The Ides of March Have Passed, but Volatility is Nowhere in Sight… For Now

Tom Cleveland

The Ides of March have come and gone without much fanfare, and now it’s time to toast St. Patrick’s Day, or is it? The Fed may have raised rates as expected, and the Dutch may have dodged another populist bullet, but volatility remains subdued. Whatever happened to the swell of chaos that was supposed to roil its way through our foreign exchange markets and create trading opportunities for all involved? Where is that tsunami that everyone expected to appear on the horizon?

Financial markets have remained calm, trading within very tight ranges. The USD Index burped at another 25-basis point hike and then promptly “sold-on-the-news”, as many had predicted, falling from 102 down to 100 where it rests today. The VIX, the generally accepted measure for market chaos and uncertainty, barely budged, choosing to stay within its 11 to 12 range, as it has for all of 2017. It did blast above 24 last November, but it has chosen dormancy over dynamism in quite a departure from what the analyst community had been expecting. The G20 meeting will end on Saturday, but so far, no great shakes are emanating from that maddening throng either.

The word on the street is that sooner or later market sentiment has got to give way to fundamental reality. In other words, gravity does not just disappear forever. What goes up will eventually come down. The fall may come swiftly, as many profess, or like a slow drip, but it will come. Whether it is a death spiral or a minor correction is to be determined at a later date, but the guessing game has begun in earnest. In order to reach a credible conclusion, however, analysts are fixating on the reasons for the boring calm that is and then modifying the prevailing narrative of how things will play out. Once again, uncertainty is having a field day playing with people’s minds. These times, they are certainly different, and that supposition can mess with even the best storyline.

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Why did the U.S. Dollar “Sell-on-the-news”?

The Fed has spoken. Yes, it raised its benchmark rate guideline by 25 basis points, but the Dollar actually fell on the news and stocks rallied, a rather odd response for the uninformed. In fact, the USD Index for this week may post its largest weekly decline since election results back in November. It would appear that investors may have run up the Dollar prior to March in anticipation of a Fed increase, only to take profits after momentum had died. The Euro, the Pound, and the Yen have appreciated for the month to the tune of 200, 130, and 90 pips respectively. Even the Aussie bounced up 60 pips.

Why the odd reaction? Independent of the Fed, fundamentals are improving in other markets. Mario Draghi, the head of the ECB, claimed that deflation in Europe was no longer a problem. The ECB did not change rates in the EU, nor did the BoE in the UK, but the apparent conclusion was that the gap is closing between competing economies. As for the Yen, it had materially appreciated nearly 300 pips in just the past week alone, a sign of declining risk tolerance within the investment community. It is important to remember, as one analyst put it, “People do not move to safe haven assets when “stuff” hits the fan. They move to safe haven assets when they do not want to deal with a high degree of risk.” Are investors sensing an imminent pullback in equity valuations?

What is going on behind the scenes with the four major currencies?

In each case, the greenback had already had a good appreciation run versus the Euro, Pound, and Yen a few weeks prior to the critical FOMC meeting, a sign that investors were a little more confident in their consensus judgment on whether the Fed would actually take action in March. The script had read differently back in January, when analysts were not buying into the Fed’s proclaimed timetable for interest rate normalization. The market was expecting moves to be delayed until June and beyond, but a mild winter led to employment gains and a sense that the time was now right.

The lack of volatility in the currency arena, however, has caused consternation in our sector. Experts point to central banking policy as the culprit, arguing that artificial controls are preventing capital flows from moving expeditiously. As one insider put it, “Currencies are trading in a false paradigm in that they have been sheltered from the storm of volatility by existing in a rather closed system. Wealth is contained within this system of fiat money by laws and rules that discourage freedom of movement. It is the coordinated collusion of the major central banks that has allowed this charade to exist.”

Charade or not, the U.S. Dollar still reigns supreme as the world’s leading reserve holding currency, as demonstrated in the following diagram:

CB Reserve Holdings

USD reserve holdings are nearly double those for Euros, Pounds, and Yen combined. If there is to be a paradigm shift, it would most likely favor the Dollar in all due respects, but for different reasons across the board. Here is the current thinking for each major pair going forward.

The “EUR/USD” – To parity or not to parity, that is the question?

Europe continues to under perform, but is always hopeful that a strong recovery is just around the corner, enough so to move Mario Draghi to wax eloquently that he “no longer has a sense of urgency in taking further actions prompted by the risk of deflation.” After that positive note, he had to admit that all other monetary matters remained unchanged, including a negative interest rate of 40 basis points. The narrative for the EU, however, remains clouded due to impending elections. The Dutch may have avoided a problem, but France and Germany are next. We may see the Euro move higher, as optimism rises and as exports rebound in response to a strong U.S. Dollar.

What are the longer-term prospects for the Euro? Most analysts believe that, “The path of least resistance is lower.” Unemployment remains high and there is still no mechanism for revenue sharing between richer northern states and their poorer southern neighbors. The Dollar is fundamentally stronger for several reasons, leading one analyst to state the obvious: “The long-term trend in the euro is lower. Politics could make the euro move within its trading range in the weeks and months ahead, and we may see lots of volatility. However, the trend is lower, and I expect the euro to work its way to parity and beyond against the dollar.”

The “GBP/USD” – As with a Shakespearian play, the “Brexit” must go on.

The Pound has been bouncing between 1.20 and 1.28 since last October. It rests presently at the mean, 1.24. Prime Minister Theresa May has covered her Parliamentary bases, such that exit papers may be filed in Brussels by the end of the month. The Scots are not happy. They voted to stay in the EU, but now may be emboldened to proceed again with independence efforts. Political parties in the UK are also in disarray, which will not help matters or ensure stability for May or her comrades.

The stage will then soon be set for a lengthy round of caustic negotiations, as the Brits attempt to retain advantages, while EU officials play hard ball in order to send a clear message to other member states considering secession at the moment. The prevailing opinion for the road ahead: “The value of the pound will give us a scorecard on how market participants believe that the negotiations are going. Uncertainty implies volatility – and so one might expect some pretty interesting movements based upon current events.” Expectations, however, are for a downward trend over time.

The “USD/JPY” – When is a safe haven not a safe haven?

Of the four majors, the Yen has demonstrated remarkable stability during 2017. Its value to the Dollar has been confined to the 112 to 115 range, while it closed the week at 112.7. Investors generally perceive the Yen to be a safe-haven currency and flock to it when uncertainty is in the air. The Japanese economy, however, has flirted with recession for decades, leading one to question why the Yen is so revered? The reality is that the strength of the Yen does not depend on the Japanese economy, as strange as that may sound. Over the years, Japan’s export trade has created enormous current account surpluses, making it the largest creditor nation on the planet.

The BoJ and government officials have done their best to weaken the Yen since mid-2016 while committing to a low-interest rate policy, efforts designed to stimulate exports and the local economy. The result of these actions has moved the “USD/JPY” pair from 100 to its present valuation, thereby creating a critical 38.2 Fibonacci floor at 111.5. A close watch on this key value is advised: “If USD/JPY breaks below support around 111.50, then that would indicate that investors are starting to lose their appetite for risk. Given that the markets are already overvalued, that would indicate an increased chance of a correction.”

Will the G20 meeting have any major impact on capital flows?

The first G20 meeting of the Trump Era concluded Saturday with measured trepidation. Treasury Secretary, Steven Mnuchin, made his debut, literally trumpeting the “America First” theme and refusing to acknowledge previous commitments of the group to reject protectionism and deal with climate change on a coordinated basis. His general position was that the United States was all for “free and fair” trade that was balanced, but the tension among the attendees was palpable. Germany and China have been frequent targets of the Trump administration, and attending financial ministers sensed a severe break in U.S. economic policy.

International trade agreements and cooperation will suffer as a consequence, amidst a backdrop of ballooning central banking balance sheets across the globe. The chart below depicts how far global monetary policy has put us out on a limb:

Central Bank Balance Sheets
One thing is certain – volatility in our currency markets will only destabilize the global economy. At some point, the above trend must be reversed, but how, when, and at what cost? Are we back to questioning the pull of gravity again?

Concluding Remarks

The Trump Era is upon us, and volatility in our financial markets, especially in foreign exchange, has been held at bay, but for how long? Uncertainty has not dissipated, but the prevailing narrative is sensing a major decision point down the road. Stay cautious!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Tom Cleveland
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