Three Thoughts from London

Tower Bridge morning traffic

Ilan Solot outlines three key developments in the markets, as Mexico takes steps to regain its position as an important player in the energy market, Malaysia joins Brazil and Turkey in the political tail-risk EM club, and reaction to the EUR/USD implied volatility is smaller during the latest stage of the Greek crisis than seen in 2011.

1) Today Mexico holds its first oil field auction since 1938. This is another major step towards regaining its position as an important player in the energy market after a decade of steady decline. Last year, Brazil’s production rose above Mexico’s for the first time in history, but the gap is already closing again. Interestingly, Pamex will not participate in today’s auction. The decision seems to be less political/procedural and more practical. Instead of entering into a new venture, the company will focus on conserving cash and creating partnerships to streamline existing projects. Other companies have also pulled out after the government announced a requirement that bidders have one partner to act as guarantor for at least $6 billion of shareholder equity. Still, there seems to be plenty of interest for today’s historical event.

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2) Malaysia is joining the political tail-risk EM club that Brazil and Turkey are part of. Last week, the police raided the office of 1MDB as the investigation about corruption links to PM Najib deepens. 1MDB is a quasi-sovereign fund and development bank. The situation is heating up and dividing the country, with several opposition members calling for the PM’s resignation. In contrast, the Foreign Policy Magazine announced that Malaysia jumped from 11th to 6th (out of 110 countries) in its ranking of the most attractive destination for foreign investment. And for what it’s worth, the Economist Intelligence Unit attributes a rating of 29 to Malaysia’s political risk, considerably lower than its peer average of 41. (For comparison, Singapore = 12; Thailand = 64). We think the price of oil is a more important short-term driver for Malaysian asset prices, but the deteriorating political situation creates an entirely new set of medium-term tail risks.

3) Let’s take a quick look at implied volatility for the euro during the recent Greek drama. First, it’s worth noting how much smaller the reaction in EUR/USD implied volatility has been during the latest stage of the crisis when compared with 2011. Moves have been relatively modest even when Greece was on the verge of leaving. This may suggest that markets have accepted the premise that Europe is better prepared for systemic shocks this time around. Zooming into the last few months, risk-reversals show that demand for protection against further EUR downside risks has been reduced to pre-referendum levels, but it hasn’t made material gains beyond that. Meanwhile, implied volatility for the cross is still well within the range seen since March, after having climbed steadily from a low of 4.2% in August 2014 to around 12% now. Although notoriously difficult to interpret, the recent price action in the options markets suggests two non-exclusive possibilities: (1) FX markets are far from pricing out EUR downside from the Greek crisis; and/or (2) lower downside EUR risks from the Greek deal is being counterbalanced by the re-emergence of Fed-ECB differential theme, maybe following Yellen’s recent comments about the timing of the first hike.

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