Markets in Focus
Since the middle of March, the Dow Jones index experienced two weeks of a relief rally, which is typical after the market was short-term oversold. It is also a result of the market living through the initial gyration and knee-jerk selling to the geopolitical news. However, the index failed to recoup 35000 above the channel support line, which has now turned into overhead resistance.
Similarly, the Russell 2000 index could not stay above 2100, a critical support level for more than twelve months. This has become a resistance that has rejected the index’s advance multiple times since the beginning of the year. The index will likely find its support only near the 1900 region.
The MXN/USD pair has been trading in a rectangle range for more than a year. Its recent rally towards the top end of the range was again rejected. As the Fed becomes more hawkish to tighten the financial conditions, the US Dollar is likely to strengthen further against EM currencies such as the Mexican Peso.
The Australian Dollar has kept its relative strength against the US Dollar lately because of the very strong price actions of the entire commodity space. However, 0.76 has proven to be an important level for AUD/USD. Tighter financial conditions, hence a stronger US Dollar, could set back this pair in the near term.
The Australian Dollar has also been outperforming its closest neighbor, the New Zealand Dollar, on a relative basis, as seen by the AUD/NZD pair reaching the upper trendline of its massive eight-year descending triangle. It further suggests that the Australian Dollar is likely to underperform for the next few months.
Market Views
Bill Dudley, former president of the New York Fed, stated on Wednesday (6th April) that “if stocks don’t fall, the Fed needs to force them.”1 The idea is that financial conditions need to be meaningfully tightened to curb inflation and prevent the economy from overheating further. As Fed Chairman Powell has clearly expressed in the March FOMC press conference, “policy works through financial conditions. That’s how it reaches the real economy.”
How could the financial conditions be tightened? Higher short-term interest rates, higher bond yields, wider credit spreads, a stronger US Dollar, and last but not least, a lower stock market. It is not hard to see that rate hikes are but one of the tools to achieve the goal. So far, the interest rate market has already priced in a very aggressive rate hike path (close to 300bps) for the Fed in 2022. The long-end bond yields have had one of the fastest rises in history. Credit spreads are still well contained, and the US Dollar has strengthened against most other currencies.
The problem, however, lies in the resilience of the stock market. After the initial selloff in Q1, the US stock market has rebounded sharply since mid-March. S&P 500 and Dow Jones are both only 6% off their recent all-time highs clipped at the beginning of the year. Financial conditions cannot be meaningfully tightened when the stock market remains elevated at this level. What this means for many equity investors is that the “Fed Put” they subconsciously clinch on could still be quite far down below.
How to play the theme out
A hypothetical investor can consider the following trades2:
Case Study 1: Short Micro E-mini Dow Jones Index Future
If the investor were to short the Micro E-mini Dow Jones Index future (MYMM2) at 34500, and set the stop above 35500, his maximum loss per contract would be (35500 – 34500) x 0.5 = 500 USD. An initial target points to 32500 and subsequently 30000, resulting in (34500 – 32500) x 0.5 = 1000 USD and (34500 – 30000) x 0.5 = 2250 USD.
Case Study 2: Short Micro AUD/USD or AUD/NZD
If the investor were to short the Micro Australian Dollar future (M6AM2) at around 0.747 and set the stop above 0.767, his maximum loss per contract would be (0.767 – 0.747) x 10000 = 200 USD. An initial target points to 0.73 and subsequently 0.7, resulting in (0.767 – 0.73) x 10000 = 370 USD and (0.767 – 0.7) x 10000 = 670 USD. Alternatively, to reduce the US Dollar exposure, the investor could construct a short AUD/NZD pair by selling 1 Micro Australian Dollar future (M6AM2) and buying 1 Micro New Zealand Dollar future (M6NM2) at a rate of 1.088. The stop would be above 1.1, and the target would be below 1.03.
Original Link: https://www.cmegroup.com/newsletters/fresh-from-the-trading-room/files/fresh-from-the-trading-room-2022-04-13.pdf
https://www.bloombergquint.com/gadfly/if-stocks-don-t-fall-the-fed-needs-to-force-them, accessed on 8th April, 2022.
Examples cited above are for illustration only and shall not be construed as investment recommendations or advice. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.