The Daily Fix - The Fed put a floor under its liquidity regime


Pepperstone Representative
The market went into the FOMC meeting expecting a snoozefest, where USDJPY overnight implied volatility, if we use this as a proxy, sat around 9% through European trade and if we genuinely felt the FOMC meet was to be a volatility (vol) event it would be closer to 12%. The same can be said in AUDJPY overnight vol which refuses to push above 10% despite China’s Q1 data clearly going to take a hit from the reduction in consumer activity, fallout in confidence and a refocus of supply chains – 10% being a level I feel defines sentiment in FX, where a push through here would indicate FX markets, and even asset classes like equities, bonds and credit may start to see more pronounced moves in price.

The fact is, vols has fallen a touch thanks again to the Fed, and ironically Fed chair Powell, even touched on the idea that the Fed weren’t directly trying to suppress volatility in money markets. Perhaps directly no, but the Fed’s balance sheet expansion, subsequent increases in excess reserves, along with a widely held belief that any rapid tightening of financial conditions will be met with a show of defiance - with interest rate cuts, yield caps, or increased liquidity conditions, has been a strong contributor to record low vol seen in FX markets, and subdued vol in fixed income and equities too.

Tweaks to IOER and its liquidity timetable

The Fed did lift IOER (interest earned on excess reserves) by 5bp to 1.60%. This was a point of contention for interest rate traders, who were divided on whether they would lift IOER at this meeting or in the months ahead. Outside of rates markets, this hike mattered little for price discovery, other than it would lift the Fed funds effective rate into the middle of their fed fund target band of 1.50% to 1.75% and allow flexibility should we see excess reserves (in the banking system) grow from current levels of $1.535t into/and above $1.7t, which would have the effect of lowering the fed funds effective rate towards the 1.50% lower bounds of the FF range.

The Fed have detailed that they will remain in the market offering repo and T-bill purchases (currently running at $6ob p/m) through to Q2, which, in turn, could be the catalyst for excess reserves to lift through $1.7t. So, when they decide to phase out/taper the program, there should be enough liquidity in the system to hold above the floor of $1.5t – a new defined level Powell has now introduced.

Introducing this floor is important, it shows Powell is clearly cognisant that the equity and credit traders have bid up risk, pushing equities to all-time highs and reducing vol in correlation with it balance sheet and increased excess reserves. So, he is concerned that any reduction here, as they phase out the program, will work against the markets, causing traders to close short vol positions (such as VIX futures) and out of equities.

(Red - S&P500, yellow - Fed's balance sheet, white - excess reserves)


A dovish turn on inflation

We also heard that the Fed “are not comfortable with inflation running persistently below our 2% objective”, and that read as dovish to market participants. While there are many other comments to consider, these on inflation caused the reaction with rates traders buying into January fed funds and eurodollar futures, subsequently increasing rate cut expectations for year-end by 4.5bp. We see 1.6 rate cuts now priced by December, up from 1.2 cuts.

US 2-year Treasury yields are 5bp lower on the day, and 3bp lower since the Fed meeting, with all parts of the Treasury curve lower by 5 to 8bp. Real (inflation-adjusted) yields are lower, and we see 10-year real yields turning decidedly negative at -5.5bp, with 5s -18bp and it interests me that gold is only up 0.7% given we are seeing US yield curve inversion and ever deeper negative real yields. AUD-denominated gold looks the better trade and we eye new all-time highs here.

USDJPY has lost small ground on the moves in US bonds and rates and once again looks to test the 109-handle, with solid two-way flow in USDCHF, with increased buying into 0.9730. Flip onto the daily though and see the pinbar (see below) looking ominously in play. EM FX has seen a mixed fare and perhaps hasn’t seen the buying one would expect given we’ve seen a Fed happy to keep liquidity in check and offering a slight dovish turn on inflation. I guess we still have the 2019-nCov to work through and the economic overhang that will require the PBoC to go hard on liquidity to keep hibor and shibor in check and allow efficient access to working capital for Chinese businesses.


US equities have closed down a touch, although all the action is taking place post-market with Facebook and Tesla reporting. The market has treated these names very differently, with Tesla currently up 6% in the post-market trade, while Facebook is lower by the same amount. Not sure this help NASDAQ futures too greatly though. We see the lead in for Asian equities as somewhat soggy, but I’d expect the ASX 200, Hang Seng and Nikkei 225 to open modestly lower.


Pepperstone Representative
The scene has been set for a solid drop in Asian equities on the open, with the ASX 200 likely to fall some 100-odd points, while the Nikkei 225 is likely to unwind -2% lower. Hong Kong should fare somewhat better, but the variance will be dictated to by mainland equity moves today.

The big unknown, of course, is how China's financial markets trades and ultimately respond to a show of force from the PBoC who have injected $174b into the financial system through reverse repo, and while much of this will be used to cover a chunk of short-term maturities, the net effect is $21.7b massaged into the financial system. There will be some focus then on shibor and Chinese rates market, although for those who can’t see this then USDCNH is our best guide, although it's unclear how this trades as textbook theory would suggest liquidity is bad news for the yuan. However, in this case, any news that is beneficial to the Chinese economy may indeed strengthen the Chinese currency and that seems to be the case with USDCNH trading a touch lower in interbank FX trade.

For those watching the yuan, do consider the daily CNY mid-point fixing at 12:15aedt, which could offer some good insights. While any news of cuts to Reserve Ratio Requirements (RRR) or the reduction of various instruments used through their open market operations could be well received.

If we look at moves in AUDJPY in early interbank trade, we see small gains here suggesting the market is somewhat enthused by actions from the PBoC, as sideways in this cross is in many ways the new up, given the horrible price action of late. The moves in AUDJPY also suggest S&P 500 futures may open on a stable note, although, I’d be waiting for clarity from mainland China, as the tape here will spill over into sentiment more broadly.

(Red - S&P 500 futures, white - AUDJPY)

(Source: Bloomberg)

So, we watch the re-open of the Chinese equity markets which falls somewhat inconveniently around the third quarter of the Superbowl. One guide that has been widely used has been the 7.3% net percentage change in the A50 futures index from the close of the CSI 300 and Shanghai Composite cash market close on 23 January (18:00 aedt), which has led us to believe the mainland equity markets will be taken to the woodshed on open at 12:15aedt, with the bond market another guide, opening 30 minutes earlier. That said, we know the Chinese authorities have curbed short selling, which is an act of desperation in any jurisdiction, while there seems to be a strong risk we will see the powers that be look instruct local banks to support the equity market.

(Orange - A50 futures, white - CSI 300)

The fact the China Securities Regulatory Commission (CSRC) have detailed they see the impact of the Coronavirus as “short-lived” is designed to instil confidence. Whether the market feeds off this optimism is another thing given the spread of the virus is still in its exponential stage, and worryingly we have seen the first death outside of China, amid the multitude of countries imposing travel restricting to and from China. There is still such little clarity on the fallout on China’s economy, although we know its going to be brutal and traders naturally are sensing an inevitable fallout in activity in China's key trade partners.

Hedging flows are all the rage

There has been sizeable hedging activity playing out, not just traders closing core equity positions, or selling copper and crude, or hitting the bid on JPY, CHF and US Treasury’s. But in the volatility space, there has been decent interest in the VIX futures, with the VIX index closing at 18.84%, with solid buying S&P 500 25-delta 1-month puts, where the implied volatility has risen from 20% - the highest since October. If we look at the skew of 1-month 25-delta calls minus puts, we see this sits at a 7 vol differential, which is close to 2 standard deviations (of the five-year range) and shows the demand for put volatility over calls is reaching extremes and a solid guide to semantics.

We can look at the S&P 500 put/call ratio which sits at 1.03, where moves above 1 generally don’t last long.

Central banks expected to act soon

Another aspect I am watching closely is the reaction in the rates markets to the tightening of financial conditions. We have the RBA meeting tomorrow and it would be a huge surprise if they moved on rates, and for those looking to sell AUD, my trade is to hold off, ideally using any strength to sell into before governor Lowe’s speech on Wednesday (12:30aedt). However, while we may not see a move tomorrow, a cut in the March RBA meeting is a coin toss at 48% and one suspects it will just north of 50% later today and things then become interesting. The fact we see a 66% chance of an April cut suggests that the RBA is poised to move and we step closer to Aussie QE.

In the US, a cut at the April FOMC meeting is priced at 58%, with a cut now fully discounted by July. We also see two cuts priced through the end-of 2020, up from one at the start of the week. The market is once again expecting central banks to resume their easing cycle, and it makes sense to believe Canadian rates will respond after the recent dovish turn from the BoC, where the probability of a cut in the March meeting sits at 27%.