It’s probably safe to say that there’s now a palpable sense of anxiety hanging over global markets.
We previewed the flight to safety here yesterday, noting that Brexit risk was driving investors into supposedly “riskless” assets and haven currencies. Currencies like the yen, which is trying pretty hard to press towards 100, creating a rather tricky situation for the Bank of Japan which, like the Fed, meets this week.
Yen strength on Monday left a trail of destruction across Asian markets and the pain spilled over into Europe and, eventually, to the US where the VIX spiked 23%.
On Tuesday it was more of the same. The headline grabber was the 10Y German bund, the yield on which dipped below zero for the first time in history.
(Chart: Bloomberg)
Japanese yields fell to fresh lows as well with JGB 10s touching -0.185 at one point. “In a clear sign the yield plunge was driven by a flight to safety, rather than expectations of BoJ easing, the yen was trading higher at ¥105.9 to the dollar,” FT correctly notes.
That’s an important point and it serves to underscore what we’ve discussed here at length over the past several weeks. The BoJ needs to weaken the yen, but market jitters continue to effectively put a floor under the currency.
When you see yields on Japanese government bonds drop to fresh lows two days ahead of a BoJ meeting, you might be tempted to think it’s traders frontrunning the central bank - until you look at what the yen did overnight. Recall, however, what we’ve said recently about the correlation between the yen and US stocks: when one is down, the other tends to be up and vice versa, as carry gets going or unwinds. That’s why it’s always funny to watch the yen right when US stocks open. Zooming in on Tuesday’s chart we get this:
You can begin to see how this is all connected. It’s just ebb and flow. Interconnected global liquidity moving from market to market, asset to asset, depending on the headlines. It’s actually very predictable. Until it’s not, that is.
And speaking of headlines, the threat that “the British are leaving” (so to speak) is what’s driving the safe haven flows. Here’s Bloomberg:
“The NumberCruncherPolitics estimate of the probability of a Brexit surged to 32.6 percent on Monday from 23.7 percent and Oddschecker’s survey of bookmakers’ implied probabilities rose to 42.5 percent on Tuesday morning. ‘The momentum is such that it seems inevitable Brexit will be the favorite by the weekend,’ said William Hill Plc spokesman Graham Sharpe.”
As you might imagine, that’s weighing on the British pound (no pun intended). “Short positioning in the currency is now the highest amongst all G-10 peers, as demand intensified this week,” a London trader told Bloomberg. Here’s a chart from Deutsche:
And here’s a table from Citi which outlines important events to watch in the lead up to the referendum:
Ok, so what does this mean for US equities traders? Well, frankly, it means you’re staring down a potentially historic political split the consequences of which are impossible to know ahead of time. That probably means you need to prepare yourself for increased volatility.
It likely also means they’ll be more days like Monday and Tuesday coming up. That is, more days where risk has trouble catching a bid and safe havens see inflows.
There are two things to beware of as we head into the Fed tomorrow, the BoJ on Thursday, and the UK referendum next week.
First, you should watch the 10Y German bund yield. It’s one of those things that you might not be used to checking, but if it overshoots to the downside it can snap back violently and trigger a VaR shock like we saw last summer. That could wreak all kinds of havoc on global markets.
Second, watch the yen. If the Fed stays on hold and the BoJ doesn’t ease, there could be a whole lot of appreciation pressure. If you see it pushing through 105 towards 100 we might see an intervention from Japan.
Trade accordingly.