Dollar and Equities Soft as Markets Return to Risk-Off Territory

  • We are facing a classic risk off move from recent geopolitical events
  • Recent price action in the FX market has proven difficult to analyze
  • The US has a busy data week, capped off with December jobs data Friday
  • UK and eurozone reported strong final December services and composite PMIs
  • The Chinese government appointed a new head of the liaison office for Hong Kong

We are facing a classic risk off move from recent geopolitical events. After last week’s drone killing, Iran has decided to effectively pull out of the nuclear deal by announcing it will no longer abide to uranium enrichment limits. Meanwhile, Iraq’s parliament voted to expel US troops, but Trump has already pushed back by threatening sanctions.  Trump continues his threats, vowing to attack Iran “in a disproportionate manner” if it retaliates against US targets. To further complicate matters, a US base in Kenya was attacked by an Al-Qaeda-linked group, killing three staff members.

Our base case is that the conflict will be fought through proxy battels (including cyber-attacks) and verbal posturing, but not through direct conflict. In other words, we expect that after some retaliation from Iran there will be a gradual albeit bumpy de-escalation. That said, the risk of a misstep seems large, thus opening a new and fat tail risk for investor to contend with.

Asian equity markets and US futures are all lower, gold rose to the highest level in more than six years, and US 10-year Treasury yields are below 1.80%.  USD/JPY is down about 0.5% over the last two sessions to trade below 108, falling below the 50-, 100-, and 200-day moving averages.  Brent oil is up nearly 6% over the last two sessions to trade back above the $70 per barrel for the first time since September.  European equity indices are down over 1%, with the Dax underperforming (-1.7%), with US futures pointing to a weak open.

Most of the geopolitical anxiety’s impact on implied volatility measures were seen in the equity space. The VIX (S&P 500) and V2X (EuroStoxx) are around 4 percentage points higher and both back above 16. Implied volatility in the DM and EM FX indices were also higher, but not as much; same as US interest rate volatility (MOVE index).

Recent price action in the FX market has proven difficult to analyze.  After staging a solid recovery in November, the dollar looked poised to add to those gains in December.  Instead, DXY peaked on November 29 and then sank to a new low on December 31.  The greenback has staged a comeback of sorts in early January, helped in large part by the risk-off impulses coming from Iran tensions.  Yet DXY has given back much of its recent gains today as markets return from holiday.  We think market movements have been distorted by thin markets and year-end positioning.  As such, it will likely take several days, if not weeks, to get a clean read on market sentiment.



The US has a busy data week, capped off with December jobs data Friday.  Consensus sees 162k jobs added vs. 266k in November, unemployment steady at 3.5%, and average hourly earnings also steady at 3.1% y/y.  The only US data reading today is final Markit services and composite PMIs.  On Friday, ISM manufacturing PMI unexpectedly fell to 47.2 from 48.1 in November whilst auto sales slowed to 16.7 mln annualized form 17.1 mln in November.  While we remain upbeat on the US economy, these softer December readings are not helpful.



Markit final December eurozone services and composite PMI readings came in higher than expected.  Headline services and composite PMIs both rose from the flash reading to 52.9 and 50.9, respectively.  Germany improved significantly from the flash reading, whilst France was steady.  Both Spain’s readings improved from November to 54.9 and 52.7, respectively, while Italy’s were mixed.  Lastly, Germany reported strong November retail sales, up 2.1% m/m vs. 1.0% expected.  This pushed the y/y rate up to 2.8% y/y from a revised 1.4% (was 0.8%) in October.

Markit final December UK services and composite PMI readings also came in higher than expected.  Headline services and composite PMIs both rose from the flash reading to 50.0 and 49.3, respectively.  Other than that, it will be a quiet week data-wise.  Despite persistent Q4 weakness in their economies, neither the ECB nor BOE are expected to change policy this month.  At least the UK has the luxury of some upcoming fiscal stimulus, if Johnson’s election pledges are to be believed.  In the eurozone, the surplus nations are showing no softening of their anti-spending stances.

UK politics will take center stage as Labour’s National Executive Committee is set to outline its timetable today for the leadership election.  There is a clear struggle within the party between the Corbyn and moderate wings.  Elsewhere, the UK Parliament will start debate Tuesday and ultimately pass Johnson’s Brexit deal Thursday.



Markit final December Japan manufacturing PMI weakened further.  The economy slowed sharply in Q4 due to a combination of the typhoon and consumption tax hike.  The supplementary budget is meant to address this slowdown, and so the Bank of Japan is sidelined for now.  Next policy meeting is January 21 and no change is expected then.  USD/JPY traded earlier today at lows not seen since October 10 near 107.75 but has since recovered back to 108.  The pair is likely to remain under pressure if risk-off sentiment continues.  Break of the 107.70 area would set up a test of the October 3 low near 106.50.

Caixin December China services and composite PMI readings both weakened.  Services came in a full point weaker than expected at 52.5, dragging the composite down to 52.6 from 53.2 in November.   Last week, the PBOC cut reserve requirements 50 bp and an official said it has room to cut further.  With the economy still struggling, monetary policy will clearly remain accommodative this year.

The Chinese government appointed a new head of the liaison office for Hong Kong, Luo Huining. To be clear, this not a replacement for Carrie Lam, Hong Kong’s Chief Executive. The move seems to be both a sign of China’s frustration about how Luo Huining’s predecessor handled the protests, and a sign of China’s continued commitment towards a firm policy towards protestors. Separately, reports suggest that a Chinese delegation will be in Washington to sign the first phase of the trade deal with the US on January 15.  We don’t expect any further problems with Phase One, but Phase Two will prove to be even more difficult.