Market Insights

The UK General Election is upon us

Here we are then. The Day of Reckoning. Is Theresa May about to pull off the most audacious political victory of recent times, delivering the Conservative Party their biggest majority in 30 years? Or will it go down in history as the greatest miscalculation of the political mood since James Callaghan tried to portray the winter of discontent as not much of a crisis?

More importantly for those of you from around the world, what will the market impact be?
At first sight, it would appear the market couldn’t give two figs about this election. Here’s where implied 1 week GBP/USD volatility is trading:

You can see the previous spikes, starting with the Scotland referendum, then the 2015 election, then the massive panic over Brexit, followed by quite frankly a very pathetic attempt at a spike right now.

This can mean one of various things:

  1. No one cares at all about the election as it’s not going to change anything
  2. The result is entirely predictable
  3. Positions are so light that no-one is using the options market to hedge them, or indeed to leverage up and speculate on the path of GBP
  4. Absolute volatility levels are low, so the spike might not look like much, but relative to general volatility levels it’s still decent

Most likely, all of the above are true. If so then point 3) becomes curious. If it’s a very predictable result then why not bet on it? A slam dunk at 100-1 on still returns £1 for every £100 bet. Equally curious is that if 1 + 2 are true, then there should be no spike at all, rendering point 4) irrelevant.

When this kind of internal logic fails, it’s a sure sign that the market isn’t functioning at a rational equilibrium. The reality is that overall volatility is so low that it’s not worth taking a risk on anything. In this environment, “Buy the Dip” is the only risk to take, because basically the market has decided that it isn’t a risk at all. After all, 3 weeks after the Brexit vote, stock markets rallied. The same thing happened within hours of Trump’s victory. For the Italian referendum, minutes. Then for the French Presidential election, it happened a week before the final 2nd round vote was done. Markets have decided that if political risk exists, it’s a darn fine time to perfect the successful central-bank-mandated Pavlovian strategy of the past 8 years: buy all dips in risky assets.

And yet. Everyone also knows that event risks can create binary and extreme outcomes. Fortunes were made and lost on June 23rd last year. So why not take a punt this time around? At the very least, consider EUR/GBP volatility. Whatever happens in the next 24 hours, someone is going to sit at the big round Brexit negotiation table in 10 days’ time. That’s going to have a pretty big impact on the price of both European and UK assets. But no, the 1 month implied volatility there is near the lows of the past 4 years:

In fact, right now it’s more expensive to buy GBP/USD 1 month volatility than EUR/GBP! Which seems odd, given that there is some specific event risk within Europe, rather than the US, during this initial Brexit negotiation period. Here’s the spread of the two volatility pairs:

So, no-one is punting. That suggests, rather than the vote being entirely predictable, it is in fact entirely unpredictable. Which rather blows up the first two points in the list above. People do care, but it’s so difficult to price it that it is being ignored. The market remains ostrich-like, head-in-sand, over the outlook for political risk. Partly this is because so far it hasn’t disrupted the Buy The Dip narrative; partly because it’s so difficult to price that it is not worth bothering with. The irony is that being unable to price something doesn’t mean that it has no price. Hence why there is a spike in those GBP volatilities – just for protection’s sake eh?

The market gropes around for something quantitative to hold its hat on, hence the interest in the polls. But then, oh dear, the pollsters tried to develop their models further, and we ended up with such a broad range of outcomes that they also started to become irrelevant. And why are their models so different? Because the electorate is so unpredictable. How do we know who will turn out? The polls which have a small lead for the Conservatives tend to overweight the youth vote, which is overwhelmingly pro-Labour. There were a significant proportion of young voters in the last minute voter registrations for this election:

Blondemoney will not make a prediction on the outcome. But we can say with some certainty that market risk is failing to take into account the upcoming Brexit negotiations, and how tricky they might be for whoever wins this election. Neither party has had a good campaign, and Theresa May has been politically wounded. It’s not fatal, but it’s not a good start. If she fails to get the 80+ majority, the other side of the negotiating table will know:
1) She gambled and failed – suggesting she raises the stakes at the wrong moment
2) She couldn’t unify the country– suggesting the court of public opinion is flexible
3) She couldn’t unify her party – suggesting she misjudges her political capital

Of course, she may very well get the landslide. But even if she does, for each of the EU, US, and the UK, political risks are not something to be ignored. When the market puts its head in the sand, it’s usually time to look out for the lions on the horizon.

Now, if you haven’t done so already – VOTE !!!

Remember the ECB?

There’s a lot happening tomorrow, from the UK election to Comey’s testimony, so let’s spare a thought now for the ECB. (Particularly as Comey is expected to stop short of saying whether Trump obstructed justice, as reported overnight, and that the UK polls have become almost entirely irrelevant through their variation). The market doesn’t seem that interested in the ECB, with overnight EUR/USD volatility pricing a move of only ~75 USD pips. Yet it’s more than likely that Draghi will have to use this meeting to offer something to the hawks, not least with only 3 months (and 2 more monetary policy ECB meetings after this one) to go until the German election.

The hawks have reason to be bullish. Eurozone inflation expectations are steady but not stellar, while the PMIs are booming:

Meanwhile, Draghi’s second line of the statement has read as follows for a while:

We continue to expect [interest rates] to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases

You would have to imagine that the hawks would like to remove the words “or lower levels”, as well as “extended period”, and then do something about the expression “well past the horizon”. In other words, expect the first lines of the statement to be significantly amended.

After all, this is what has happened to German inflation ever since the rubicon to QE was crossed in January 2015:

The plunge in the oil price kept it in the depths for a while longer but there is no mistaking that lovely rally up to the 2% point over the past year. Meanwhile German 2 year yields headed ever further into negative territory. Negative interest rates and QE were already leading the German press to scream at the ECB at the beginning of this year, with headlines running from “Raise Rates Now” to “Change Course Mr. Draghi!”. What will they think now that the inflation target has been reached even as the 2 year yield almost hit -1%?

Of course, the ECB create monetary policy for all the Eurozone members, not just Germany. But then not every Eurozone member has a significant election taking place, is one of the biggest economies in the Eurozone, and is facing an existential battle with Britain leaving the EU. It’s no surprise that the next ECB President is expected finally to be a German, after Dutch, French and now Italian incumbents.

Yet we can always rely upon ECB press conference days to take the Euro in directions different from what might be expected. And so it may prove tomorrow, with the market apparently quite long of Euros. The IMM positions are the longest in several years:

One loyal BM reader has pointed out that IMM positions are growing because the open interest on the IMM is growing, so we have to be careful in reading too much from the history of such charts (unless you’d like me to Z score it, but I haven’t had my cup of tea yet…). The fact remains however that the Euro has rallied against almost all currencies since the French Presidential Election was concluded on 7th May:

The winners against the Euro have been the bigger carry currencies although not, somewhat bizarrely the Japanese Yen. Until Friday the yen was also a loser against the Euro, but that has shifted in the past couple of days. Perhaps some of the ECB related “Buy rumour/sell fact” is happening ahead of the event. (If markets keep discounting themselves like this, we’ll be taking off positions before we’ve even put them on…!!)

There are other events tomorrow though, and part of the reason for the yen’s rally is the decline in US interest rates. With Japanese yields stuck due to the BOJ’s Spanx-like Yield Curve Control policy, USD/JPY moves lower as US rates move lower. So with the world now looking rather skewed towards risk-on once again, what with higher stocks, easier financial conditions, and low implied volatility, it’s worth keeping an eye on the downside in EUR/JPY. We had a gap after the first round of the French Presidential election around 119.00 that might come lurching into view if the market finds out it’s got too much risk on for the political risks ahead:

Mind the gap…?

Being pulled in different directions

We are still thrashing out the driver for markets. As discussed in “It’s volatility Jim, but not as we know it”, we are now rotating between carry, politics, and the economy. The next two weeks provide us with something juicy for each of them.

  1. Carry

We start with the ECB this Thursday and move onto the Fed and Bank of Japan next week. The detail doesn’t matter as much as the sense of direction. And for the first time since Blondemoney starting asking “Hands Up If You’re Not Easing”, central banks have changed course from cuts to hikes:

CB next rate move

It’s quite remarkable how this has occurred while stock markets keep on pumping up to new highs. This withdrawal of stimulus was supposed to hurt wasn’t it? Ah, but then you see this chart, which shows that even if the future path withdraws stimulus, right in the present time it’s still ploughing on:

total CB assets

In other words, the ECB and BOJ have been doing enough to replace the Fed’s withdrawal. Enough to have a self-reinforcing impact on flatter yield curves: since the Fed last hiked in March, the US 10 year yield has fallen 0.35bps. Effectively the Fed hikes are being neutralised by the ongoing wall of money. There was a slight dip in the total central banks assets in the final quarter of 2016, but then fortunately we had a US election that returned a clean sweep for pro-business anti-regulation Republicans, and the world got all excited about reflation. The reflationary dynamic was genuine, with Chinese PPI having emerged from 5 years of deflation last September. The market only made a small political miscalculation, failing to spot that the separation of powers alongside a President disliked by his own party might not quite deliver the reflationary boost they initially hoped.

  1. Politics

Investors think they’ve put that mistake behind them, however. Only to make a second one. They moved from anticipating an omnipotent Republican administration to deciding the President is impotent and therefore irrelevant. He is neither. He’s constrained, sure, but so are all the other branches of government. That’s how the separation of powers works. Trump is blustering around trying to find the levers of power. At some point, he’ll find one. Note that the decisions over who to appoint to the Fed board are gathering momentum, with news today that one candidate is the chairman of a bank in Vice-President Pence’s home state.

Then we come to the UK Election. Those of you outside of the UK seem to regard this as almost a non-event. The polls have become so divergent as to have lost all predictive power, along with a rational belief that no Prime Minister could have possibly called an election if they genuinely were to lose it. That may be true, but let’s pay heed to polling guru Nate Silver’s point that the conventional wisdom is exactly what went wrong in the last 18 months of elections (including an outsized fear of Le Pen):

Nate Silver

Either way, the risk of a Corbyn government – or even a Government of National Unity – is not zero, and it could happen in just 3 days’ time.

Meanwhile, the VIX plumbs the depths once again. As @selling_theta flags, there have only ever been 14 times the VIX has closed under 10, and six of those have happened in the past month:

VIX Closes

Putting these first two points together we can see why volatility is so compressed. As JPMorgan point out, over one-third of the world’s government bond markets are now owned by central banks, and HALF is held by them plus commercial banks:

share of bond market

These guys are buying and holding these bonds. Add this to the increase in passive equity investors, and trading volumes are plummeting:

trading turnover

This isn’t anything new, you might think. We know central banks are crowding out private investors. We know they’re driving volatility lower. We know they’re still indulging in QE but that’s ending soon and hasn’t caused a problem yet, has it?

Carry on carrying. Friday saw the biggest one-day inflow of the year into the largest Emerging Markets Debt ETF:

EM debt ETF

Markets are indeed supposed to be fully rational and price in all future expectations. That chart about future rate hikes should be in the price already right?

  1. The Economy

What if it’s not? What if, at the exact moment we realise the QE is ending properly, at say, a couple of central bank meetings in the next couple of weeks, we also realise that reflation isn’t quite as robust either? And not just for political reasons?

Blondemoney is usually sceptical about charts where one line is progressed forward to make it sit nicely on top of another line. Surely if some data had such predictive power, we would know about it and already discount it? But this chart is from the usually reliable Capital Economics and there is a pretty tight relationship between two variables that should correlate:

 

China PPI Capital Economics

In conclusion:

  • The Carry Trade hasn’t come under any pressure yet as the Central Bank wall of money continues
  • The compression of volatility means that when it does unwind, it will be violent
  • Reflation is under threat, both politically and economically

Firewood? Check.
Tinder? Check.
Matches? Ready.

Just wait for the spark.

It looks like we need to have another word…

It looks like we need to have another word about GBP. The pollsters are once again making waves, this time with YouGov forecasting a hung parliament. Their central scenario is for the Conservatives to lose 20 seats, and Labour to win 30. With other polling agencies still predicting anything up to a 100 seat majority, is this YouGov sticking their necks out looking for glory, or does it reduce the information content of all polls to zero?

We can know this: all the polls have behaved similarly in relative terms. They all started with an increasing Tory majority, as UKIPpers mostly went back to the Tories. Then after the manifestos were released they showed a resurgence for Labour, who offered well telegraphed freebies against the Tories mixed messages on social care. We can conclude that when this was “The Brexit Election”, the Conservatives benefitted, with even many Remain voters now thinking it just needs getting on with. However when the manifestos reminded voters of specific policy concerns, old tribal habits die hard, and disgruntled anti-Corbyn voters returned to the fold.

Voters are realigning themselves. There’s a shakedown in the UK political system and the pieces of the puzzle are still mid-air. This happens after huge economic shifts that change the social landscape. The reality is that the politicians are behind the times. Across the world, voters want new faces. But then their loyalty to those new faces is untried and untested. Does the UK really want just to decide between Theresa May and Jeremy Corbyn as PM? It has been said by the great veteran psephologist David Butler (follow him on Twitter if you’re not already!), that he’s never seen such a volatile electorate in the run up to an election. What are the Conservative and Labour parties and who do they represent? What are the big issues of the day, when 52% of the electorate ripped us out of a network with our closest trading partner? We want change, and the current system is straining to cope.

That’s the reason why this is such a bizarre election. And the big unknown factor is how will this volatile electorate turn out? Will they bother to vote at all? As Brenda in Bristol put it, when the election was first called: “Oh no, not again!”. The main reason for the wildly different seat predictions from each polling agency lies in their voter turnout filters.

For markets, the reality is that the Conservatives losing seats must now enter the scenario analysis. Or even if they fail to achieve even a majority of, say, 50, it will leave Theresa May looking weak for having gambled by calling an election in the first place. As discussed, this is the phoney battle ahead of the Brexit negotiation war. These polls suggest that the probability of a disorderly outcome is rising.

Just a thought on GBP

The past year of how GBP/USD has traded could be characterised thus:

* Sell it on Brexit vote
* Sell it on Theresa May “Hard Brexit” conference speech
* Buy it on govt having to consult parliament on Article 50 trigger after losing court case
* Buy it on rebellious House of Lords

This could be called Stage 1 of the grief that a “Remainer-mindset” market felt after the UK apparently took leave of its senses by voting to Leave.

Then Trump turned up, Article 50 was triggered, and The People had to be heard. As they had said they wanted to Leave, well then, the market had to accept it. GBP/USD then turned into this:

* Don’t sell GBP as the economic data looks good, but wait to sell rallies instead, as the data will eventually turn
* Buy GBP for long-term hedges around 1.20-1.25 as it’s good value

Which led to a fairly narrow GBP/USD range. Until…. Theresa May calls an election! Given the massive lead for the Tories in the polls in the months prior to that decision, and the self-immolation of the Labour party, this could only mean one thing…. She would win, win big, and reduce the risk of a disorderly exit as her hand would be strengthened in negotiations. All that faffing with the court case wouldn’t happen again. The country would be set on its Brexit path. We entered a new phase:

* Buy GBP as Brexit is now going to happen in a “strong and stable” fashion
* Sell GBP if Conservative poll lead wobbles

This is somewhat ironic. Those opposing Theresa May have argued either for a 2nd referendum (the Lib Dems) or less hardline Brexit stance (Labour). Back in Stage 1, the thought of Brexit itself took GBP lower; anyone preventing it took GBP higher. That has now reversed.  This is because the market has reconciled itself to Brexit actually happening. The first stage of grief, Denial, has passed.

This means that the default impulse to be short GBP has passed. Indeed, some degree of certainty from Theresa May’s increased mandate, along with the improving economic data, suggests the natural inclination might be for a slightly long position. Or at least a neutral one. Certainly volatility in GBP/USD has been falling:

gbpusd historical vol

This opens the way for the Second Stage of Grief: Anger. Once we proceed to June 19th, when the negotiations truly begin, we will see a lot of heat and light from politicians on both sides. Theresa May could go into negotiations with a stronger hand; but David Davis seems to want to use that hand for an early knockout punch, threatening to walk out if the EU27 don’t play ball. The EU27 have been remarkably unified thus far, likely united by the dawning realisation that the UK’s money is coming out of the pot. No-one wants money to walk away without a fight. Hence their obsession with a large headline figure for the divorce bill. Who cares about who gets the cat when you realise you’re not getting the same income?

If the market thought the UK have been irrational, let’s see how they feel about the EU27’s position. If the market still has the mindset of the UK being the guilty party, then EU27 intransigence may be considered more rational than the UK’s.

The point of all of these musings is that the moves in GBP are strongly sentiment driven. It can be no other way, as we are about to enter a period of non-linear political risk. If investors felt that the risks for GBP died with the announcement of the election, they are about to receive a significant shock.