MI2 Trader - Correlation Break

8th December 2015

Macro Intelligence 2 Partners LLC is sharing influential reports that we have published throughout our time as an independent macroeconomic research company. 'MI2 Trader - Correlation Break' from 8 December 2015 is the first part of a series that will track our Long - XAG/USD trade over time. Enjoy.

Comment

Last week, the ECB and OPEC delivered tangential body blows to the market forcing many market participants to questions their fundamental assumptions. However, of more immediate concern they also threaten to disrupt market correlations, which into the year end illiquid markets could be particularly destabilising. In particular, we are worried about a break between the dollar and commodity prices, especially oil. Naturally, this seems counter intuitive, because the dollar is the denominator of these markets. However, it is possible for a while if the fundamentals of relative markets can reassert themselves, i.e. demand/supply dynamics force oil lower, while the dollar’s value is driven by ECB disappointment and dominant positioning. For markets used to formulaic behaviour these regime shifts can be volatile and are frequently associated with “risk-off”. Note a close about 1.1053 in EURUSD would be an outside month. Indeed, this spring we saw a very clear example of the disruptive effect of a correlation break, when the assumed relationship between bond and equities was stressed by risk parity and reserve mangers asset disposal. However, along with the potential risks these periods offer significant trading opportunities, especially in FX, where the inherent interplay of two currencies can offer unique payoffs.     

At times like this we frequently find ourselves resorting to the Yen, because it is uniquely positioned to benefit from “disruption” and also enables us to remove the dollar from our trades. In addition, as we discussed in “Japan: The Bigger Picture” (25th Nov), the unwillingness of Japanese authorities to provide more monetary support to the economy ahead of next summer’s election “suggests to us that the biggest risks are on the downside”. 

One cross we have been watching for a while is GBPJPY. Back on the 27th November in “MI2 Trader Acceleration” we flagged the 184.30 as the key level to watch. Thus far, the market has held these levels but if correlations continue to break we could see a meaningful move to 175.

Two other crosses that have potential are CADJPY and AUDJPY. Like the Canadian (EWC) and Australian (EWA) equity ETFs we suggested selling on Monday in “Oil: What could go pop?” they offer a great way to play weak commodities. CADJPY has already broken its key support as BoC dovishness on commodity induced weakness has intensified the pain for CAD longs.

However, AUDJPY has yet to break but is clinging to support here and threatens a resumption of the bigger downtrend.

Another risk-off/commodity trade pair is MXNJPY. While MXN has been hit particularly hard in the last few days MXNJPY has yet to break so offers a potentially great trade on a break of critical support.

While the current risk off moves have been largely triggered by the oil plunge, if we are about to see accelerative Yen strength, the Nikkei is clearly vulnerable. Back in August we caught the break of the diamond pattern (“MI2 Trader: Tactical Risk Reward”) and having bounced it has now rolling over in our target window. It should be sold on a break of the bottom of the box at 19,150-60.

Adding to the potential risks in Japan are the ongoing deflationary pressures in all of Asia, which are epitomised by renewed CNY weakness. We highlighted the potential risks of a break of 6.3850 and since then USDCNY continues to march higher.

Not surprisingly, the ADXY (JPM Asian Currency Index) with China a big component and EM risk getting hit, is again under pressure and now sitting on multi-year support. 

Sticking with EM, we suggested selling EEM back on the 14th October (“A Destructive Bounce”) in the 36.25/50 area. We are still looking for an immediate target of sub 32. However, we are cognisant that is a popular trade and hence vulnerable in broad “risk-off” to a squeeze. Hence, we suggest lowering the stop to 34.60.

Finally, we thought that it was worth pointing out that we’ve had a number of big reversal weeks in various markets including Gold, Silver, DXY, EURUSD and Bobl’s to mention a few. This offers the potential for significant reversals, which will just add to the turbulence and general “risk-off” environment. Precious metals should do well with this backdrop. 

In silver the outside week came just as we were hitting long-term support on the monthly chart. Remember, this is one of our “classic bubbles” but off this trend line at 13.75 we’d be tempted to buy as it could easily have a mini rally towards $20.

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