Pegging and Negging

So that US holiday appears to have just been a pause for breath before the selling resumed. Yet again we are unable to move for the weight of negative headlines. Negging, by the way, is the act of undermining someone’s self-confidence with enough negative comments that they become grateful for any scrap of solace. At some point this market will have broken people enough to reach that base, but we are not there yet. Too many people are still saying “there’s value in emerging markets at these levels”, even as these same people think there is more volatility in FX than equities, and that the world is going to hell in a handcart now the Bank of England might even CUT rates this year. None of these stories yet adds up. Lower for longer used to be the green light for more equity investment; now it’s a sign of a recession. The volatility is actually in equities and not much else. Some emerging markets may look valuable even as pegged regimes appear to be about to bust. What’s going on?

1. Equity markets can go down as well as up, even without an economic recession

S&P losses without recession

The key point about this list is that some of the losses were part of a broader financial markets meltdown (1987, 1998, 2011), even as they were not part of an economic crisis.

2. Risk indicators are flashing red, but contagion is relatively contained

Here’s Citibank’s Macro Risk Index, which shows we are getting up towards the big risk averse periods of the past ten years…

Macro Risk Index

But on Blondemoney’s risk measures, it is really only equities that have seen a significant increase in implied volatility – the green line for FX vol and the lower lines for Bond and Swaptions vols, remain stable:

Cross asset vol 20 Jan

3. But make no mistake, tectonic plates are shifting

Some of the longest standing pegged currency regimes in the world are now under historically extreme amounts of pressure. Here’s a chart of the forward points on the Saudi Riyal and the Hong Kong Dollar:

peg 12mth points

The responses from the authorities? The Hong Kong Finance Minister has said USD/HKD will likely hit the other side of its band at 7.8500. So far, so relaxed. The Saudis have now decided that all the people trying to speculate against the SAR in the option market will soon find those options to be worthless, by preventing anyone from trading them – see Bloomberg article that a loyal Blondemoney reader flagged up.

Will the authorities succeed? For now, perhaps, but a peg is just an accident waiting to happen, as the SNB found out to their cost last year (check out the SNB’s accounts for 2015, recording a loss of 5% of GDP!). Hong Kong may have to introduce some flexibility, just as mainland China has; while the Saudis may struggle to keep their eye on their currency even as their economy strains domestic political tensions.

Adding it all up…..

Tensions on pegs + equity market volatility + unfounded macro fears = a good old fashioned market correction. A proper one, not a flash crash. Not Bobby’s Dream, but a genuine shakedown. And so we should be, as the sands shift beneath us. The question is whether the policy makers keep fighting the last war (volatility = bad = deflation fears = bad = lower for longer) and if so whether they run the risk of a severe credibility breakdown. Which would be even worse.

 

 

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