Risk-on, risk-off tops the agenda again

The equity market’s fresh weakness has traders on edge again, especially as the bounce from last week’s ugly sell-off hasn’t taken the market back into a more technically neutral territory. The 200-day moving average in the S&P 500 looms large again after another touch yesterday and the pivot low from last week’s sell-off needs to hold on today’s close to keep the bears at bay here. We’ll rinse and repeat last week’s warning about closing on an ugly low on a Friday potentially making for very rocky market conditions early next week.

Let’s recall the February sell-off in equities for comparison, as it was a very different animal than this latest weakness in risk appetite. Back then, the correction came only after a parabolic acceleration to the upside. The selling was even more brutal, but quickly found a low that was revisited only several weeks later after a powerful initial bounce and a volatile consolidation period. This time around, the first multi-day bounce attempt has been weaker and suddenly we find ourselves testing lower once again. 

In FX, the reaction to all of the above still feels muted, and we credit a large degree of that to the two things. First, the equity market weakness may be linked to a decline in the negative correlation in equity and bond markets as we note that the latter are providing no real haven status on this selling down of risky assets. Second, all eyes remain on the USDCNY rate and whether China will choose to defend the floor in the renminbi, possibly keeping volatility suppressed until we see the price action veer strongly in either direction.

Still, yesterday’s fresh equity market volatility did show the patterns we normally expect when risk appetite sours, with the JPY and USD catching a bid and emerging market currencies finally wilting as a group. 

The euro is under fresh pressure from Italy’s budget setting process as the EU has roundly rejected the proposed budget and says the deficit must come in below 2.4%. Italian BTPs were heavily offered again, with the 10-year yield closing at a high for the cycle north of 350 basis points yesterday. The EU approach seems to be one of forcing. For perspective, a weighted average of the yields for BTPs that need to be rolled over in 2019 is around 2.7% (this does not count the new issuance necessary to fund the deficit), and sovereign funding at these levels and even higher is possible, but as yields rise, the focus will intensify on Italian banks.

The situation is untenable – which side will blink? I would have thought at some point Italy’s populists would compromise just enough to ram some half-measures through this year and then pick up the fight again next year, post-EU parliament elections that the Lega’s Salvini will cement a rising populist wave. Either way, max pressure on the euro for now as long as Italian yields continue to rise and maximum two-way headline risk.

Chart: EURUSD - weekly

EURUSD is finding more separation from the 1.1500 area and momentum is building for a retest of the 1.1300 area, which is unlikely to hold if we continue to see a stand-off over the Italian budget situation and an ugly intensification of that crisis could see the pair testing into the 1.1200-1.1000 area. Note the important 61.8% Fibo retracement level at 1.1187.