Can you feel the Bern?

Summary

• Global update - CoronaVirus is going to impact growth.

• Fed policy - Monetary policy convergence in the cards.

• Market dynamics - Gamma and convexity hedging.

• The week ahead - Slippery once again.

It has become clear that the CoronaVirus will have an impact on economic growth.

The CoronaVirus continues to dominate headlines following the World Health Organization's (WHO) declaration of a global health emergency.

Between governments issuing travel restrictions, a rising death toll, and headlines that the CoronaVirus surpassed the precedent set by SARS in 2003, there was little reason for investors to be long risk assets going into the weekend. The WHO declared a global emergency that, on the bright side, should free up more resources and boost efforts to contain the outbreak. Markets did recognize that and rallied after the announcement. However, sentiment took a turn for the worse into Friday's close. Despite the WHO's plea that travel and trade need not be affected, travel restrictions/warnings have become the norm rather than an exception.

The fear remains that this global pandemic turns into an economic one as China gets knocked off course.

The coronavirus will undoubtedly derail the nascent economic recovery in Asia. In particular, in China, where many cities and provinces will remain closed past February 2nd (the end of the Lunar New Year). Ballpark estimates put the potential closures impacting nearly 2/3's of Chinese GDP representing approximately 3/4's of exports. That will do severe damage to a county whose recovery was fragile at best and none existent at worst. Although manufacturing data last Week was decent, the data continues to remain on a knife's edge and does not reflect the full impact of the virus. Ultimately, it will be difficult for China to weather this storm. China's deleveraging campaign will continue to keep monetary stimulus coming in dribs and drabs. While some fiscal policy response is expected, it remains unlikely that we will see the type of "kitchen-sink" style stimulus many market participants became accustomed to in the past. The offshore Chinese Yuan depreciated throughout the Week and broke below the critical 7 USD mark.

Chinese markets will open for the first time since January 23rd.

If South Korean equity markets are any indication of what we can expect, there is a lot of catching up to do in Chinese equity markets. South Korea suffered the largest decline since October, down nearly 6 percent on the Week. You can't help but feel bad at this point. Economic data out of Asia has been good and was providing a clear sign that the global economy was ready to pick itself off of the proverbial ground. Unfortunately, all of that will be overshadowed by this respiratory virus. The People's Bank of China (PBOC) has injected US$ 174 billion into the system to help provide some cushion for markets. It's important to note that these numbers are not that large when you consider a large portion of the money in the system will be maturing on Monday. The PBOC is likely planning to issue more liquidity throughout the Week as needed. Currently, the CSI 300 is trading 8 percent lower.

European GDP data was an unexpected dumpster fire on Friday.

The Euro area barely managed to grow in the fourth quarter of last year. Worse yet, France and Italy both unexpectedly contracted. France's Finance Minister was quick to dismiss the data as temporary. If anything, Macron's headache just got worse as a weaker economy increases the blow from any tariffs that may be coming his way from the US. Meanwhile, in Italy, political uncertainty from the 5-Star movement continues to weigh on growth. As of late, it appears the 5-Star party will split once again after a failed allegiance with the League. Italian long-term yields were down a shocking 30 bps as a result. For the ECB, this will likely mean that they remain on autopilot while berating governments to spend responsibly.

The Bank of England (BoE) left rates unchanged, and the UK has officially parted ways with the European Union (EU).

The close call that the market had begun to discount a few weeks ago following a mixed bag of economic data turned out to be not so close after all. The Governing Council of the BoE voted 7-2 in favour of keeping rates on hold. The market took the news in stride; Gilt (UK bond) yields drifted higher, and the Pound rallied to the highest level since the start of the year. The BoE lowered its growth forecasts for the year and left the door open for a cut in March if necessary. Ultimately, the long-term outlook for the UK will be dependent on how Brexit unfolds. With the UK officially out of the EU, the market should brace itself for at least another year of negotiations. If that wasn't enough, Scotland's nationalist leader, Nicola Sturgeon, is using the momentum in Scotland against Brexit to push through another referendum for Scottish independence. Jolly good.

The US consumer continues to drive the bus while business investment slides.

Estimates for US GDP indicated that the US economy grew at a rate of 2.1 percent during the fourth quarter of last year. That puts US growth for 2019 at 2.3 percent. That may be well below the US administration's "target" of 3 percent but these numbers are solid considering the macroeconomic backdrop. Despite rampant trade tensions, consumers have continued to spend, stepping up to the plate right when business investment got stage freight. Concerns surrounding business investment remain, particularly in manufacturing, where the latest print shows the sector has continued to contract. Although trade tensions have subsided somewhat, the viral outbreak will likely serve as an offsetting drag. The question now is whether the US consumer will continue to hold out amidst this outbreak. If the virus starts to spread in a significant way to people who had not been to Wuhan, that may be enough to rattle the US consumer.

Oil prices have stumbled into 2020, posting the worst January since 1991.

What started with a massive surge in oil prices following the assassination of Qassem Saleimani has culminated in a nearly 16 percent decline since the start of the year. Although the receding threat of World War III has had some impact on oil prices, global recession fears are likely driving the majority of the decline. Supply concerns regarding Iraq, Libya, and Venezuela pale in comparison to the pent up anxiety surrounding overall demand and a tenuous growth outlook. The fall in oil prices is swift enough to merit an early OPEC (Organization of Petroleum Exporting Countries) meeting surrounding further production cuts. Ubiquitous travel restriction/warnings threaten to reduce demand for jet fuel, and, realistically, sentiment surrounding growth is not going to provide support for oil.

An economic slowdown may force monetary policy convergence to avoid a strengthening US dollar.

The Fed kept rates unchanged last week.

There wasn't much "news" at the latest FOMC meeting. The Fed Chair, Jerome Powell, indicated that Treasury bill purchases would continue until the second quarter. By then, reserves should be large enough to ensure the overnight markets function reliably. There was no indication of how the Fed would reinvest proceeds from Treasury bills, although it is likely they will need to go in search of more duration for liquidity reasons. A subtle shift in the language in the press statement was aimed at curbing any expectations of asymmetric preferences to inflation. That's to say that above-target inflation will be equally as important as below-target inflation. That's a moot point, particularly given that the Fed is in the midst of a policy review that's expected to provide some change in the way inflation is measured and/or targeted.

The Fed will likely cut rates in 2020.

The last thing anyone wanted was a deadly respiratory virus to knock the global economy off-balance after being battered by a trade war and an ill-advised effort to normalize monetary policy. Unfortunately, that's the world we live in, and it's important to ponder how things will turn out. In reality, the virus will probably have a disproportionate effect on China relative to the US. As such, the US will remain the "cleanest dirty shirt" in the market and attract more capital into US assets, increasing demand for US dollars. That appreciation of the greenback will result in the US importing global disinflation as import prices fall due to the stronger currency. That alone undermines the case for inflation and can very well result in the Fed lowering rates further. Even if the US avoids a recession, domestic price pressures have not proven to be enough to generate inflation on their own. The flattening of the Phillips curve is a clear sign of that. When you throw in a collapse in oil prices and inflation expectations that remain below target, it isn't easy to imagine a situation in which the Fed remains on hold. Market pricing indicates that there is a 10 percent chance the Fed remains on hold by December.

Equity markets remain vulnerable as market makers remain short gamma while bond yields are feeling a little stretched given their fundamentals.

Global equity markets were down anywhere from 2-6 percent over the Week.

The economic impacts of the virus coupled with generally weaker than expected data out of Europe helped dampen the mood in trading last week. Bond yields were broadly lower, and curves flatter as long-end rates started to reprice growth prospects. The US dollar was stronger against many commodity currencies but weaker against the safe-havens (Swiss Franc and the Japanese Yen) as investors piled into safer trades. The general risk-off tone, coupled with the rise in negative-yielding assets, helped support gold which broke out of recent ranges.

Big tech did not disappoint on earnings last week.

For the most part, earnings were alright. Apple came in above expectations, as did Amazon and Microsoft. Some companies issued warnings that the CoronaVirus could impact earnings in the coming quarter. Starbucks, in particular, noted that the outbreak is going to result in nearly 2000 stores closing in China. Caterpillar also reported this week, adding to the gloom in industrial production globally.

Bernie Sanders's poll numbers may be contributing to the risk-off sentiment in US stock markets.

Although Wuhan remains more relevant to markets than Bernie, on the margin, Bernie surpassing Biden for the Democratic nomination may begin to turn a few heads in the coming weeks. The market risk from Sanders' potential Democratic nomination is, for the most part, underpriced. The chart below shows data from PredictIt showing the odds of the leading Democratic candidates winning the nomination.

Source: PredictIt.com

The term structure of the VIX, representing 1-month implied volatility of S&P500 options, has begun to price in the US elections, and there was some evidence from Nomura that market participants were buying volatility going into the primaries. The chart below shows the term structure of the Vix from last Friday. Notice the spike in volatility for October heading into the November electio.

Source: Vixcentral.com

Stability from dealer gamma breeds instability.

Many investors use volatility as a toggle to deploy funds to different asset classes. The low volatility backdrop we witnessed earlier in the year came from extremely long gamma positioning among the market maker community. That's to say that dealers were acting as a shock absorber to any news flow. When news pushed markets lower, dealers were buying, and when markets drifted higher, the same dealers were selling. That all changed 2 Friday's ago when the majority of the options these dealers were hedging expired. With these options gone, dealers are now closer to neutral if not short gamma. In these positions, dealers are hedging with the market. That means that selling will beget more selling and buying will beget more buying as dealers are no longer absorbing any market moves. That's problematic for many reasons, but not least of which is that many investors ramped up their exposures in equities given that volatility had been suppressed by dealer gamma hedging. Any shocks, for example, the CoronaVirus, thus have the risk create a nasty feedback loop.

Market makers remain short gamma going into the week.

The chart below is an update from last week's gamma schedule. We can see that the spot (the red line) is now clearly in a negative gamma position. That's to say that markets will likely remain slippery next week.

Source: CBOE & author calculations

The US 10-year 3-month spread inverted for the first time since August.

Last week was one of the best weeks for long term bonds. Bond yields fell around 20 bps in the US, which was enough to bring in the convexity hedging flows. That makes for a particularly challenging situation. The market is beginning to think the Fed is behind the curve as risks to the global outlook mount. Hedging flows in the bond market, which are not well understood by many market participants, are making matters worse by acting as accelerants, causing yields to fall further than can be explained by fundamentals. USD swap spreads also tightened on the week. Although ominous, it's likely the inversion of the curve has little to do with fundamentals and more to do with these convexity hedging flows.

The Week ahead will provide us with plenty of economic data around the globe, although headlines surrounding the CoronaVirus will likely dominate.

Growth concerns will continue to reverberate throughout the global economy.

In the US, all eyes will be on non-farm payrolls along with some manufacturing/service sector surveys. The surveys will be particularly crucial considering the Chicago survey printed a truly heinous number earlier last Week. In Europe, we will get an update on German factory orders along with Euro area retail trade. Realistically, all of this data will be overshadowed by any headlines surrounding the virus. With dealers generally short gamma, we should expect some sloppy equity markets. Bond yields may pull back should the US data come in stronger than expected.

Tiago Figueiredo