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August 15, 2016

Looking at recent price action in financial markets, it is easy to find many similarities as to what transpired close to one year ago.  The early summer months produced a low volatility melt-up in global equities and risk-correlated assets, only for participants to be awakened from the summer doldrums by a wash-out in risk appetite as Chinese equity markets plummeted and the yuan devaluation roiled markets.  While the grind lower in the VIX over the last two months poses some similarities to the lead up to the Chinese meltdown of last year, the international financial landscape does appear to have cleared many recent obstacles that could have tripped up investor risk appetite.  The fall-out from the Brexit vote has been well contained and responded to in appropriate fashion by major central banks, while the yuan has continued its rebalancing process of a measured depreciation against the USD and a basket of major currencies, without drawing much negative attention from investors.  That said, while the international landscape appears to be free of any major hurdles at the moment, the known unknowns of how the US presidential election plays out will certainly draw concern from market participants should the race remain tight down the stretch to the finish line, and we would caution that volatility at such depressed levels can act as a breeding ground for market events that might not be apparent at the moment, and consequently require investors to unwind high-yield carry trades.

More broadly, the risk events for the week ahead will help shape the overall investment landscape, though there is likely little that will materially alter the backdrop as it currently stands, and thus it is possible we see the VIX grind lower, inspiring a continued rally in high-yielding instruments.  The incoming economic data for the United States will continue, though we still view the results of the incoming data as an asymmetric risk for dollar price action, with negative prints being exaggerated, and positive data points being overlooked in favour of clearer guidance from the Federal Reserve.  The technical condition of the DXY is one that favours further profiting taking for the greenback linked basket, though it will take a break of the early August low of 95 for a deeper correction.  Retail sales numbers on Friday were disappointing for the bulls, but June’s numbers were revised higher and therefore the net effect was marginal at best.  Effectively, the print wasn’t rough enough to suggest a resumption of economic growth in H2 is in danger of not materializing, though participants will be eyeing the minutes from the last FOMC meeting for clearer direction in the months ahead.  If anything, the upgrading of economic conditions on both a domestic and global scale is likely to lend a hawkish slant to the discussions during the last two-day meeting, particularly given there was also a dissenting vote at the last meeting.  For investors and market participants, it might be beneficial to look past the noise of the minutes the gives strong weight to regional non-voting Fed presidents and instead focus on NY Fed President Dudley’s speech on Thursday.  Time and time again we’ve seen direction of monetary policy modeled by speeches and actions emanating from the troika of Fed leadership which Dudley is a part of, so his prepared remarks along with his Q&A period will be a good guide of how the leadership is leaning, ahead of the Jackson Hole symposium that will be happening later this month, where Janet Yellen will be speaking after skipping the event in 2015.

The recent run-up in the price of hydrocarbons may continue to have legs, if only for technical considerations as opposed to the main driver being changes in fundamental factors.  As my colleague Mr. Schamotta discussed prior to the weekend, the constructive price action in black gold has been spurred by jawboning from the Saudis pertaining to supply cuts in order to address market factors, though we would assign a low probability to any follow through materializing in Algeria when both OPEC and non-OPEC members meet.  Iran still doesn’t appear to be in a position to adhere to any supply cuts while they are continuing to ramp up production to pre-sanction levels, while at the same time, other members of OPEC are hitting record production numbers in an effort to provide incremental cash-flows to insulate dreadful fiscal deficits that have been materializing given the stubbornly low price of oil.  The recent developments are in-line with our thoughts that oil will likely continue to trade within a range of prices throughout the balance of 2016; as anything above $50 elicits fresh capital and otherwise unprofitable taps being turned back on and fresh supply driving prices back down, while south of $35 will defer US production and help chew through some of the overhanging supply that will need to be utilized before oil prices can generate a more realistic and sustainable recovery.  The open interest in futures contracts has surpassed the previous month’s front contract, so in the near-term, a continuation of short-covering could help the constructive technical picture improve further.

It is possible the yen could help arrest the negative tone the greenback ended last week on, as the currently overvalued state (as per OECD models) may be running out of gas given the domestic economic situation.  The Bank of Japan underwhelmed market participants at their last monetary policy meeting, though expectations are that further adjustments to policy will be required as soon as the next meeting, where a review of overall monetary policy has been promised.  The market has illustrated to policy makers in Japan that small tweaks to policy are insufficient to meaningfully tackle the problem of slow growth and inflation, so it will be interesting to see if a bazooka-like situation is waiting in the wings for the next meeting.  The domestic economic situation would support additional stimulus, given second quarter GDP was flat on a quarter over quarter basis, below what analysts had been predicting, and only able to manage a 0.2% increase when annualized, well below the 0.7% that had been forecast.  The new fiscal spending plan will unlikely be able to materially address this period of stubbornly slow growth, and thus we expect the BoJ will have to respond alongside what Abe has already announced – the issue will be if the bazooka is pulled out or what is presented amounts to what the market thinks is a pea-shooter.  While the price action of the yen has been confusing at best of times over the past year, there is the potential to see volatility increase in the pair, influencing other crosses and overall market risk appetite, as policy makers experiment with monetary policy in order to try and tackle a challenging economic environment.


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