It was generally assumed that last Friday’s Non Farm Payroll release would mark the beginning of the end of the FED’s bond buying program, as the forecast number would be sufficient to confirm that the US economy was finally gaining some traction. The way ahead for the FED appeared to be well mapped out with an end to the program scheduled for mid 2014.
However, with the NFP number coming in much lower than expected, and earlier releases also being downgraded the question is now whether this timetable has been thrown into doubt. Aside from the lack of job creation, what is also of concern is the fall in ‘participation rate’ which has been responsible for driving down the headline unemployment rate to 7.3%. In other words, are there simply no jobs available, or does this represent a structural change in the labor market, and the participation rate will not improve even if the economy does recover?
Why the FED’s taper decision matters, regardless of your market or instrument or whether you are a trader or investor, is the impact it will have on market direction. Ever since May when the FED first mooted the prospect of the taper, we have had dramatic flashes of volatility across all markets, which has even extended to some emerging markets.
So far this week the taper question has been set aside and market sentiment appears to have shifted to the positive end of the spectrum, helped along by encouraging Chinese data, and the Nikkei 225 posting some impressive gains, since attributed to Toyko’s successful bid to host the 2020 Olympics.
To help us navigate our way though this constant churn of market sentiment we are fortunate in being able to reference two key indices which will tell us instantly what the market is feeling, and its likely direction. The first of these is the US Dollar Index and the second is the VIX.
In pairing these two indices together we are essentially looking at the fulcrum of the market, in other words the risk on/risk off seesaw counterbalance. In general terms the markets are driven by one of three pivotal behaviours, namely risk appetite, risk aversion and indecision.
In considering these two indices we have an answer to all three.
When risk appetite is high money flow will be into high yield assets, such as stock, exotic currencies, commodities and emerging market assets. When markets are nervous, in a risk off environment, then the money flow will move into more conservative investments such as bonds and safe haven currencies, such as the US Dollar and Japanese Yen.
Market indecision is typified with a flip flop and sideways price action, as traders and investors sit on the sidelines and wait for the next trigger.
The US Dollar Index at present is the one to watch at present, primarily as a result of the indecision over the taper, in other words when the bond buying program is likely to slow down, which will only occur when the FED feels comfortable that the US economy is beginning to recover from its deep recession.
As already mentioned the taper decision is key as it will then signal to the markets, amongst other things, the potential for a move in interest rates at some point in the not too distant future, which in turn will render the US Dollar a more attractive proposition, and simultaneously reduce the amount of currency in circulation.
Moving to the VIX, this index describes volatility in the market, and specifically implied volatility in the options market. It is often referred as the fear index, and when risk off appetite is in the ascendancy the risk will rise accordingly. Conversely, it will fall when risk appetite is high.
From a technical perspective the daily chart of the US Dollar Index reveals weakness at present, having run into solid resistance at 10,820, and following Friday’s weak employment data now looks set to test the platform of potential support at 10,700, and from there a possible deeper move to a more sustained level of support at 10,650.
The recent price congestion, which has seen the index oscillate between these price levels throughout August and September is clearly evidenced on the volume at price histogram on the left hand side of the chart.
Moving to the weekly chart of the VIX, here we can see a perfect illustration of the constant ebb and flow of risk appetite beautifully demonstrated by the catenary price action which has seen the VIX repeat this pattern since August 2012. In other words, fear enters the market sending traders and investors scrambling into safe havens, before the market calms and risk appetite returns once more.
By Anna Coulling