Talking Points:

Stocks Plunge….Dollar Drops
Yen Crosses Suffer Biggest Single-Day Drop in 7 Months
Euro Rallies Despite Risks Theme, Trades Growing Concerned

Stocks Plunge….Dollar Drops
Fear swept through parts of the global financial market Thursday, generating exceptional volatility for some of the most exposed assets. And yet, in this confidence stumble, the dollar would suffer the indignity of a bearish performance of its own. That is an unusual outcome for FX market’s most renowned reserve currency. Some take this as a sign that benchmark is no longer the safe haven it once was – perhaps because the Fed’s Taper shift is unnerving investors or long-term development issues (such as a persistently rising debt load) are eroding its global standing. However, before we suspect the barometer is faulty, we should first check the actual financial pressure.

Looking to Thursday’s ‘risk aversion’ swell, there were dramatic stories to latch onto and some sharp moves to put the proponents of the buy-and-hold crowd at unease. One of the most visible cracks in confidence was measured in global equities. Stocks from Asia, Europe to the US were awash in red. A benchmark (effigy) for the asset class, the S&P 500 finally broke from a bout of tight congestion and cleared a highly visible trendline that had guided the market higher for three months. Elsewhere, the VIX Volatility Index hits its highest level since the beginning of the year, the carry and stimulus-backed yen crosses tumbled and Treasuries rose. Yet, nowhere was the situation more extreme than in the emerging markets. The MSCI Emerging Market ETF dropped to a four-month low, while the Argentine Peso suffered a dramatic collapse.

There is little doubt that the market fear spanned the broader market, but what is still missing is a sense of depth and persistence. While headlines of the Argentine currency dropping as much as 15 percent – set against the backdrop of record levels of leverage and capital sloshing on the risky side of the pool – draws some early parallels to the 1997 Asian Financial Crisis. The ingredients of extreme risk and narrow exits are there, but the spark may not be definitive enough yet to send the crowds running. In the event that fear builds to panic, the blind demand for liquidity leaves little recourse for money managers other than US Treasuries and money markets. That is the dollar’s underlying appeal. Turning this long bullish investor ride will take a monumental change in confidence (founded in growth, stimulus, capital appreciation). While it is likely to happen, the question is whether the market will do it ahead of next week’s major event risk: the FOMC decision and US 4Q GDP.

Yen Crosses Suffer Biggest Single-Day Drop in 7 Months
On a day of extraordinary headlines and volatility, AUDJPY dropped an incredible 2.1percent Thursday – the biggest single-day decline for the pair in seven months. The Japanese currency is typically bundled into the category of a ‘safe havens’, but – like the dollar – its position on the scale is more nuanced than that simplistic assessment. The yen crosses are carry-based pairs without carry. These crosses have barreled higher as traders have attempted to take advantage of the Bank of Japan’s effort to forcibly drive the local currency lower. Yet, the success of this policy is dependent on low market volatility as relatively little loss on the exchange rate could easily wipe out all carry returns. Seen from this perspective, an ‘expensive’ and low return asset pulling back at early signs of risk is not a surprise. Furthermore, the central bank’s recent stay on policy and their view that current policy is putting them on pace for their targets is lower expectations of the hoped-for QE upgrade.

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Euro Rallies Despite Risks Theme, Trades Growing Concerned
Just as remarkable as the dollar’s slip during this past session’s risk aversion move, the Euro rallied through the period. Though not considered a carry or ‘investment’ currency in the traditional sense, the Euro has certainly earned the title as of late. Where the unit lacks short-term rates, the periphery Eurozone member’s government bonds make for attractive, depressed investment. The constant bid is likely reaching the end of its cycle soon given the drop in yields, but this is likely another area where the market needs to be snapped out of its trance. In the meantime, the strong PMI figures yesterday and the drop in overnight funding rate (EONIA)pressure offered bulls a boost.

British Pound Continues its Drive Higher, 4Q UK GDP Due Next Week
The sterling was another currency that managed to outperform the dollar Thursday, but its performance elsewhere fell more clearly along the lines of ‘risk trends’. Interest rate forecasts that have been reinvigorated by the BoE’s situation with its forward guidance are an appealing compliment to the strong recovery in growth. But what happens if that economic boom cools? The 4Q GDP figures due next week.

Australian Dollar Yield Hopes Faded Quickly
The fourth quarter Australian inflation figures were exactly the kind of numbers that yield-hungry (or depressed-assets that gain on forward rate expectations) traders usually look for. That said, the rebound for the Aussie dollar was remarkably short-lived. The Aussie 10-year government bond yield has dropped to a two-month low alongside the AUDUSD’s three-year low after another China credit warning.

New Zealand Dollar: Make or Break Next Week with RBNZ Decision
The Kiwi has enjoyed an impressive run – as far as the traditional carry currencies can claim – in large part due to the exponential build up of rate hike expectations. The RBNZ has set the market’s expectations with a forecast for 225 bps worth of hikes through 1Q 2016. But when is that first hike? Swaps show traders expect there is a 50 percent chance of a hike next week, but economists are less certain.

Emerging Markets: Argentine Peso Collapses, Generates Stability Fears
Volatile capital flows are one of the Emerging Market’s greatest risks – something we witnessed in practice this past session. The central banks of Argentina and Turkey have had to step in to protect their exchange rates. Where the latter reportedly spent $2.5 billion of its reserves to stabilize its rate, chatter that Argentina had given up (or was running out of funds) led the peso to a 15 percent collapse.

Gold Bulls Rush Drive Metal Above $1,250 as FX Volatility Explodes
Instability in traditional fiat and capital markets is gold’s best fundamental draw. With emerging markets tumbling and volatility readings on the rise, the unloved commodity finally found a strong bid. The 2.2 percent jump was the largest since October 17 was backed by a substantial jump in volatility. Now, the question is whether a rising dollar would offset gold’s alternative asset appeal should the risk aversion drive continue.

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