Market Musings (15 Dec 2023): Everything Rally

 

·        Monumental week for all asset classes as Fed confirms pivot to rate cuts

·        Broad rallies across the board in equities, fixed income, currencies, precious metals and cryptocurrencies, setting up for a December to remember as 2023 comes to a close

·       Amid a likely melt-up in US equities into year-end, there are signs of protection-buying

Equities

US equities rallied to fresh YTD highs as the Fed confirmed its pivot to rate cuts. Major indices come within striking distance of their 2021 all-time highs, with the S&P500 and NASDAQ100 just 2% and 1% below their prior zeniths respectively. Small caps were the biggest winners with the Russell 2000 index surging 5.5% on the week (up over 3% on FOMC day itself). Littered with unprofitable names often saddled with debt, the affirmation of rate cuts were undoubtedly a welcome reprieve for battered small caps this year. The surge was likely exacerbated by generally poor liquidity in many names and dealer delta hedging-related buying from a large jump in call options open interest on the index.

Over in Asia, the surging Japanese yen took its toll on Japanese equities (well-known inverse relationship between the yen and Japanese stocks) as the TOPIX lagged US counterparts to end the week only marginally higher. Hong Kong shares fared better, helped by an 800bn yuan liquidity injection from the People’s Bank of China (PBoC) on Friday, the largest on record, which helped markets glance over weak retail sales data released the same day. Mainland Chinese shares however were not uplifted by this (temporary) shot in the arm, closing the week down 1.7% at a fresh YTD low.

Cryptocurrencies

BTC and ETH steadied after the FOMC decision on Wednesday, following a wave of liquidations triggered by a sudden plunge on Monday. This did not derail the general bullish momentum across the asset class however, as several Layer-1 coins (SOL, AVAX, ADA) touched new YTD highs on Friday. It is evident that retail interest is returning to the cryptocurrency market, and it is probably only a matter of time before crypto makes headlines in mainstream media once again (hopefully for the right reasons this time).

Although only a local anecdote, one may noticed the increasing number of posts on reddit forum r/sgcrypto, which was largely devoid of activity for much of this year. A simple search on Google trends for “bitcoin” shows a gradual uptick in interest since September. While not certainly fodder for a bullish crypto thesis (always too many of these anyway), it does suggest that the space is not (yet) mired in a speculative fever pitch despite the recent run-ups in crypto prices, as was the case in 2021, and we are not in a “bubble” thus far.

Commodities

Gold mostly took cue from interest rates and the US dollar, regaining the $2000 level post-FOMC after testing resistance-turned-support at $1980 earlier in the week. Palladium was the highlight, surging over 20% on concerns over UK government sanctions targeting Russian metals. Although palladium was not targeted, the news prompted concerns over supply disruptions and was sufficient catalyst for a short squeeze in the metal, which has been mired in a deep bear market this year on weak demand from auto manufacturers.

Elsewhere in commodities, bullish bets on a squeeze in uranium that peaked in popularity during the meme stock mania of 2021 are now paying off handsomely after spot uranium prices hit the highest since 2007. Uranium prices have been on a bull run this year, fanned by rising US-Russia geopolitical tensions frequently spurring concerns of a US import ban on Russian uranium.

Spot FX

Tracking USD interest rates lower, the USD sank after the Fed’s dovish pivot on Wednesday, in a resumption of the weak-dollar theme since late-Oct. The Norwegian Krone was by far the biggest winner this week after Norges Bank (Norway’s central bank) surprised markets by unexpectedly hiking interest rates by 0.25% a day after the pivotal FOMC decision on Wednesday, ostensibly in direct defiance of the increasingly dovish stance taking hold across major central banks.

Volatility

The quarterly “triple witching” took place on Friday as single stock options, equity index futures and equity index futures all expired at once. The day saw an estimated $1.3 trillion delta notional (~$5.4tn notional) expire, most of which likely cancels out. While options dealer positioning after this week is still likely long gamma, thus continuing to dampen market moves in both directions, this sizable expiry should “loosen up” US equity markets to make larger moves in the weeks ahead.

Current narratives contemplate the possibility of a “spot up, vol up” market dynamic in which US equities continue to rally but implied volatility (IV) instead picks up rather than comes lower (opposite of what IV usually does in a rally). This would suggest the current rally could be on its last legs and needs a pause or consolidation phase.

Indeed, there are some signs of protection-buying creeping back into markets after the euphoric rally since late-Oct. The SDEX Index (measuring the relative cost of out-of-the-money options to in-the-money options, or skew) shows signs of a short-term bottom after declining sharply over the last 2 months. Indeed, selling downside protection (eg. selling cash-secured puts) has been a beloved strategy of retail investors this year, and the increased supply of left tail gamma may be one factor weighing on skew.

Similarly, the ratio of VVIX to VIX – ie. ratio of the implied volatility of implied volatility to implied volatility, is now at the highest level since mid-July, a month which marked a near-term top that kicked off a 3 month-long 10% correction in US equities. History may not necessarily repeat itself, but this does suggest the opportunistic purchase of relatively cheap equity hedges by investors in the form of volatility topside (and therefore the relative unattractiveness of selling puts by extension, as downside vol is cheap).

Interest Rates

Central bank decisions were in the spotlight this week as decisions from the Fed, European Central Bank (ECB), Bank of England (BoE), Swiss National Bank (SNB) and Norges Bank were due on Wednesday and Thursday. Undoubtedly Powell’s pivotal press conference was by far the single most important event and a major market-mover.

In an about-turn from his resolute no-cuts stance just over a month ago, Powell acknowledged that the FOMC discussed rate cuts at its December meeting, although the exact timing and magnitude of which are still up in the air. In alignment with the Chairman’s dovish pivot, the Dot Plot surprised markets as FOMC participants pencilled in a median of three 25bp rate cuts for 2024, more than the 2 cuts markets had expected them to signal. It was a clear proclamation of the end of the current tightening cycle. The market reaction was emphatic – the policy-sensitive US 2-year note rallied to touch a low of 4.28% on Thursday, marking a nearly 100 basis point move since the late-Oct highs. STIR futures moved to price in more than 220bp of cuts over 2024 and 2025, with an 80% chance of a 25bp rate cut by the March 2024 FOMC meeting.

Unfazed by the Fed’s pivot a day before, Thursday saw renewed attempts at pushback from the ECB and BoE, both reiterating that it was too soon to consider rate cuts. While President Lagarde appeared moderately successful at first as interest rates ticked higher following her press conference, bond bulls stepped back into the fray to reverse the move by Friday’s close.

Apparently unsettled by the market reaction, Fed President Williams appeared on a CNBC on Friday to push back against market pricing, insinuating that markets had gotten ahead of themselves, and it was “premature” to be considering a cut in March. While bond yields briefly rose after Williams spoke, his efforts were in vain as traders once again called his bluff and interest rates quickly reversed course.

Short Term Interest Rate (STIR) Futures moved quickly to price in additional rate cuts following this week’s developments. Markets now expect ~140bp of Fed cuts in 2024 – nearly six 25bp cuts spread across 8 FOMC meetings, a huge jump from the ~80bp priced for 2024 just 6 weeks ago.

As a rough measure for the distribution of rate cuts between 2024 and 2025, the SOFR H4-H5-H6 butterfly surged to touch a high of 120bp on Thursday on back of the intense front-loading of rate cuts into 2024 (see chart below). Pricing for the Fed’s terminal rate now sits at ~3.25%, expected to be reached around 1Q2026.

From an economic perspective, rate cuts are the logical next step given that recent data shows inflationary pressures have diminished and holding interest rates far above neutral (the r-star) for too long risks dragging the economy into recession. Central banks are, as always, treading a difficult path – pivoting too late and too little risks causing an economic slowdown, while pivoting too early and by too much risks the return of inflation, and even more so it risks inciting the markets’ worry that policymakers foresee a sharp slowdown ahead and acting pre-emptively (“do policymakers know something about the economy that we don’t?”).

The following graphics visualize the changes in rate cuts priced by markets over the past 6 weeks.

USD SOFR

EUR 3M EURIBOR

GBP SONIA

The Week Ahead

As markets wind down into year end, thinning liquidity and favourable seasonality (“Santa Claus rally”) should keep risk assets supported, especially in equities. While signs of froth may be emerging and there are emerging signs of protection-buying, it will take a lot to derail the current bullish momentum in markets. Many investors were under-invested throughout 2023 and may be resigned to chasing the market melt-up into year-end. Markets love a target and the 2021 all-time highs in US Equity Indices are likely to be breached in the final two weeks of the year. Santa Claus is coming to town.

The final major event of the year is the Bank of Japan on Tuesday (19-Dec), which will be closely watched by the Rates market for additional signs that confirm a committed shift toward normalising interest rate policy. UK inflation data is also due on Wednesday (20-Dec), which will be instrumental in influencing the priced path of BoE interest rate cuts for 2024.

Market Musings (8-Dec-23)

Equities:

The slow grind higher in US equities persists with the S&P500 touching a fresh YTD high on Friday. Market volatility remains subdued as the index remained within its ~1.5% trading range over the last 2 weeks. Paradoxically, sentiment indicators and volatility gauges suggest a whiff of complacency setting in as the festive season is around the corner.

 
Things were not so sanguine in China. The CSI300 and Hang Seng extended last week’s selloff and sank to new YTD lows, in part catalysed by Moody’s credit rating downgrade (which was fiercely rebutted by Chinese authorities). Commentators then quickly seized the opportunity to contrast the growing rift between India’s roaring stock market and Chinese markets stuck in the doldrums. In Japan, the age-old negative correlation between stocks and the JPY returned to the fore, with equities taking a hit as the yen surged (more on this below).
 
Commodities:
Energy markets continued their tumble following last week’s disappointing OPEC+ cuts announcement and renewed doubts about Chinese demand as the economic situation remains soft. Slight reprieve came on Friday after the US Department of Energy announced plans to purchase 3 million barrels of oil for refilling the Strategic Petroleum Reserve, helping WTI crude close the week above the psychological $70 level.
 
Spot gold kicked off a dramatic week in precious metals, surging to a record high above $2100 in usually-lethargic Asian Monday morning trading, taking out many stop losses along the way. Inflicting even more frustration, the entire surge higher was retraced within the same day by the time Europe opened for trading. While gold managed to hold within a trading range for most of the week, silver continued to slide throughout the trading week before escalating into a full-blown crash on Friday following stronger-than-expected US payrolls, capping off a bruising week down 9%. No doubt the whacky price action in precious metals caught the attention of mainstream media – I recall seeing searches for “gold price” trending on Google.
 
Cryptocurrencies:
Another banner week for crypto as Bitcoin pushed above $44,000. Other large-cap L1s surged to fresh YTD highs (eg. ETH, SOL, AVAX). Mainstream interest in crypto is resurfacing, based on empirical and anecdotal evidence (own observations), and the stars appear to be aligning for a new bull run. Planning to pen my thoughts on crypto if I can find the time.
 
Spot FX:
The US dollar regained some luster this week after a soggy November, gaining ground against most major currencies except the JPY, which saw the largest one-day surge since last December after speculation of an earlier-than-expected BoJ policy normalization following Deputy Governor Himino’s comments that a properly executed exit from negative rates would reap economic benefits. JPY strength was further catalysed by Thursday’s extremely weak 30-year Japanese Government bond auction which saw the biggest tail on record.

Interest Rates:
Front-end rates in major markets largely reversed the previous week’s rally after US NFP, while persistent buying interest in long-dated government bonds kept downward pressure on long-end yields. Japanese Government Bonds (JGBs) were in the spotlight after yields jumped on a ferocious selloff following Himono’s comments and lackluster 30y auction. Notably the selloff in 10Y JGBs opened a rift with 10Y Treasuries, leaving one to muse whether the tail (JGBs) could soon wag the dog (Treasuries) in spurring a reversal of last month’s sharp Treasury rally.

Over in short-term interest rates, markets walked back pricing for a March FOMC cut following a firm employment report on Friday. Rate cut pricing for the European Central Bank (ECB) however remained sticky as markets continued to look through ECB officials’ often half-heated attempts to pushback against cuts pricing.

US inflation breakevens tracked the trajectory of oil prices, bouncing higher after touching the lowest levels in 2 months. In the cross-market space, Australian 10y bonds outperformed their US counterparts, as traders were unimpressed by the neutral tone struck by the Reserve Bank of Australia (RBA), following a softer-than-expected inflation print last week and promptly set about fading what remained of the rate hikes priced for early-2024.

Credit spreads remained priced for a no-landing economic scenario, with high yield spreads continuing to tighten as sentiment remained buoyed into year-end. US CCC spreads (in deep junk territory) continued to tighten from their late-Oct highs.

Volatility:
Reflecting the subdued realized volatility in large-cap US equities, the VIX closed at a new YTD low on Friday. Perhaps another sign of market complacency setting in, S&P500 options skew (as measured by the Nations SkewDex Index) cheapened to a new low this week – hedging tail risk has never been cheaper on a relative basis.

The Week Ahead:
Next week brings a litany of central bank meetings. Among the G10, the Fed, European Central Bank, Bank of England, Norges Bank and the Swiss National Bank are due on Wednesday and Thursday.

US CPI on Tuesday will be closely watched and will likely determine market direction for the remainder of the year. A 3.1% y/y headline reading is expected. A slight miss or in-line print would likely reinforce the notion that inflation has been beaten and rate cuts can now commence in 1H2024, likely sparking another rally into year-end should the Fed maintain its current posture at the following day’s FOMC decision. It would take a large beat on the inflation front to shock markets into reversing the rate cuts priced, given how deeply entrenched the disinflation narrative (albeit well-supported by data) has become.

How Different Asset Classes Could React After US Elections | Analysis & Opinion

The markets hate uncertainty. Going into the US Presidential Elections on Tuesday 8^th November, the financial markets have experienced considerable volatility, affecting nearly every asset class from stocks to bonds to commodities.

Since nobody can claim to have a crystal ball that can predict the election outcome with absolute certainty, investors and traders alike are bracing for more volatility post-elections. We can, at best, guess what could happen to the various asset classes should either candidate win.

Before any analysis is done, I wish to emphasize that I remain neutral on the Presidential Elections and I do no support/endorse any candidate.

A Nail-Biting, Close Race

Given his unpredictability and unorthodox policies, the financial markets have some sort of disdain for Donald Trump, preferring Hillary Clinton instead, who in their eyes largely represents the status quo. It is therefore no surprise that there was a spike in market volatility in recent days as Trump’s standing in the polls gained ground rapidly. While Clinton does appear to lead by a small margin, traders are taking no chances this time, with the memory of the shock Brexit vote still vivid in their minds, they are hedging themselves in or cutting exposure altogether. 

The uncertainty in the run-up to Election Day has bloodied the stock market, with the S&P500 index falling for 9 days consecutively – a phenomenon that has not happened in 36 years. Safe haven gold has also rallied sharply, while the US Dollar sold off. It does appear that the market is already pricing in a Trump victory.

Should Donald Trump clinch the presidency, the current trajectory of the asset classes would be exacerbated for sure, but the duration which it lasts before calm and rationality are restored is anybody’s guess. However, knowing the financial markets behave like a hyperactive kid, attention could quickly turn away from the election result and onto the next big event on the calendar – the OPEC meeting on 30^th November, and again suffer from volatility until that outcome becomes known. 

In the long term, and in the greater scheme of things, the outcome of the elections won’t matter. Long term investors should do nothing but sit tight and at most purchase some downside protection if it helps them sleep better at night. The markets would probably dismiss this event quickly and move on to focus on other things. 

However, if one were a trader/speculator, it would be interesting to know the potential reaction of the markets (and hopefully be able to profit off this risk event). Being inclined to both long term investing and trading, I see no harm in predicting what could happen in either scenario.

Equities

For certain, a Donald Trump win would spark a sharp selloff in stock markets worldwide that may last the week, but not discounting the possibility of upward bounces in the interim. A Clinton win would see a quick relief rally, before the markets forget about the event altogether and then become influenced by other (more exciting) happenings. Given either scenario, the greater directional likelihood is still to the downside, but the extent of the any one day move will not surpass that after the Brexit vote.

S&P 500 (SPX)

The brutal 9-day losing streak has broken through long term resistance-turned support at 2120. A Trump victory could spark a further selloff to challenge support at 2040 (about a 2% drop). However, given that equities have already seen such a long losing streak and technicals point to oversold conditions, the likelihood of a plunge to challenge the extremely critical 2000 level is small. Instead, traders could shrug off the outcome altogether toward the end of the week and equities could see a bounce.

A Clinton win would like turn the trend around, with the S&P heading back to challenge the 2120 level. However, attention could quickly turn to the OPEC meeting and the potential Dec 16 Fed rate hike, which could dent sentiment once again. Not forgetting that the rather solid jobs report on 4^th Nov was neglected by the market obsessed with the election and therefore traders “forgot” to price it in. 

Therefore, the potential upside in the event of a Clinton win would be smaller than the potential downside from a Trump win.

US Pharmaceutical & Biotechnology Companies (IBB)

With Clinton very vocal about clamping down on US pharma and biotech companies, this sector could take a beating rather than rally along with the broader market in the event of a Clinton win. This view appears to be clearly expressed as the ETF tracking NASDAQ biotech companies, IBB, has been falling as of late. 

A Clinton win could see prices fall to challenge long term support at $240. However, a Trump win may not guarantee a rally in IBB as the broader market suffers. This interesting scenario could be exploited in an options play.

US Energy Companies (XLE)

Similarly, with Trump promising to cut down regulations on the energy industry, energy stocks could see a rally should he win. With the SPDR Energy ETF (Ticker: XLE) in a nice uptrend channel since May, going long XLE to potentially profit off a Trump win. A Clinton win could see XLE hold the lower trendline, but any significant move is unlikely as energy stocks would quickly switch to taking direction from news regarding the OPEC meeting.

Straits Times Index (STI)

Our local index has been swinging around aimlessly for most of 2016, and has been stuck in an approximately 100-point trading range since the aftermath of the Brexit vote. Following the worldwide selloff in equities, the market is now converging on critical support at 2790. 

A sharp break through this support level should Trump win would be technically damaging, and further losses could follow. A Clinton win could see a brief relief rally and the resumption of the observed trading range. However, other fundamentals would take centre stage following the elections and thus any long-term effect on the local market seems to be unlikely.

Government Bonds

US Treasuries (US10Y)

While yields on US 10 Year Treasuries have risen, as global bonds selloff in a massive unwinding of what has been a very one-sided trade (long bonds) this year, they have come down in recent days as investors seek shelter in the safety of bonds amidst turbulence in the stock markets. 

A Trump victory could see a flight to safety, pushing down yields to challenge the 1.7% level. However, fundamentals could take over quickly and the direction of yields would take cue from broader happenings. A Clinton victory could see the resumption of rising yields, in light of a likely Fed rate hike in December.

US Yield Curve

Also, in light of a probable rate hike in December, the 2 Year US T-Note (2 year bond) could rise to a smaller extent that the 10 Year, and hence the 2 Year yield would fall less than the 10 Year yield, in the event of a Trump win. This would have an effect of flattening the US yield curve, as the spread (plotted in the chart above) between the 2 and 10 year narrows, in line with the broader trend of a flattening curve and giving off the ominous signal of an impending recession…

Commodities

Gold (XAU/USD)

Needless to mention, safe haven gold would rally in the event of a Trump victory. The anxiety in the run up to elections has already driven spot gold (XAU/USD) to challenge resistance at $1298 and $1307, with gold making a weekly close above the psychologically important $1300 level for the first time since early October. 

A Trump victory would be the much-needed catalyst to push gold firmly above $1300 and even potentially challenge the yearly highs at $1375 in the longer term. However, a Clinton victory could see gold selloff sharply, as traders “suddenly remember” the solid jobs report on 4^th November and how that substantiates a December rate hike. That could quickly drive gold back down to around $1265 by the end of the week.

Crude Oil (WTI)

In a more precarious situation is crude oil, here represented by the US WTI benchmark contract. The sharp selling all week has driven it down to the bottom of the channel, and also into the awaiting arms of converging support levels in the range of $44 to $44.30. A Clinton victory could see oil bounce from this level, fuelling a short covering rally at the same time, and it could end next week in the $47 zone. 

However, a Trump victory could see prices push through support and stop out many long positions, further fuelling the selloff. However, downside momentum is not likely to sustain a drop to $40, as oil would quickly take further direction from the looming OPEC meeting at month end.

Currencies

US Dollar Index (DXY)

After a strong rally in October, the strength of the US Dollar, measured by the US Dollar Index (DXY), has waned in early November, hit by uncertainty over the elections. However, the outlook in the aftermath of the elections looks the most clouded to me. Traditionally, the USD is a safe haven currency and should rally when unfavourable events occur.

Since a Clinton victory is viewed to bode better for the US economy than a Trump victory, the US dollar could technically rise as traders undo the recent losses in relief, as well as turning attention to a possible Dec rate hike, which is a dollar positive event. 

A Trump victory could fuel foreign demand for safe haven US Treasuries that are traded in USD, thereby driving up demand for the USD as well. However, since Trump has signaled protectionist trade policies, which could weaken the USD’s status as the world’s reserve currency, the USD could also fall in response to a Trump victory. To me, the outlook remains the most uncertain for the USD.

“Safe Haven” Currencies (JPY, CHF, EUR)

No doubt, safe haven currencies (Japanese Yen, Swiss Franc and to a lesser extend the Euro) would see large inflows should Trump win, and outflows in the event of a Clinton win. However, in light of the uncertain outcome of the USD highlighted above, safe haven currency pairs with the USD (USD/JPY, USD/CHF, EUR/USD) could experience significant volatility.

Mexican Peso (USD/MXN)

The easiest to predict of all in this binary-outcome event would definitely be the Mexican peso, which is why I saved it for last. With threats to build a wall along the Mexican border and have Mexico pay for it, a Trump presidency is not Mexico-friendly and the Mexican peso would tank severely as a result. Currently, 19.50 seems to hold resistance, with USDMXN unable to break through it, evidenced by the long upper candle wicks. A Trump victory would see this level demolished in no time, with USD/MXN challenging the 20.00 level very likely. 

A Clinton victory would see a sharp relief rally in the Mexican peso, again fuelled by short covering as funds cover their shorts in what has been another crowded one-way trade for 2016. USD/MXN could potentially challenge support at 17.800 in this scenario as peso losses year-to-date come undone.

Fed Dec Rate Hike Probability 

As a side remark I’ll also discuss the Fed rate hike probability for December. Following a rather solid jobs report on Friday, which showed that the economy added 161k jobs in October, the case for December tightening has strengthened, with the Fed Funds futures currently pricing in about 80% possibility of that occurring. 

However, since the Fed is supposed to be apolitical, whatever the result of the Presidential Elections should not influence their decision to hike or not. However, traders may think differently following a Trump victory, causing the implied probability to drop in the short run. I do not expect the probability to move much should Clinton win. Whatever the result, I continue to see a hike in interest rates come December.

Just my two cents.