward rate. Why? Because the 3m Treasury is close enough to the fed funds effective rate, while the forward rate is the market’s interpretation of the longer-term neutral rate. That being, the implied policy setting in fed funds future for the anticipated levels of inflation and growth. With the 3m Treasury yield now 58bp higher than the forward rate, it quantifies how the market sees Fed policy as being too tight, and the Fed needs to cut by 50bp just to get to the neutral setting, that is neither stimulatory nor restrictive. Again, it’s hard to see equities rallying too intently in this environment.

Inflation expectations will keep the Fed from getting ahead of the curve

What we have seen moving is crude, with WTI closing up 1.6%, Brent +1.5% and gasoline +2.7%, driven by a monster 10m barrel in crude and 2.09m in gasoline draw seen in the weekly DoE inventory report. This was somewhat reflected in the price, given we saw an 11.1m barrel draw in the private API survey yesterday. This has helped push US 5-year inflation expectations (swaps) up another 7bp, and at 1.98%, it seems unlikely the Fed will do anything other than a further insurance 25bp cut, when the FOMC next meet on the 18th September.

The US data certainly doesn’t give the Fed scope to ease by 50bp, and the 8% probability of a 50bp cut, implied in rates markets, reflects that. Certainly, if we look at yesterday’s US consumer confidence print, we are yet to see the consumer feeling the world is a darkening place, even if business investment, trade volumes and manufacturing have been a red flag. Consider then, that the next ISM manufacturing report comes next week, ahead of the August retail sales report on the 13th, and that could be a market volatility event.

FX intervention unlikely… for now

In FX markets, the USD has rallied against all G10 currencies and had some bullish moves against EM FX too. The USD index is into the top of its range and would be higher if it weren’t for the fact EURUSD closed the session down a mere 12pips at 1.1078. It’s interesting that Treasury Secretary Mnuchin has said the department doesn’t intend to intervene in the USD for now.

With USD intervention such a hot topic, and the smoking gun for those calling for a future currency war, the use of ‘for now’ will be debated on the floors. We’ve got a decent idea of how intervention looks like, but what are the triggers that change ‘for now’, to ‘right now’. Is it a trade-weighted USD some 3-5% higher, the USD index pushing towards 103, with EURUSD into 105, or USDCNY moving markedly higher? Perhaps its these factors married with a higher rate of change…However, a market which feels US FX invention is coming is a market one step closer to buying FX vol in size as their play on currency wars and gold will be above $1600 in a flash.

GBP – the wild west of FX

GBPUSD has been the talk of the town though, with the price falling from 1.2286 to 1.2157 with Boris Johnson requesting to prorogue (suspend) parliament, something which was later approved by Her Majesty the Queen. The betting markets now have a no-deal Brexit at 45%, although a general election, perhaps after a short A50 extension, still seems the base case for now. However, one thing is for certain; we are in for a lively period of headline risk for GBP traders to navigate, when parliament comes back from recess on 3 September through to when they go back on recess on 9 September.

GBPUSD 3-month implied volatility

As many have commented, this is an incredibly tight window to pass new legalisation from the Remainer camp and a no-confidence vote, therefore, seems incredibly elevated to be enacted through this period. Of course, if neither play out then when parliament comes back on 14 October, with the Queen due to address the nation, then given the limited time until the Brexit deadline on 31 October, the risk of a no-deal Brexit will become the markets base-case. GBP is the wild west of G10 FX from here…consider your position size and risk tolerance above all when trading the quid.

Also, keep an eye on the AUD with private CAPEX data out at 11:30aest. Weak number in the planned spend could push AUDUSD for a further test of 67c, which has acted as huge support of late.

 

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Chris Weston, Head of Research at Pepperstone.

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The Best Recession Indicators You Have Never Looked At

I understand this won’t help your trading in the immediate term, but it could help with trigger points to identify if we are going into a sustained higher volatility environment.

1 – We can search on Bloomberg for the keyword ‘recession’ and see this has spiked to the highest level since 2011.

2 – We have seen searches of ‘recession’ on Google Trends increase to GFC levels. In this chart, Nordea Research shows prior periods where the US 2s10s Treasury curve inverted.

We can look at market pricing, to see the perception of how close are we to a US recession. Here, we can extrapolate that if we see one in the US, then we are likely to see far tougher times in other countries, such as Australia.

3 – The NY Fed recession probability model (12-months out) – this currently sits at 31%, which seems low, but consider prior probability readings going into recessions (highlighted by the red shaded areas) were not much higher.

What trigger points are worth watching?

4 – The US labour market has been at full employment for some time, but should we see cracks appear it will rubbish the Fed’s belief the US economy is in a ‘mid-cycle adjustment’. Here I look at the 4-week rolling average of the weekly jobless claims (white) and overlap against a 36-month average. Historically, when we see jobless claims rise, and subsequently break the 3-year average, it tends to precede a recession (red shaded areas)

5 – Conference Board (CB) ‘jobs plentiful / jobs ‘hard to get’ ratio. This is part of the monthly CB survey, where we see respondents offering their belief in the labour market outlook and the ease of obtaining employment. Again, if the labour market turns, its often a sign business is cutting back as we head into tougher times. This indicator has seen a dip into prior recession, showing more respondents see jobs harder to come by on a relative basis. No red flag at this juncture.

6 – CB leading index – An index of 10 leading US economic indicators, which, as we can see, will decline sharply into recessions. We are not there yet, but it is turning lower and consider that we get the July US leading index update tonight at 00:00aest. So, it is worth watching.

7 – Consumer confidence (white) vs the S&P500 – It won’t shock to see consumer confidence decline into a recession, and the sharp turning points are the red flag. As we see, the index is not giving any clear signal we are headed into tougher times.

8 – The US 10-year Treasury – German 10-year bund spread. We often see the US Treasury’s outperform its German peer, resulting in the US Treasury yield advantage over bunds coming in aggressively into recessions. It has also been a reasonable predictor of how the S&P 500 may trade too. So, the fact we see this spread narrow at this juncture is something I have an eye on.

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Chris Weston, Head of Research at Pepperstone.

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Things That Keep Me Up at Night

A strong USD and an end of globalisation simple exasperate the issue. Anyhow, happy to be shot down, so feel free to critique, and respond with views.

Houston, we have a problem. Well, actually if we look across the financial landscape, there are many, and the cross-currents through which traders have to navigate are perilous, to say the least.

We can take Brexit, the Hong Kong protests, a likely German recession, an unfolding European banking crisis, future Italian elections and their inevitable budget showdown with the EU, or trade tariffs – in fact, it’s a surprise we haven’t seen an absolute collapse in risk assets .

Is the USD too high?

My own view is that the two most pressing issues are that Fed policy is too tight and that the USD is too high. But don’t just look at the USD index, which sits at the top of its multi-month range, where a break will get a lot of attention in the market.

Do absolutely focus on the trade-weighted USD, which resides at all-time highs, and one can only imagine how much worse things would be if bond yields weren’t collapsing. Emerging markets would be taken to the cleaners. But bond yields are collapsing; yield curves are inverting and globally, over $16t of bonds are trading with a negative yield.

US-China trade tensions have put USDCNH at the heart of markets and have been the must-watch currency pair, offering an ever-greater impact on China proxies, such as the AUD and NZD. Despite all the calls of ‘manipulation’ from the US trade team, if we look at the set-up on the weekly timeframe, the pair has traded with an air of predictability. And if the USD continues to grind higher against the CNH (offshore yuan), then rallies against the AUD will be sold.

Rising protectionism is not helpful

Clearly rising protectionism and an end to globalisation are not particularly helpful, especially when both the Fed and the ECB lack any real urgency to get in front of the aforementioned issues. Certainly, Trump’s strong desire is for the Fed to act as his hedge against economic fragility, but thus far, he isn’t getting the required support. Regardless of whether we see a Democrat or Republican win in late 2020, Jerome Powell days are numbered and he is not going to see a second term.

In actuality, what I think is at the heart of everything, and truly underappreciated is the impact on the US and global economy of nine Fed rate hikes from December 2015 to December 2018, married with $730b in balance sheet tightening (quantitative tightening or ‘QT’). The strong USD exasperates this and monetary policy is too tight, the market knows it and if the declines were seen in planned investment and trade volumes filter into broader economic indicators, notably the soft data, then the market will take its pound of flesh. Just like we saw in Q418, where markets forced the Fed and the world’s central banks to act.

Much will depend on the data, but should we see a re-run of Q418 it will have huge implications on FX markets, especially for the counter-cyclical or ‘funding’ currencies, which are commonly known as the EUR, JPY, and CHF. As we can see, the CHF and JPY have performed well over the past month, and this could be a glimpse through the looking-glass, to see how things could play out if the market really forces the world’s central banks to ease aggressively.

For those who trade using fundamentals, or adopt a more tactical approach to trading, in this chart, I have overlapped the Deutsche Carry Index (red) against the 1-month implied volatility of 30-year US Treasury futures (green). Here, we see volatility increase in US bonds; we’ve seen carry positions being closed aggressively.

How do I read that policy is too tight?

Well, aside from the more traditional yield curves (such as UST 2s vs 10s), I look the differential between the US 3-month Treasury & the US 5y5y forward rate. The US 5y5y forward rate being the markets best indication of where the neutral rate sits. That being the rate which is neither stimulatory nor restrictive, given the expected levels of future inflation, and growth. Currently, we see ultra-short-term rates 44bp above the implied neutral rate, so it tells me the fed need to cut almost twice just to get to a neutral setting.

The Fed has a communication problem

A US central bank behind the curve and seeing the US economy in ‘mid-cycle’ is dangerous, but, so too, is a Fed that has a communication problem – which it does, especially within the inner sanctums, with the market having seen multiple mishaps from chairman Powell and NY Fed President Williams. What’s worse, is there is a growing view that monetary policy, be it through interest rates taken to zero, or even if we see quantitative easing, will not work should the economic wheels fall off.

Let’s hear what Powell and others have to say at this week’s Jackson Hole Symposium, and whether they see the 12% chance of a 50bp cut priced and look to guide on this.

If the world is sceptical of the ability of central banks to meet their objectives, especially when all central banks, bar the Norwegian Central bank have pretty much laid out their path for further easing, we have to turn to fiscal policy here. There is a growing movement that in the next downturn, we will almost certainly see fiscal policy play a far great role. Potentially using the central bank and the government together to expand base money and target funds to specific areas of the economy.

Fiscal stimulus to play a greater role in the next true downturn

We’ve already heard of a €50b fiscal stimulus proposed from the German Finance Minister, possibly breaking away from the discipline of a balanced budget, which would be a huge political development, but this would be reactive, and not pushed out until the economy reached a maximum pain point. It all suggests to me that ‘real’ (or inflation-adjusted) rates are going far lower, which has huge implications not just on FX markets, but gold and all facets of the capital markets.

The idea of combining monetary policy and fiscal policy is a world away at this stage, but what is important is that market participants believe there is a genuine circuit breaker if things get a bit crazy. A weaker USD would be very helpful, but that would require the Fed look to get ahead of the curve and chop away at rates faster than priced, or even intervention from the USD Treasury department, selling USDs in the open markets, and that is also an unlikely prospect.

Watch the EURUSD set up on the weekly timeframe for guidance

Looking at the current set-up in the USD index (weekly), the current structure doesn’t suggest a crash is coming. Although, the RSI is failing to print the higher highs seen in price. With the EUR offering a 57% weight to the USD index, we keep a close eye on this pair. We certainly haven’t seen the sort of strong trend conditions seen in the GBP or JPY cross. But that could change. This pair will break out of this consolidation pattern, and when it does, it may come up on more trend-followers’ radars.

EURUSD weekly 

I guess the other positive catalyst is a scenario where we see a full trade deal, although this seems unlikely before the 2020 US election, or we see global growth somehow improve. The irony in this scenario would be that rates markets price out the aggressive rate cuts, the yield curve flattens, with short-term yields rising faster than the long-end, and again we see risk aversion plague markets, with the JPY, CHF and gold the beneficiaries.

A change of personal at the Fed

All roads led to a world of worry, although the goldilocks scenario is a Fed that goes hard and the data improves slowly but surely. Now consider that in 2020 the Fed will turn structurally far more dovish anyhow with Judy Shelton and St. Louis Fed research director Christopher Waller fill the two vacant Fed Governor positions. Similarly, the dissenters we saw in the July FOMC meeting (George and Rosengren) will be dropped to non-voter status. While the biggest dove on the FOMC, Minneapolis Fed President Kashkari, will have also gain voting status.

The battle lines are there for all to see, but it’s the USD I am watching most closely, and I have little doubt if the USD continues to grind higher there will be a point when market volatility ramps up again and tests global central banks.

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Chris Weston, Head of Research at Pepperstone.

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The Volatility Playbook for The Event Risk Ahead

With a 32% chance of a 50bp cut priced into the rates markets for the September FOMC, it feels on balance, that if anything, Powell will be more hawkish than current pricing is suggesting and it could be a USD positive affair.

As detailed on Friday, I think most were hoping to hear from vice-chair Richard Clarida, as he is considered the true spokesman of the Committee. However, the full agenda has not been announced, but when it is, you’ll see it here on Thursday. We are due to hear from RBA Governor Lowe, who will close out the proceedings on Sunday (02:25aest), so this opens up the prospect of AUD gapping risk on Monday – something for all AUD traders to consider.

Challenges for Monetary Policy

As discussed, the title of the conference is “Challenges for Monetary Policy”. So, with one explanation for the recent yield curve inversion, and the incredible buying taking place in the longer-end of the curve being the belief that monetary policy will not save us should we see a far more aggressive downturn, this title is incredibly relevant. The objective of the conference will, therefore, be about installing a belief that monetary can save us if we see a downturn and while most the speeches will be of an academic nature, I expect central bankers to drill home that they still have the resources to support economics.

Unprecedented policy coordination

I also want to pass over this white paper from the Blackrock Investment Institute, which now includes Stanley Fischer (former vice-chair of the Fed) and Philip Hilderbrand (ex-chair of the Swiss National Bank). For anyone who wants to know one way we may see central bankers respond, read this….it is getting a lot of attention from strategists.

It’s fitting that we hear more and more noise about a potential fiscal stimulus from the German government. While any fiscal program will take time to play out, if we marry this news flow with a dovish shift from the ECB in its 12 September meeting, then EUR assets look incredibly interesting longer-term. EURUSD on the weekly is ready to make a move. Which way, we shall see, but when this pattern breaks, then it will impact global markets.

EURUSD weekly

There is not expected to be any key representation from the ECB at Jackson Hole, but EUR traders will be watching PMI data due on Thursday, and any deterioration here will only build up expectations that the ECB cut its deposit rate to -60% and talk up renewed QE.

Weekly volatility report

I have updated the volatility report for options that expire on Monday, thus capturing the event risk over the weekend, with the markets implied moves based on various options strategies. I explain my logic in the webinar:

Aside from classic realised volatility measures, such as the ATR and Bollinger bands (BB), which traders use effectively to assess risk, and even entry points (BB). I have added the weekly Commitment of Traders (CoT) futures positioning (and change) from non-commercial players for key markets I look at. The implied rate path and what’s expected from select central banks for the September meeting and also over the coming 12 months, and 1-week risk reversals, which offer possibly the best guide on sentiment and perceived directional risk. I have percentile ranked these, which offers context into where the absolute number is in relation to its 12-month range.

I like to use this as a holistic oversite at the start of the week, to offer insights into expected moves, while offering insights for our risk-to-reward assessment.

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Chris Weston, Head of Research at Pepperstone.

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The Bond Market Driving The Show

The idea of a flatter US and global yield curves is certainly not a new theme. In fact, it is very mature. However, the fact the US 10-year Treasury has traded with a lower yield-to-maturity than that of the shorter-term US 2-year Treasury has fully caught the attention of all market participants. As has the bid in the US 30-year Treasury, which is currently trading below 2% – a new record low, with the hunt for (quality) bonds, with any positive ‘real’ yield rolling on like a juggernaut.

Gold, as usual, is the net beneficiary of these moves in yield, and the yellow metal has resumed its bull trend. The fact we now have $16t of bonds with a negative yield is driving further flows…it is the best hedge, or offset, against negative-yielding assets we have.

Assessing the moves in US trade:

  • White – US 2-year vs 10-year Treasury CURVE
  • Yellow – S&P 500 futures
  • Green – US 30-year Treasury

As we can see, bonds seem to be leading equities, and this leads back into my view detailed earlier in the week that bad news is actually bad news for stocks, and we don’t just pile into equities because low bond yields make corporate cashflow more attractive, or results in the equity dividend yield more attractive. Lower yields are a sign that US monetary policy is too tight and the market sees a higher prospect of recession.

The S&P 500 closed down 2.9%, which for the stats heads out there was a three standard deviation move, on volumes 35% above the 30-day average, and that is a red flag. I continue to watch to see how price reacts into 2822/25. A break here and the drawdown could get ugly. A Trump tweet is never far away.

US 2s vs 10s curve

Take the picture out to a multi-decade view, and we can see how curve flattening is not a new story. The fact the market chose to react overnight when we traded below zero (inversion) is clearly psychological. Consider, that while asset markets have sensed a need for the Fed to ease quite drastically, for those who use the curve as a precursor for the US, and perhaps global recession, then it is not until rate cuts are really enacted, that we see 2yr yields falling faster than long-end bonds and subsequently we see the curve steepen.

This is where we get the recession. Luckily, we are not there yet, but the market is obviously concerned given the Fed see no urgency in cutting rates. Consider next week we get the annual Jackson Hole Symposium, where the world’s central banks will gather to discuss all things on monetary policy. What’s interesting is the title of the conference is “Challenges for Monetary Policy,”. Seems incredibly apt if you ask me!

Remember recessions don’t just happen, they are caused by a major event or a policy mistake, and in this case, the combination of tight US Fed-policy and an end of globalisation seems to be a potential trigger.

Aussie yield curve

All the focus is on the US, but we’re seeing the Aussie 2s vs 10s curve about to invert. A 41.1k net jobs seen in todays Aussie July employment change has been the catalyst here, and also why AUDUSD is up0.5% on the day.

Key stats on curve inversion

We take the inversion of the curve as a signal in a process to eventual recession. As we can see from the chart, which I borrowed from Jeroen Blokland (@jsbloklan on Twitter), the average lag from the last five occurrences from inversion (in 2s vs 10s) to an eventual recession has been 21 months. We can also see how markets reacted here.

The best yield curve to watch

While there has been so much focus overnight on the UST 2s vs 10s, my preference is to watch the US 3-month Treasury vs US 5y5y forward rate. In layman’s terms, the forward rate is the instrument the market believes is the best representation of the Fed’s long-term neutral rate. That being, the rate by which is the correct policy setting for the level of anticipated inflation and growth.

This turned negative (or inverted) on the 28 May, and backs my view that Fed policy is too tight right now. If ultra-short-term rates are above the implied long-term neutral rate, then the market is telling me they feel rates need to be lower and by around 50bp just to be at a neutral setting.

Two of the most important charts in my universe

US 5Y5Y inflation swaps

Forget the name of the instrument, effectively, these just are one of many instruments institutional traders use to express a view on future inflation expectations, and exchange their liabilities. The Fed looks at inflation expectation readings very closely, as do the ECB and other major central banks. Inflation expectations are now headed lower, and this will sit poorly with the Fed and market participants. Although it is also great for bond investors.

Bloomberg financial conditions index

The index is a weighted blend of various inputs, such as implied volatility, the S&P 500, money market rates (and others) and funding markets – A move lower here indicates tighter financial conditions. Again, the Fed sees a strong connection behind financial conditions and the real economy, so it’s important for us too. When we saw the July FOMC meeting, conditions were still accommodative enough that the Fed would not have been overly concerned. That is changing.

The markets have a major role in both the Fed’s future thinking and potentially even the US-China relations, provided the drawdown in equities is prolonged. If the markets go after a 50bp cut, and they think 50 is genuinely warranted, which seems likely given the moves in the bond market, then financial conditions will express the level of worry in markets, and the Fed will have to react.

US 2s v 5s yield curve

One of my favourite indicators on the Fed’s implied path, largely because it tends to lead other parts of the bond curve. As we can see, after inversion, it doesn’t take long before steepening plays out here (i.e. 2-year yields falling faster than 5-year bonds), and this is taking place right now. It is often the clearest precursor to aggressive rate cuts from the Fed, which I’ve highlighted in the lower pane.

 

Who is the big equity loser from the flatter curve? Well, take a look at the KBW banking index. It looks terrible, although traders are far more focused on the longer-term chart of the EU banking index, which is about as ugly a chart as you will see.

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Chris Weston, Head of Research at Pepperstone.

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This is Not a Game Changer – Sell Strength in Risk

The fact we are hearing China sticking to the September trade talks after Trump’s move on tariffs should limit pullbacks in risk assets, but the belief to any lasting solution is still met with incredible skepticism.

In fact, the growing view is that for a real solution to play out, that doesn’t involve a Democrat victory in the 2020 US presidential election, we will need to see a lot more pain in financial markets that cant be offset by central banks, to really drive China and the US to form a deal. We are not there yet.

Market Prices
Bloomberg

Those trading the period at the start of US trade would have seen and felt the moves first-hand. And, it’s for this very reason why many take a broad assessment on positioning, risk reversals (sentiment) and technicals. As this holistic approach offers insight into our risk, and from here, we trade price and react accordingly.

A staggered approach to tariffs

The idea that Trump can stagger the 10% tariffs into two tranches, with $130b tariffs kicking in on 1 September and the balance on 15 December, has been framed as a relief for American consumers ahead of Christmas. But if we take this move isolation, the end result will unlikely be any different, and this tax will likely act as a headwind to US and Chinese growth by some 30bp and 50bp respectively. That does not change, although if you think markets are driven on sentiment and psychology, the fact we have not seen anything but bad news of late, shows the impact of even the smallest sign of convergence, without any immediately apparent concession from China, has been enough to provide a relief rally.

The fact we have seen the PBoC ‘fix’ the mid-point on USDCNY today at 7.0312 and lower than markets model of 7.041 – the fifth consecutive day in a row the PBoC could have depreciated the yuan by less than expectations, has been a stabilising factor for markets. There is little doubt the PBoC could have really accelerated rush to preserve capital and increased market volatility.

Selling strength in equities

However, a ‘relief rally’ is all I sense here, and a position adjustment, notably in some very loved assets. In fact, the idea that if we marry this tariff news with a slightly hotter US CPI print, with headline running at 1.8% and core CPI 2.2%, and we get a market that has mostly priced out a 50bp cut in September, and that on any other day could have be seen as bad for risk assets. The probability of a 50bp cut from the Fed at the September meeting now sits at 15%, so, a strong print in tomorrows US retail sales report (22:30aest), with consensus calling for 0.3%, and rates pricing will head to just one cut, while the 90bp of cuts priced over the coming 12 months will come into question.

If we look at the set-up on the S&P 500, we’ve seen sellers into the 61.8% retracement of the July to August sell-off, ahead of horizontal resistance at 2958. In fact, S&P 500 futures are starting to attract sellers, and maybe that’s a sense that the US session rally was overdone, or perhaps it’s the fact that today’s Chinese data was so poor, with July industrial production coming in at 4.8% (consensus at 6%), and the lowest levels since 2002. Retail sales printed 7.6% growth and a full percentage point below expectations. Chinese equities seem unperturbed, although, we have been seeing buyers in USDCNH, and this will just ramp up calls for liquidity to stay accommodative.

A quick review of Asia trade

So, while higher, Asian equity markets have come off their highs and we see a renewed bid in the JPY, resulting in a whippy session in USDJPY, while US 2-year Treasury’s are 3bp lower at 1.63% through the session. US crude is 1.2% lower, although this move lower has been most heavily influenced by a 3.7m drawer in the API inventory report, with traders extrapolating how this feeds into tonight’s more official Department of Energy (DoE) crude inventory report (due at 00:30 AEST), with the consensus currently estimating a draw of 2.19m barrels.

For those close to crude, it won’t have gone unnoticed that the US oil rig count (see chart below) has fallen from 888 rigs in November to stand at 764 rigs. If you want to know a clear area where business investment is falling, we look to energy. Lower oil prices are not good for economics.

Bloomberg

The AUD is holding in quite well, trading towards the top of its session range of 0.6809 to 0.6778, despite the weakness we have seen in CNH (yuan traded in HK), with some focus on the local data with the August Westpac consumer confidence increasing 3.6% and Q2 wages growing 0.6% QoQ (VS 0.5% consensus). There has certainly been a muted impact in Aussie bonds, with the 3-year Treasury +3bp at 68bp, while the implied chance of a September cut has fallen to 43%.

Economic data aside, it’s been all eyes on the news flow out of Hong Kong, and the situation remains fluid and concerning. The Hang Seng failed to close Monday’s gap (at 25,824) and has gone into the lunchtime close +0.5%, but 1.2% off its opening high. With the market on edge to see if we do get a formal military response from the PLA, and how this plays out, it shouldn’t surprise that traders are selling strength in the Hang Seng.

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Chris Weston, Head of Research at Pepperstone.

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Remain Cautious, The Worst is Not Behind Us

Market participants have enough complexity in their trading without having to assess how assets will react to news when often logic means little. So, the fact that bonds rally (yields lower) on bad news and subsequently we see equities trade lower, makes life a touch easier. The TINA trade is seemingly over, and the equity market is sensing a message from both from the bond market, which to be fair isn’t particularly upbeat right now.

Economic data and the S&P 500

If I look at the relationship between the S&P 500 and the Citigroup US economic surprise index, we can see an interesting correlation. I have flipped the S&P 500 to highlight the relationship, but as US data has come in slightly hotter than expectations in recent weeks, with the Citigroup surprise index (white) increasing, equities have still struggled.

(White – 30yr Treasury, orange – 30yr Treasury implied volatility)

The question is, why are stocks falling when data is coming in somewhat better and failing to rally when the data comes in worse? Well, firstly the flow into longer-maturity bonds has been relentless, as we can see here from the US 30-year treasury (white). The buying in the long-end has been one-way, with yields now at 2.14% and about to test the 2016 low of 2.08%, and as we can see US 30-year Treasury implied volatility has pushed to the highest levels since early 2018.

Equities are no longer rejoicing at the lower yield environment, in fact, with the Fed’s recent formal communication, detailing a bank that is still reluctant to ease for a sustained period, any positive economic data that threatens the four rate cuts that are priced over the coming 12 months is seen as risk negative.

US CPI is near-term event risk

With this in mind, keep an eye on US CPI due at 22:30 aest, with the consensus calling for headline CPI to push to 1.7% (from 1.6%) and core CPI to remain at 2.1%. The risks seem symmetrical, but the market will be sensitive to this, and from a simplistic perspective, a hotter number only reduces the need for the Fed to ease in September and this will be a headwind for equities. Put USDCHF (see below) on the radar with a weak CPI print likely pushing yields lower with the probability of a 50bp cut in September increasing from 31%.

With inflation on the mind, we can also see US five-year inflation expectations holding in at 1.80%, and until we see this instrument trending lower the market will demand more from the Fed, but they may not get what they want.

Happy to stay cautious on risk assets

As previously stated, I think that while the Fed would be influenced by external factors, they are watching US and global inflation-expectations and financial conditions very closely. Neither variable, if we take these in isolation, are giving us any reason for the Fed to ease aggressively, and that in itself makes me feel caution is still warranted and the likes of gold, the JPY and Treasury’s, despite being incredibly well-loved, have further to go.

If I look at the S&P 500, it feels as though the risk is, we head back to the August lows and a re-test of 2820. I would expect the bulls to defend this area again, but that depends on the news driving at the time, and if I knew that news flow that was driving us into that support zone then I would share. If I look at the S&P 500 high beta index vs low volatility index (denominator) ratio, which is a good way of visualising how defensive stocks are outperforming the theoretically more riskier stocks, we can see this working in favor of defensive stocks.

We can look at the US 10-year ‘real’ (or inflation-adjusted) Treasury, yielding 4bp and, about to turn negative. We can see the US 2s vs 10s yield Treasury curve now a mere 5.9bp from inversion, with long-term yields lower than short-term yields. It’s obviously a global issue, with Australia’s yield curve (2s vs 10s) now at 19bp and at the lowest since 2010, with calls for inversion here growing by the day. Hardly a development in which equity is going to shine and further confirmation the T.I.N.A trade is waning.

The geopolitical argument is real and another reason why equities are failing to rally when we see any better data. Traders are currently treated to a whole barrage of negative themes. At the epi-center is an ever-deteriorating US-China trade relation, with Trump putting on the façade that he’s happy either way if the talks take place in September. The narrative in local Chinese press is defiant, with calls they can “defeat any challenge”, and that the “US should not underestimate China’s will”. Talk is we could see China place new restrictions on exports of rare-earth to the US.

We have developments in Argentina, which is weighing on EM, while Hong Kong is clearly a bigger market issue and we watch to see how this unfold. Traders are so short of GBP, with GBPJPY or GBPCHF getting taken to the woodshed and chopped up and we watch with bated breath at the reaction from Corbyn when the Commons comes back from Summer reassess on 3 September as a vote of no confidence seems almost inevitable.

Italian politics, or the woeful chart set-ups in the European banking, are also in the headlines, and it’s hard to see how any of these factors give us a belief the worst is behind us.

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Chris Weston, Head of Research at Pepperstone.

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Using Volatility to Enhance Our Trading

Hedge funds and pension funds use implied volatility as a core input, either defining how invested they are in equities, bonds and commodities, or through the use of volatility, products to track a benchmark or to enhance yield.

My view is we, as retail traders, can use the implied volatility in an instrument to trade smarter, with a view to define and enhance our risk. Rather than look at realised volatility, which is what 95% of retail traders already do, we can look forward. Implied volatility offers insight in how the market feels about all known event risk ahead of them, and how it should affect prices moves.

The options market is perfect for this, as it is based on math, and therefore, we can assess with differing degrees of confidence how far prices could move through a set period. We can apply these concepts and statistical-based moves to our spot FX, index, commodity and equity trading with great effect.

Volatility does not predict direction, but it can help us understand if the market is expecting higher or lower degrees in price moves. This can help us understand event risk far greater, and it can help us.

define our risk. This insight is useful for those running expert advisors (EA), where the performance can often be affected by the levels of volatility (vol) seen in the market. If your EA works best in a low vol environment, and you can see the market expecting higher vol, perhaps it could be advantageous to either reduce position sizing or even stay out of the market until more favourable conditions return.

I will be rolling out this spreadsheet each Monday, which looks at both realised and implied volatility and the implied moves in various instruments. I’ll explain what risk reversals are and how we can use them as a sentiment guide, as well as the weekly Commitment of Traders report, which can feed into our risk-to-reward assessment.

Register now, and even if you can’t attend you will automatically be sent the recording. For those who feel this could help improve your connection with the rhythm and feel of markets I am hoping it will be an insightful evteent.

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Chris Weston, Head of Research at Pepperstone.

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Classic Make or Break Session

The cause of the recent move

The cause of the vol spike seems clear, but we have to revisit the ebb and flow of the market structure on Wednesday. Here we can see that the market dynamic centered on signs of better data in the US, and enough to confine the Fed to a 25bp cut. A US-China trade truce that had seemingly filtered into the background, sufficient that investors were happy to pay up for the historically higher earnings, supported by the lack of alternatives, low ‘real’ (inflation-adjusted) bond yields and subdued implied volatility.

Fast-forward a couple of days and are hit with the toxic-combination of Trump’s 10% tariffs on $300b of consumer-focused goods, China’s subsequent rebuttal with the halting the purchases of US ag products, and the symbolic gesture of China being labelled a currency manipulator. This series of events was absolutely not in the script, and we have been treated to a genuine shock to the system, that needed to be discounted rapidly. The spike in implied volatility saw volatility-targeting funds dumping risk, and we’ve had a solid shake out.

The politics of tariffs

The market has clearly formed a view that this saga has far more to play out, with a number of investment houses saying we will not see a deal between Xi and Trump until after the 2020 US presidential elections. Trump wants to lean on the Fed to support his hawkish plans to use trade as a policy initiative, designed to galvanise his base and elevate his election chances. However, the Fed currently sees a US economy lacking a need for aggressive stimulus, at this juncture, and the issue of independence has become so great that we saw the unprecedented step of all four prior Fed chairs putting an op-ed piece out to the world.

Just take St Louis Fed President James Bullard comments (in US trade), who has become a reasonable proxy of the Fed collective, with comments that “trade has been tit-for-tat since the spring or even earlier than that,” And, “I’ve already taken into account that trade uncertainty is high and going to remain high.

China, on the other hand, will be hoping the US economy weakens sufficiently that the Democrat candidates can leverage off any economic fragility as a policy miscalculation. With hope, they can forge a far more compelling deal with a less hawkish government. Although, the near-term risk is that China may have to withstand Trump lifting the 10% tariff to 25% or higher, which will no doubt be offset, somewhat ironically, by a weaker yuan. Trump knows the politics involved but understands that he needs the Fed as his offset should the economy deteriorate.

Lower rates will have limited effect on the economics

That’s all well and good, but if the clarity for US businesses under this tariff regime is so poor, it’s hard to see any spike in demand for credit, even if the Fed is making capital far cheaper. It is a dangerous game played by Trump, and the markets know it.

We had some relief yesterday, and as mentioned yesterday, when the PBoC refrained from lifting the mid-point of the USDCNY its daily ‘fix’ anywhere near as high as the models suggested, the market rallied. While a 30b RMB bill sale stabilised helped breath some life into the CNH on the perception that liquidity would be sucked from the system. The PBoC has been out reassuring corporates that the yuan won’t keep falling, but they haven’t seen that today with the bank fixing the USDCNY 313 points higher at 6.9996. This was just above the consensus view of 6.9977, which is close enough, but USDCNH buyers are now making their case, and this is again proving central to moves across markets in Asia.

If USDCNH is going higher, risk assets are going lower, and traders unwind carry structures in earnest, which is why the EUR, the ultimate funding currency (for the carry trade), has been working so well. S&P 500 futures are now -0.7%, and we watch to see if we get a re-test of the 200-day MA in S&P 500 and NASDAQ futures, which is where the buying kicked in yesterday. A break here and thing turn ugly again.

Asia agrees that we are not out of the woods here, and despite the S&P 500 closing 1.3% higher, we see the ASX 200 up 0.4%, however, China, Japan and Hong Kong are trading lower. The China A50 index (CN50) found a strong bid off horizontal support yesterday, and if traders were happy to defend into 12,329 a closing break on the next attempt will be taken poorly.

Big moves in FX markets

In FX, it’s been a huge day for the NZD, with the RBNZ cutting 50bp and showing once again, if you want to get ahead of the curve then the RBNZ does this better than most, and is not one to mess around. One questions if this is a message that if they are genuinely worried, and if so, we should be too? The moves in NZD have resonated in the AUD and AUDUSD has traded below the December flash crash low…all rallies are to be sold here, it seems.

White – NZDUSD Yellow – AUDUSD

USDJPY saw a huge turnaround yesterday, but traders are flipping back to short exposures today and we are seeing the pair through 106.00. The pair taking its direction from US Treasury futures, where we can see yields 3bp lower across the curve on the day, driven by some incredible buying in Kiwi bonds. Its real Treasury yields that interest most here, as US Treasury 10-year ‘real’ (i.e. inflation-adjusted) yields are now just six basis points from turning negative. We see the 2s vs 10s Treasury curve testing 10bp, where a break of 10bp and we talk inversion here and that is certainly not telling me we the world is fine and suggests the rally yesterday was a relief rally – nothing more.

We have seen gold futures traded above $1500 today, although, we watch for spot gold to move to the figure too. If real rates are turning negative, then gold is only going one way. Oil is flat on the day, but flip to the four-hour chart, and if this kicks lower I am jumping on board.

White – gold futures, Yellow – spot gold

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Chris Weston, Head of Research at Pepperstone.

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Labelling China an FX Manipulator Raises the Tension Levels

The need for capital preservation and a return of their capital is in play while shorting equity indices is working well for traders, with many looking to take advantage of the sheer lack of buyers of risk assets.

It’s the rate of change in asset pricing, which is just so important here. We know the disdain central banks have for fast-moving markets, and what we see across global equity indices, FX and bond markets suggests rising risks of calming rhetoric and promises of better liquidity dynamics in the near-term. In China, the markets have been on heightened alert around the daily CNY (yuan) fixing, which takes place daily at 11:15AEST, and where the PBoC ‘fix’ the USDCNY mid-point of relative to consensus estimates. Traders sense this is symbolic, where a fix higher than estimates sends a message to the White House.

A focus on the CNY ‘fix’

Importantly, the PBoC fixed the USDCNY mid-point at 6.9683 (+458p) today, and while that is higher, it was far lower than the consensus estimates of 6.9871. In a psychological way, the market saw this as a quasi-olive branch from Beijing…or, at least it didn’t inflame the issue further.

Yellow – USDCNH (Inverted) White – S&P 500 futures

We have also seen the PBoC detail that they are to sell 30b yuan in short-term money market bills. By issuing this debt, it should have the effect of reducing liquidity, which has had a positive effect on the CNH, and we have seen better sellers in USDCNH.

The mere fact that USDCNH has fallen has seen brought out buyers off the opening low in Chinese equities, as we can clearly see in the China CN50 chart – an index that weights the top 50 Chinese mainland companies traded as a futures index on the Singapore futures exchange. In turn, we have seen S&P 500 futures follow suit and while still -0.8% in Asia trade, sits 1.2% off the earlier low. The ASX 200 has found stability, although a 2.5% sell-off in this market holds few positives.

China A50 index

The impact of tariffs on China’s economy

Economists are running the numbers, and the impact of Trump’s unexpected additional 10% tariff will likely have on the Chinese economy. Most estimate the new tax will reduce China’s exports by around 2.5% to 2.7%, and act as a headwind by some 50bp to growth, with an unwelcomed negative impact on employment. Perhaps I am too simplistic, but if Trump were to slap Australia or Europe with this tax, one would expect the AUD or EUR to be smashed. So USDCNH gaining 2% and we subsequently hear the US Treasury department label China a ‘manipulator’. It all seems just a bit too convenient.

If we go back to 2015 and look at the guidelines the US set for labeling a country a manipulator, it’s hard to categorically say China fall into that camp. Although, the script can change at any stage and the goalposts pushed any which way Mnuchin and Trump decide.

Is China really an FX manipulator?

The first criteria (of three), was for China to run a trade surplus of over $20b with the US, and on current numbers, it’s clear, that’s a huge fail for China here. The second is whether China has a current account surplus of over 3% of GDP, and as we see on the Bloomberg chart below, China’s current account has been under this threshold since Q3 2011. The third and more contentious part is whether the Chinese have purchased foreign exchange of at least two per cent of GDP of a 12-month period. If we look at the trend in the CNY over the last year or so, if anything, the PBoC would have been buying their currency, and we see that China’s foreign exchange reserves have been stable for many months now.

Bloomberg

Does this raise the threat of intervention?

The first question everyone is asking is what will be the repercussions on China of being labelled a ‘manipulator’. Most end up drawing the conclusion that the call modestly raises the probability of FX intervention from the US Treasury department. Intervention was already a hot topic in the markets anyhow, given Trump et al. have spoken out about their concern around the USD strength. However, it raises the point of what intervention could look like, what sort of size of USD flow we could feasibly see, and how much of a collaborative effort would there be between the Treasury Department and the Federal Reserve.

It seems logical that if we are going to going to see USD intervention, then we would initially see the Treasury department conduct a verbal exercise, scaring USD longs into reducing exposures. We are not there yet, and if we ever truly thought the US would intervene, then USDCNH would be below 7 in no time at all. USDJPY would be trading below the December flash crash of 104.70 and gold would arguably be north of $1500.

So, a theme to watch, but we have to think that if Donald Trump wants to use trade tariffs to get lower rates, then he’s pulling the right levers. Fed fund futures are pricing a 39% chance of a 50bp cut in September, although pre-China CNY ‘fix’ that stood closer to 50%, and there are nearly four cuts priced over the coming 12 months. If Trump wants a weaker USD, he is now shaping the narrative to intervene to weaken the USD in the period ahead. If he wants lower oil, he can work the supply/demand dynamic…it’s obviously, a very dangerous economic game, as the changes in globalisation are having a lasting effect on the business landscape and will impact hard data at some stage.

However, to understand the circuit breaker we have to consider what Trump is wanting to achieve from these actions, and at this stage, while we could have seen a more punchy response from the PBoC on the CNY, Washington and Beijing are moving further apart; not closer.

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Chris Weston, Head of Research at Pepperstone.

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Volatility Spikes as Traders Head to Risk Aversion

Certainly, we are seeing increasing outperformance from defensive assets, with rising implied volatility, with the VIX index-tracking into 17.6%. The S&P 500 looked heavy on Friday, with price having closed below horizontal support at 2958, as well as price having filled and surpassed the 2950 gap – best seen on the four-hour chart. S&P 500 and DAX futures are lower by 1% and 0.8% respectively indicating a tough open for both Europe and the US.

A statement of intent from the Chinese?

We are certainly seeing Asia opening on a sour note today, ad at the heart has been the moves seen in USDCNH. The PBoC ‘fixed’ the USDCNY mid-point 229-pips higher (at 11:15aest) and certainly higher than what the market had calculated in their respective models. The market took this as a message of intent from the PBoC direct to Trump, while fears of a yuan depreciation and currency wars have ramped up again. This will only compound the issue across broad financial markets, as the market really does not need worries about a capital flight in China at this point in time and a subsequent tightening of financial conditions in the Chinese economy.

The fact we’ve seen the report that China asked state buyers to halt US ag purchases is not going to be taken well. Are we back to square one?

The moves in USDCNH above 7.00 are clearly resonating in a weaker AUDUSD, while USDJPY has traded below 106.00 and we are seeing broad declines in Asian equity indices today. US Treasury futures are rallying, with US 2s lower by 8bp at 1.63%.

White – USDCNH, yellow – AUDUSD (inverted)

Bloomberg

No support from the Fed…yet

Last week’s 25bp hawkish cut from the Fed did not meet expectations, and the market feels exposed, vulnerable and missing the psychological hug from the Fed to justify the dovish implied policy path. The Fed’s “mid-cycle” belief is not shared by the markets, so when we marry that with renewed trade tensions, covering a basket of goods which strikes directly to the heart of the US consumer when consumption and consumer confidence are an area of relative inspiration, the markets turns and demands action.

What is the circuit breaker?

As always though, if risk aversion picks up for any period of time, we search frantically for the circuit breaker that will solve all ills. If we don’t know our circuit breaker, we become risk-averse, it becomes more problematic to price risk, and we lack the visibility to feel confident in our exposures. Markets are driven by semantics, psychology and in most cases, randomness.

In my mind, that circuit breaker comes either from a more a series of constructive Trump tweet and that may not occur in the near-term or from global central bank actions and easier policy, although that is already a mature trade and much is discounted. As such, we see the market now fully discounting a 25bp cut from the ECB in its September meeting, as is the case from the Fed in its September meeting, and there is even a 19% chance of a 50bp cut. Look out through to December, and the markets are pricing close to two cuts.

A re-run of the July FOMC meeting?

At this stage, we’re shaping up for a re-run of the July FOMC meeting, where the likely debate will once again be whether they go 25bp or 50bp cut. This time around the financial markets may play a greater role, as financial conditions were extremely accommodative going into the July meeting, and as we can see, the Goldman Sachs Financial Conditions Index is starting to head higher, highlighting that broad financial conditions are starting to tighten and the Fed will be watching this closely.

Bloomberg  

Moves in the US Treasury and the global bond market will also be on any policy markers radar. We can take the US 2s vs 10s curve and see this trading at 13bp, and eyeing a test of the multi-month floor at 10bp. If this level breaks, it would likely coincide with higher implied equity volatility and the S&P 500 through 2900 and the 100-day MA.

Where to for the USD?

The USD index (USDX) is a tough one because nowhere else is really offering a compelling alternative, although if this period of higher volatility is pushing capital into the JPY and CHF and they will work best. In Germany, we can see the yield curve negative all the way out to the 30-year maturity. Denmark and Switzerland have had negative curves for all maturities for a while, and the total pool of negative-yielding debt has racked up to $14.5t, or 26% of outstanding bonds.

Gold has been the net beneficiary of this uncertainty, as has the JPY, and in the case of the yellow metal, we can think of it as a currency in its own right, and a hedge against this ballooning pool of negative-yielding assets. That said, gold in AUD-terms is performing strongly, putting on over 3% last week and pushing into a new all-time high. Although that will be tested to a small degree given the event risk from tomorrow’s RBA meeting and Friday’s testimony from the governor, Philip Lowe, who speaks in Canberra to the Committee (09:30aest), ahead of the RBA’s Statement on Monetary Policy (113:30aest).

Judging by AUDUSD implied volatility (expiring tomorrow) the market is expecting the move on the day of about 40-points. This implied volatility has picked up a touch of late, but we’re not expecting fireworks and the bigger influence on the AUD is likely moves in CNH.
USD-denominated gold is up a couple of bucks through Asia and now sits closer to the top of its recent range. A daily close above $1448 would be a bullish development, and given the break of the $1448 to $1380 consolidation range, one would argue for an extension towards $1500. One for the radar, but let’s see how the bond market reacts as gold bulls will be wanting to see further love for fixed income.

It promises to be a big week for markets, and while we identify the circuit breakers, they are perhaps not immediately going to be triggered, so a more defensive stance seems logical here.

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Chris Weston, Head of Research at Pepperstone.

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Daily Wrap – The Fed vs The Markets – Part II

We knew the rates market had a pre-set vision of an easing cycle, pricing in some 66bp of cuts through to December, and some 108bp through to December 2020. Obviously, front-end Treasury yields and global bonds more broadly had been the beneficiary of this implied policy path, with funds subsequently being pushed further and further out of the risk curve in search of yield, with the hunt for duration feeding into credit and equity. So, the risk was always that if we didn’t hear what we wanted to hear we would sell out of bonds, which would cause higher implied volatility, negative gyrations in equity markets and cause financial conditions to tighten.

A hawkish cut

Well, that scenario played out. Granted, the actual statement came out just as the market had anticipated, with a 25bp cut to the fed funds rate, a formal end to its balance sheet normalisation program (QT) and two dissenters (George and Rosengren were against easing). With narrative that the board will “act as appropriate to sustain the expansion”.

This, in itself, gave us a feel we were leaning to a hawkish cut, but things got spicy in markets when Powell spoke. The focal point of what we initially heard was this 25bp cut was a “mid-cycle adjustment to policy”, and that this was an insurance cut to keep in check the fallout from considerations such as trade. That we should not just consider that we had a 25bp cut, but it should be taken into context of the broader trend in policy, with the move to a patient stance, which is now accommodative, and that in itself is providing a more holistic support cushion to a resilient US economy.

It was a cut that many saw a really just taking out the December hike.

The Fed picking a fight with the market – the market will always win

“Mid-cycle” was all that mattered though. That was the red flag, and the market heard enough evidence that its implied easing path was thrown into question. The result, hardly surprisingly, was a move in US 2-year Treasury’s from 1.82% into 1.96%, with the 2s vs 10s yield curve falling 11bp to 10bp. The USD went on a run, with USDJPY tracking into 109, while EURUSD broke the triple bottom at 1.1106, taking the DXY higher for a ninth straight. AUDUSD fell from 0.6891 in to 0.6832, with EM FX finding a wave of offers as you’d imagine.

EURUSD
DXY

Gold fell $16 into $1410, with gold stocks hit hard, while the S&P 500 was sold 1.8%. The market was viewing this as a policy error, and flashbacks of Q4 18 were all too evident…the market hadn’t heard what it wanted to hear, and let the Fed know how they felt.

Powell is becoming well known for his pivots, and in this case, it’s almost as though he had someone in his ear telling him the market reaction, that towards the latter stage of the press conference, he walked back his earlier view. Once again, it’s clear. In an easing cycle, it’s the market that set policy, not the Fed, and if you want to challenge that dynamic, we will see volatility.

To clarify the “mid-cycle” comments, Powell detailed he meant it wasn’t the start of a long cutting cycle, and that he “didn’t say just one rate cut”. This narrative saw support kick back into bonds with a decent reversal in 2s, with the S&P 500 rallying to ultimately close 1.1% lower on the session. The rates market closed the day pricing a 64% chance of a September cut, so Powell has managed to install some belief the market is still on the money, but it feels like the communication with the markets is on more shaky ground.

The market needs time to regroup

The market now needs a couple of days to really digest this, and quite often in these meetings, the first move is not always the right move. We were hoping for clarity, and what we have been left with is more questions, so its back to listening to the Fed and ideally the man who many feel is the real governor on the board – Richard Clarida. That said, in the near-term, the most immediate scheduled speaker is James Bullard (7 August).

We will be keeping an eye on tonight’s (00:00aest) US ISM manufacturing, which after the overnight Chicago PMI, which came in at a woeful 44.4 (vs 51.0 eyed), surely holds downside risk to the consensus call of 52.0 on that index. After that, it’s on to Friday’s US payrolls, although when the Fed is looking more closely at inflation expectations and trade, the payrolls print should affect pricing too greatly, unless its an absolute disaster.

A weaker Asia open

The wash-up is we will see a weaker open in Asia, with the ASX 200 called to open just below 6800. The Hang Seng, Nikkei 225 and China should open around 1% weaker, and there is little in the way of data to really influence here. Gold stocks will find sellers easy to come by on the open, while on a more diversified level, BHP is indicted to open 1.6% lower. It’s not an ideal day for RIO to report numbers (after the bell), but even though we’ll see sellers on the open, there won’t be any panic. In fact, the open will offer a lot in the way of psychology, and I will be looking to see if traders buy the opening weakness or add onto the weaker open.

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Chris Weston, Head of Research at Pepperstone.

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Pre-Positioning Ahead of The Biggest Event Risk This Year

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It was the day before the biggest central bank meeting for years, and all is (fairly) well. Risk is a little lower, where we can see the Nikkei 225, Hang Seng and CSI 300 down 1.0%, 0.8% and 1% respectively.

The ASX 200 is outperforming, with a 0.2% decline. Most have attributed this decline to Trump’s critique of China and its lack of bean buying. We’ve also got the end of month flows underway, but even then, the feel is one of calm and most have prepositioned portfolios ahead of the impending event risk.

China PMI and Aussie Q2 CPI in play

Of course, it’s all about the FOMC meeting, but traders have had to deal with Aussie Q2 CPI and China’s July PMI data through Asia today. The China data is a small risk positive, but only in so much that it wasn’t worse than last month. At this juncture, there has been no impact on markets, and to say these numbers inspire is a stretch. Manufacturing PMI contracted at a slower pace at to 49.7 (vs 49.6 eyed), although, if we look at the sub-components, we saw improvements in new orders, new export orders and output.

Bloomberg

The Aussie Q2 CPI came out 30 minutes after the China data, with AUDUSD spiking 25-pips into .6890 and as we can see from the inter-day chart, there seems to be a supply barrier here.

The fact core CPI remained unchanged at 1.6% (vs 1.5% expectations), doesn’t change the view we should get another rate cut this year, but it certainly fails to provide the RBA scope to go twice this year, and we have seen a slight re-pricing in rate cut expectations for 2019. Given the moves, its clear traders went into the data very long Aussie Treasury’s and short AUD into the release.

(Rate cut probability in Australia)

The calm before the storm?

One way I can look at traders anticipated price moves is through FX implied volatility (IV). Take USDJPY one-day IV; this sits at 11.38%, which to put context on this level, 11.38% is the 53 percentile of the 12-month range. So, given we’re talking about an event that so many have talked about for weeks, if not months, it probably seems a tad low.

We can apply this IV into the Black-Scholes model (with other variables) to understand the market sees, with a 68.2% degree of confidence, a 50-pip move on the session (higher or lower) from the current spot price of 108.5. I can increase this confidence factor to 90%, and see the market feels moves will not exceed 70-pips. We can effectively use this as a guide for risk and position sizing.

Levels to watch in USDJPY

I am not one to advocate trading over this sort of event risk; the variance in the playbook is just too diverse that a high probability trade is unclear. However, in G10 FX USDJPY is probably the purest play on the Fed meeting, as it tracks 2- and 5-year US Treasury’s the closest.

With the sort of move expected, it feels like fading rallies into 109.10/20, or buying pullbacks into 108.00/107.90, is the more compelling trade and adopting a mean reversion strategy. Of course, we will be watching gold, US equities and USD pairs more broadly, not to mention EM assets which will be very sensitive to the language.

Maybe the market is wrong with its view that the Fed meeting won’t cause too great a stir, but this is why traders buy volatility. However, it feels as though everyone is positioned for a 25bp cut, and this will be sold as an insurance cut, predominantly to meet the market and to keep the dream alive.

Of course, we may see 50bp, and subsequently, we may see a short, sharp burst of USD selling, with the yield curve steepening, and gold and equities going on a bullish run, but for a sustained reaction the Fed would need to offer insight that they plan to go again.

A more simplistic approach

Don’t underestimate the fact that fed fund futures are pricing in 66bp of cuts by December – so two cuts and a 65% chance of a third. So, at a very simplistic level for the Fed to get ahead of market pricing, they would need to go 50bp, and offer a view they are prepared, if needed, to go again this year. Anything less, will not meet the market.

The disaster situation

Of course, they could leave the fed funds rate unchanged, a fate some 11 of 86 economists (polled by Bloomberg) feel is possible. And, of course, there is logic here given US GDP is growing around trend, consumption is rosy, with the consumer is feeling fairly content. We can even see housing is fine and the labour market is in rude health, and we saw a slight uptick in core PCE, although it’s still too low at 1.6%. However, it’s the supply side which is concerning; it’s the notion that falling business investment is going to feed into hard data, at a time when global trade volumes are looking uninspiring.

The question of whether a 25bp cut actually achieves anything other than meeting market pricing and risk having the market throwing a wobbly should they not go at all has come up a few times today. Personally, I feel the answer is no, and this measure certainly doesn’t feed into Powell’s recent comment that “an ounce of prevention is worth a pound of cure”, where one would argue a 50bp cut is more suited to meet this statement, married with an outlook that gives us a belief we may see another cut in September.

Ex-NY fed president, Bill Dudley, caused a stir overnight, detailing in an op-ed piece (for Bloomberg) that he thinks it’s a one and done and that marries with the view of ex-Fed Chair Yellen.

After the wait, all the hype and speculation, we finally get a chance to hear the aggregated views of the central bank and to see if they are prepared to set policy as the markets have priced. While implied volatility is unsurprisingly elevated, the market is convinced it will hear what it wants to hear…that is no glaring surprises. Let us see.

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Chris Weston, Head of Research at Pepperstone.

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All-Time Highs in The ASX 200, While GBP is Taken to The Cleaners

GBPUSD traded into 1.2212 in US trade, but Asia has kept the momentum going trading into 1.2163, with the bigger percentage moves seen in GBPNOK and GBPCHF.

A lack of any demand for the GBP cannot be said for UK bonds, with the 10-year gilt trading into 65bp, and eyeing a test of the all-time low of 50bp (set in August 2016). We have seen strong demand for the FTSE 100, which closed +1.8% and at the highest levels since August 2018, on volume some 34% above the 30-day average. Given the moves in GBP (in Asia), our FTSE 100 opening call of 7707, suggests staying bullish on the index for now. The buying taking place, for no other reason than because the index works perfectly inversely to the GBP.

A political statement to the EU from Johnson

The market has already seen Boris Johnson’s statement to the EU by his recruitment of a pro-Brexit line-up in his cabinet. But to detail that unless the Irish backstop is completely removed from the equation, he won’t even head to Brussels for talks is meaningful. That just suggests that unless we see the biggest political pivot in recent memory, we will head into the 31 October deadline on a stalemate and the prospect of a no-confidence vote growing.

The market continues to up weight its election probability, and subsequently, raised odds of a no-deal Brexit, a fate cabinet minister Michael Gove stated: “is now a very real prospect”. So, while it’s still not the base-case in market pricing, the probability of a no-deal Brexit sits closer to 40% and rising, and the GBP is getting chopped up. This is life as a political currency, and swimming in these waters can get pretty choppy, even if the GBP is trending beautifully.

Brexit hedges becoming expensive

We can see in the GBPUSD 3-month risk reversals, that the demand for put option volatility is ramping up relative to call volatility, showing that traders are increasing their conviction of GBP downside into the Brexit deadline of 31 October. We can look at the ‘skew’ of volatility as an insightful guide to sentiment, although it’s not hard to see the poor sentiment in price action alone. But, the trend for downside structures makes sense and options trader’s biggest dilemma is whether they are happy to pay up for what are increasingly expensive Brexit hedges.

Can the ASX 200 close above 6851?

When I look around the traps, we tend to gravitate to markets that are having the bigger percentage moves and especially those with a higher rate of change (ROC). However, I can’t go past moves in the ASX 200, and while we can look down and see the ROC in the index has not really exceeded one standard deviation since mid-June, this is a perfect backdrop for investors, especially those who are in the market for income, and who generally prefer a grind, as opposed to an impulsive move.

But a market at all-time highs should be seen for what it is; bullish. In fact, the only aspect that is somewhat negative here is that despite having traded to 6875 (at 10:20aest), we have pulled back to test the November 2007 high of 6851. While there is still some time to the official close, the bulls will want to see a daily close above 6851, as a close below will highlight a lack of conviction in the move higher and could offer insights into the psychology of the market.

Like every other asset class, the index continues to look towards the FOMC meeting, but it’s almost as though the ASX 200 would benefit from a modest 25bp cut, given the positive impact a falling AUDUSD is having on sectors such as healthcare. Consider the USD is also being driven on news that the US Treasury Department announced it would issue $433b in debt issuance in Q3, $274b higher than what we heard in April https://home.treasury.gov/news/press-releases/sm743. This brings its cash balance towards $350b and is a short-term USD positive.

The golden backdrop for the ASX 200

Therefore, the golden backdrop for ASX 200 appreciation is a lower AUDUSD, subdued implied volatility both in the equity market, but importantly, in the Aussie bond market and ultimately lower bond yields. Aussie earnings season gets underway with RIO reporting on Thursday, although the meat of market cap reporting doesn’t start to affect us until the 12 August. The valuation will always get some focus then for signs the outlooks (from CEO’s) can help the index re-rate.

As we can see the ASX 200 trades on 16.9x forward earnings, which is one standard deviation from the 10-year average. It’s not cheap, but as we can see the key area to fade the index with conviction is into 17.5x to 17.75x.

We see the Aussie 10yr Treasury at 1.20% but adjust for 10yr inflation expectations (i.e. ‘breakevens’), and we see ‘real’ yields at -16bp – an all-time low. If we look at the Aussie equity market, we can subtract the Aussie 10yr Treasury from the ASX 200 earnings yield and this differential sits at some 400bp (top pane) in favour of equities. The Aussie equity market is the Mecca of yield in developed markets, and we see the differential between the index dividend yield and the Aus 10yr at this highest level since 2009.

In a world of relative returns, it’s not hard to see the appeal of income in the equity market.

In fact, if I look at the market internals, and I go by the individual panes, I don’t see any clear signs of euphoria in the internals. I guess this is a function of the grinding nature of the tape, over an explosive move, but there are no glaring sell signals here.

•    % of ASX 200 members at 52-week highs – 18%

•    % of member > 200-day moving average (MA) – 78%

•    % of member > 50-day moving average (MA) – 73%

•    % of members with an RSI >70 – 11.5%

•    % of members with price > top Bollinger band – 11.5%

 So, what’s the risk?

The biggest risk to this bullish trend remains a sell-off in Aussie bonds, lifting yields and causing an unwind of the TINA (There is No Alternative) hunt for yield. Marry this with a rise in implied volatility, and we have a risk aversion move, although the safety trade won’t be in bonds, but gold, the JPY and CHF. However, a sustained sell-off in bonds seems unlikely, if at all…but that is the biggest risk to a sustained move lower in the ASX 200.

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Chris Weston, Head of Research at Pepperstone.

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Navigating a Massive Week of Event Risks

We get the chance to marry speculation with fact. In fact, we don’t just get answers towards Fed policy, but event risk comes at us hard this week from many geographies, so it’s a case of keeping your friends close and your stops closer.

US event risk

Core PCE inflation (Tuesday 22:30aest) – expected to rise 10bp to 1.7%.

• FOMC meeting (Thursday 4 am) follow by Powell’s press conference (04:030aest) – a 25bp cut is fully priced, with 17% implied probability of 50bp.

• ISM manufacturing (2 am Friday). Expected to improve to 52 on the index

• US non-farm payrolls (22:30aest Friday) – Consensus eyeing 169,000 jobs created in July (224,000 in June), with the unemployment rate to remain at 3.7%. Average hourly earnings expected at 3.1%.

It’s all about the Fed meeting though, and the base-case is they cut 25bp and offer a view they will keep the economic expansion going. With 2.6 hikes priced in through 2019, when they do cut this week the outlook needs to install a firm belief they will go again, or we will see a decent sell-off in rates and Treasuries, and the USDX will move into the top of its multi-month range of 98.0. A move in EURUSD through 1.1100 would look very interesting, and this will no doubt bring out a tweetstorm from Trump, who has seemingly taken it upon himself to defend 1.1100.

Will we see a buy the rumour, sell the fact play out?

The key question in equities is whether we get a classic buy the rumour, sell the fact scenario playing out notably in equities. The key to that will be how US Treasury’s 2s and 5s trade, where if we see higher bond yields, equities should trade lower (and vice versa), and we can see in the Dow that price is consolidating here, and needs to be inspired to push through 27,400. The bears will want to see a break of 27,030 to confirm that the sell on fact is play out, and that would go some way to highlight disappointment.

I expect gold to be well traded, with the yellow metal tracking the fortunes of the US bond market, especially ‘real’ (or inflation-adjusted) yields.

Obviously, if we don’t see a cut, then the USD will spike higher, and equities will get taken to the woodshed. The market will take the Fed to town, as will Trump…

US Q2 corporate earnings

We’ve seen 44% of US corporate report numbers so far, with 77.5% beating on earnings, by an average of 5.3%, with 59% beating on the sales line. Aggregate EPS has grown 4.25% so far, so it’s not been a terrible earnings season, but it’s the macro that dominates this week and how the market responds to the Fed’s outlook. I’ve included a list of the names I would expect to get attention from clients, but its Apple should get the lion’s share of attention.

Consider Apple have beaten EPS and sales in their last eight consecutive quarters, with shares rallying (on average) by 3.38% on the day of release. The implied move on the day of earnings sits at 3.9%, so traders are expecting the stock to have some volatility.

Europe

I was surprised at the disappointment to last week’s ECB meeting, but it seems the lack of urgency to ease at the July meeting was the key consideration here. What I heard re-enforces the view the bank will cut again on 12 September, a fate the market ascribes a 78% probability. We also feel the ECB will announce a framework for renewed asset purchases (QE). My short EURAUD trade was hurt in the process, and I take that off the table for a loss. That said, I would be looking this week at EURJPY downside, which works as a hedge against central bank disappointment this week and tactically running EUR shorts through August seems logical.

On the docket this week we get EZ economic sentiment, German retail sales and unemployment and EZ GDP and CPI.

UK event risk

It’s all about Brexit in the UK now, with the prospect of a general election in late Q4/early Q1 rising by the day. Certainly, Boris Johnson would welcome the Tories rise seen in the weekend polls, and that he is winning over Brexit Party support. Much has been made of his pro-Brexit cabinet, including the appointment of Dominic Cummings, the Campaign Director for the ‘Vote Leave’ campaign, who has been tasked, by Johnson, to deliver Brexit “by any means” and it is a powerful statement to the EU.

As we can see below, GBP implied vols are on the rise, as traders see the possibility of bigger moves in price, so please do consider that when considering position sizing. If I were to hold GBP exposure, it would be in a smaller size than say AUDUSD.

  • BoE meeting (Thursday 9pm aest)

Thursday’s BoE meeting is about setting the scene and how they may deal with the economic fallout of a no-deal Brexit. The market ascribes a 1.7% chance of a cut at this week’s meeting, but it’s about the outlook and whether the bank layout a cut this year. Expect dovish commentary, which should keep the pressure on the GBP, although if I look at the set-up on GBPUSD, there are some optimistic signs, with bullish divergence and a wedge pattern on the daily.

Australia

After governor Lowe suggested the bank are open at another cut this year, the market has brought forward its assumptions for further easing, with the implied probability of a cut in September priced at 54%, and November at 80%. Of course, the ASX200 likes this backdrop and is eyeing a break of the 6851 all-time high, with investors gearing up for our own earnings season.

Should the market be disappointed by the Fed, then we should also see the AUDUSD re-test the recent lows around 0.6864. We can see 1-week implied volatility in AUDUSD is in the 38 percentile, and the implied weekly move of 61-pips takes the price to 0.6851, which marries nicely with the lower Bollinger band, so I’d expect some support to kick in here. Aside from the global factors, keep an eye on:

• Aus Q2 CPI (due Wednesday 11:30aest). The market expects headline CPI to push up 20bp to 1.5%, while core CPI is expected to ease to 1.5% (from 1.6%). The market will be more sensitive to weak inflation numbers than stronger, even if the market is already short AUDs.

China

• July manufacturing PMI (Wednesday at 11:00aest) – Consensus sits at 49.6, up from 49.4 in June

• Non-manufacturing PMI (also Wed) – 54.0 from 54.2

• Caixin manufacturing PMI (Thursday 11:45aest) – 49.6 from 49.4

Implied volatility

Implied volatility is, as the name entails, forward-looking and a view of trader’s perceived future movement in an instruments price over a pre-defined period. So, rather than looking at what has happened and what is effectively fact, we can assess how the market interprets the known event risk in the period ahead and how it will affect the price and to what extent it will likely move. That can be incredibly powerful for assessing how much risk to take in each position, and subsequently, our position size.

It is important to understand that we should only use the implied move as a statistical guide, and one should still look at key technical levels to work a stop loss. As at its core, the bigger the implied move, the wider the suggested stop loss and the smaller the position size. And vice versa.

With all the event risk in play, I have looked at the expected moves in the major currency pairs, based on straddle and strangle pricing. I will be sending a link to a webinar I plan to do on 10 August, if you’re interested in using this framework feel free to sign up.

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Chris Weston, Head of Research at Pepperstone.

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ECB Meeting – Your Volatility Trading Playbook

Granted, we get EU manufacturing and services PMI (on Wednesday), but it’s Thursday that traders need to be aware of the event risk, and how it could impact their portfolios.

So, on Thursday (at 18:00aest) we get the German IFO survey, and on any other day, I’d expect this to get some attention from the market. That said, with the ECB meeting shortly after (at 21:45aest), unless the survey is an absolute calamity, I wouldn’t expect the IFO survey to be a market mover.

EUR futures positions – the market is net short 31k contracts

Source: Bloomberg 

Trading the ECB meeting

The first consideration with the ECB meeting is whether they lower rates at this meeting. The market ascribes a 33% probability the bank ease by 10bp, taking the deposit rate to -50bp. So, in theory, there is a small risk the market is disappointed when they likely leave rates unchanged, but that factor will be short lived as traders turn to the outlook on policy.

Consider that 34 of 39 economists (polled by Bloomberg -see below) see rates being left on hold, so if the ECB wants to cause a reaction, they know they know the hurdle to do so is low. One research house (Commerzbank) is even calling for a 20bp cut, which, should it play out would send the EUR into 1.1100 given how surprised the market would be.

Source: Bloomberg 

As said though, a cut at this meeting seems unlikely, and it’s the guidance on what comes in the months ahead that the market will really key off.

The most likely path is that the deposit rate remains at -40bp, where it’s the tone and level of concern that traders will look to buy or sell EURs. It is widely expected that the ECB alter its forward guidance on any future rate-setting, moving to a full easing bias, which would validate the consensus view that the ECB ease rates in the September meeting. More explicit guidance on re-starting its asset purchase program (QE) in the months ahead would also keep EUR bears fairly content.

How options markets can give us a statistical edge when trading event risk

EURUSD implied volatility for options expiring on Thursday sits at 7.2%. We can use this implied volatility and apply to the Black-Scholes formula to understand the implied move (up or down) set by the market through this time. So, applying this logic, the market implies a move in EURUSD of 47-pips (high or lower) through Thursday and into the NY options expiry.

As you can see from the chart (the white shaded area), the market believes moves in price will be contained to a range of 1.1152 to 1.1246, with a 68.2% level of confidence (one standard deviation).

If the market is really surprised by what they hear, we could see EURUSD trading into, but no further than 1.1127, which using options pricing is a move (from the current spot price) the market feels 90% confident it won’t breach. For those running mean reversion strategies on the day, the 1.1120/40 area is where I would be looking to buy.

On the upside, if the market is disappointed by what they hear, then traders feel EURUSD should not overshoot 1.1252 (with a 68.2% degree of confidence). However, if we take the confidence factor out to 90%, EURUSD should not trade any higher than 1.1285. This is interesting as it marries nicely with the July highs. If I had no position in EURUSD and was looking at high conviction levels to sell into on the day then 1.1270/85 would be where I would be looking as a short-term trade.

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Chris Weston, Head of Research at Pepperstone.

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The Playbook to Shape Your Trading Week

We talked on Friday about the NY Fed walking back much of John Williams speech, and this was subsequently backed by a WSJ article detailing a 25bp cut was on the cards. I think we’re all on the same page, even if I feel the Fed should cut 50bp.

As we can see from the Bloomberg chart, the market has swung from a 66% chance of a 50bp cut on Thursday to now pricing an 18.5% chance, and the flow of US data this week is mostly tier two, and unlikely to really sway the Fed’s thinking. Subsequently, it’s unlikely we will see rates and the USD getting too much action this week. It’s certainly not out of the realms of possibility that we get an upside surprise in Friday’s US Q2 GDP read, with the consensus calling for 1.8%, but even that would have little impact on rate cut expectations.

At the very least, good GDP should compel the president to be active on his Twitter account, talking up the US economy on a relative basis.

For a more detailed look at the economic data points, see the calendar

A 25bp now seems signed, sealed and delivered, and it, therefore, comes down to the outlook on the future trajectory of rates that will cause the market’s response. But, a 25bp cut is not going to cut the mustard or change anything too intently if US Q2 earnings fail to inspire, and the reports start to pick up this week.

Q2 earnings – the assessment so far

On Bloomberg consensus numbers, consider we have seen 77 (of 500) companies release quarterly numbers so far, with 77% beating earnings estimates, with an average beat of 4.9%, and 61% on the sales line. Not terrible numbers at all, but they don’t blow the lights out, and it’s harder to make a bullish case for equities here in the very short-term.

US corporate reports to consider

While we have some influential names this week, such as Microsoft, Caterpillar, Amazon, Facebook, Intel, Tesla and Alphabet. Tesla should get the lion’s share of attention from clients, but for those trading this name, my advice, as always, is to consider position size as an utmost priority. This is a name that can have some punchy moves on the day of earnings, with the average move in the past eight earnings release at 7.2%. In fact, if we look at the implied move (derived from options positioning), we see this now sits at 6.2% – the market expects a big move, so this has to be a priority when assessing one risk and correct position sizing.

Europe takes centre stage

Europe takes centre stage, this week, with advanced PMI’s due Wednesday, and the German IFO survey (18:30 aest) seen shortly before the ECB meeting (21:45aest) on Thursday. For macro traders, the ECB meeting is the highlight of the week and puts the EUR and European equity markets front and centre. Trading the EUR this week is the focus of much debate, and even more so in EURGBP, given we’re due to see a confirmation on the Tory leadership tomorrow.

Consider the market is already discounting an element of easing in the EU rates markets for this meeting, so at a simplistic level, EURUSD could initially rally if they don’t cut, which seems likely. If we look EUR positioning, and for that, we turn to the weekly Commitment of Traders report. Here, we see net shorts (on EUR futures) have been significantly reduced of late, but we know leveraged traders are still short of EURs, so Draghi needs to bring his dovish A-game, or we could be staring at a higher EUR, driven by selling in the German bund.

I suggested EURAUD shorts last week, and continue to feel there is juice in the downside, but in the vision of managing risk, I would be reducing exposures into the ECB meeting. It’s the tone of Draghi’s statement that is really what we want to hear, with key changes to the outlook for interest rates, and a strong signal that asset purchases are back on, likely in September.  Will any renewed asset purchases include equities?

Event risk to consider in China and Australia 

There is little data to drive in China or Australia either, although, we hear from RBA members Kent (Tuesday 08:30 aest) and governor Lowe (Wednesday 13:05 aest) and they may move the AUD around a touch. That said the market really only sees a move of some 48-pips in AUDUSD on the week (up or down), and we continue to watch moves in iron ore futures and copper.

Implied volatility as a core consideration for your trading 

I always like to consider the expected moves in FX markets, as well as gold, and equities at the start of each week. Implied volatility is really the collective thoughts on traders perceived future movement in an instrument from the mean of the data set, over a predefined period. It is expressed as the one standard deviation (annualised) change. It provides insight about the level of concern around upcoming event risk, and that is key in determining if the event risk is considered a volatility event, and if so, to what extent could price move.

Looking at the above excel table, we can see 1-week IV subdued even in EUR and GBP pairs. That said, EURGBP vols are a touch higher relative to it’s 30-day average, where we can see the implied move over the week is 65-pips, suggesting the market sees a range of 130 pips. EURUSD vols have picked up a touch from last week, but we can see they are still in line with the 30-day average.

At 79-pips, this suggests (with a 68.2% level of confidence) that EURUSD should be limited to a 1.1132 on the downside, while price shouldn’t trade too far above 1.1290. I like to assess these volatilities when understanding if the market puts significant weight on the ECB meeting, which gives me clarity on how much risk I should be taking in each trade and therefore offers enhanced assessment on position sizing. The greater the expected move, the further the stop. The further the stop, the smaller the exposure.

I will be doing a presentation in Noosa this Thursday on the subject, so I’d be happy to send the recording if it’s of interest.

German DAX (GER30) at a key juncture

Certainly, the German DAX (GER30) needs something inspirational here, and the 12,200 support needs to hold and form a base, or we could be focusing on a test of 12,000 fairly quickly. How price acts here is key, but this index is firmly on the radar as a break of 12,200, and I’d be firmly trading this from the short side. If we are going to see disappointment from the ECB meeting, then the DAX will have a strong reaction than the EUR in my opinion.

Chart of the day 

I thought I’d include a chart which has garnered attention. That being the gold/silver ratio.

It’s interesting to see the level of interest from market participants in silver of late, with huge volume traded on the silver ETF (exchange-traded fund) last week. In fact, if we look at the estimated inflows into the silver ETF (SLV) last week, it came in at an impressive $164m – the biggest weekly inflow was seen since January 2013 and dwarfing that of the inflows seen into the gold ETF (GLD)
One interesting way of looking at precious metals is through the gold/silver ratio, which collapsed 5.4% last week – the biggest weekly decline since July 2016.

The trend was certainly mature, with the gold/silver ratio getting to the highest levels since 1992, so the reversal here has many questioning if this move is just a blip on the radar or something which has genuine legs. There is also an interesting macro thematic around this ratio too, with some seeing silver more aligned to the perception of real economic activity. If this is the start of a new trend of silver outperforming gold, then the debate will centre on whether things are not as bad in the US and global economy.

That said, it is easy to think this is just a reflection that market has pared back expectations of how aggressive the Federal Reserve will be in next week’s FOMC meeting, after last week’s communication nightmare, with the probability of a 50bp cut now set at 18%.

Consider that if there is more downside in this ratio, meaning gold underperforms silver on a relative basis, then being short of gold and long of silver and netting off the exposures as a ‘pairs trade’ could be an interesting way of trading this theme.

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Chris Weston, Head of Research at Pepperstone.

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