Last month I wrote about the reaction the market had to the FOMC statement which suggested that QE3 was off the cards. Implied volatility in Fixed Income markets spiked sharply higher and whilst last week's FOMC statement was little different to the March statement, the press conference that Bernanke gave, has led to the risk markets believing that Central Banks will ride to the markets rescue if, as it looks, the global economy slows in the coming quarters.
Bernanke's wish was to see the markets react this way because, it seems, there would be little support inside the FOMC for another round of QE at the moment. His desire was to get the market reaction without the actual QE. I would point to this as the reason why the market relationships are so distorted at the moment. QE is not necessary but is priced in. It has meant that making an investment strategy around the fortunes of the real economy incredibly difficult.
So for instance, whilst US$ Swap curves remain flat, there has been a marked decline in the past month of Implied Volatility and this volatility level has been depressed for most of this year as the implication has been that Central Banks will, if needs be, intervene. I am not so sure that they either have the desire or the firepower.
There is a little justification for a decline in short-dated volatility as the level of historical volatility has fallen to a relatively low level at the moment. But longer dated volatility levels should not fall as much given that at some stage the market has to price in the growing economic uncertainty. In fact it is the growing level of uncertainty that if anything is probably depressing historic volatility as well. Investors are so unsure that they are doing nothing.
Everything is trading in an ever decreasing range. The S&P 500 is stuck in an 80 point range from the beginning of March, and is looking like a 40 point range now. 10yr US Treasury yields are in a 2.10%-1.80% range, whilst Gold is in a $60 range. Most importantly the US$/Euro range is stuck in a $1.30 to $1.35 range. This range is giving the Euro politicians a sense of confidence that they can play with the Fiscal pact that was the original reason why the market became less volatile.
It is this political complacency that has to lead to a break in the Financial markets ranges!
The coming weekend sees the French Presidential election and the Greek parliamentary elections.
The results are very important for the Euro zone but the markets are complacent.
Tension will increase over the coming week leading up to Friday. How can the 10yr OAT trade so well in comparison to other markets. At 132bp over German Bunds it is at the same yield differential as it was at the beginning of the year. And yet here we are with the French Aaa rating from Moody's really under threat.
Whoever wins the French Presidential election the spread to Bunds will surely widen to at least 150bp. if it is Hollande, it could well be 200bp.
But the Greek elections will be just as important. With opinion polls banned in the two weeks prior to the elections, news stories have been limited, but it looks like the pro-EU parties will be unable to form a coalition government. It means that questions over the Greek's EU membership will resurface. That has to place the other peripheral debt markets under pressure.
Financial Credit spreads have narrowed over the past week. The 5yr Financial CDS iTraxx index is currently at +249bp, having fallen from the +270bp seen last Monday. But with the Spanish banks being downgraded following the sovereign downgrade last week by S&P, there has to be more spread widening. And importantly the peripheral banks should see credit curve flattening. BBVA's results last week show that they have used the LTRO to cover all their 2012 and 2013 bond maturities. But 2014 and beyond must come under pressure now. So look for 3yr CDS to rise in coming weeks as the effect of the two LTRO's wanes.
Commodities have also seen a "QE3" induced rally. The correlation between Copper and the S&P 500 has risen over the past month, and out of the commodity group looks the most vulnerable to a decline in the S&P 500. It has already given up today's early gains from optimism about Asian demand, and a re-test of $360/lb is almost inevitable. That would be a 5.5% retrenchment. It would lead to a decline in US Inflation breakevens. We have already seen the TIPs market become less convinced that the QE3 story is strong enough to raise inflation expectations. The 5yr 5yr Forward CPI Swaps have been stable over the past week. It gave support to US Treasury bond yields even in the face of a strengthening equity market last week. Bond investors are definitely not as convinced of the likelihood of QE3 as equity investors. And indeed if QE3 became necessary it could only be at the move to lower nominal yields and much lower inflation breakevens.
A decline in Copper by around 5% has to feed through to bond inflation expectations. I still argue that 5yr US Breakevens are way to high by as much as 30bp currently and 50bp-75bp on a longer term basis.
That alone justifies the current yield level of 10yr US Treasuries and a longer-term decline in breakevens will be the catalyst behind a further decline in 10y US yields.
Similar to Copper, Silver, which shows a higher correlation to the S&P 500 than Gold also looks vulnerable. Gold indeed should start to see a "flight to safety" bid resurface if we see financial stress develop, but Silver given its higher correlation to the equity markets will continue to underperform.
At the moment I would advocate outright shorts in Silver, but if we see Gold fall in the next few days to €1240/toz I would at that level go long Euro Gold against a short in Euro Silver. Silver in $ is stuck in a $30 to $32 range, but I would expect this to be tested early this week. I would look for Silver to fall to at least $28 or about €21.20 to €21.80 depending on the fortunes of the Euro.