“Storm Clouds” Overhead Portend A Volatile End to 2017 - BNY Mellon

Wobbling risk assets and an apparent flight to quality could suggest a volatile year-end is in store for markets, while the Dollar remains a wild card.

Recent price action across a broad swathe of the world’s financial markets has been emblematic of storm clouds gathering overhead, according to strategists at BNY Mellon, who are flagging the risk of a volatile year-end.

This price action has already seen risk assets punished, hitting emerging market bonds and currencies hard, while also seeing developed world stocks weaken. 

“The confluence of our iFlow FX flow observations for the yen, pound and Aussie dollar, along with a flattening US Treasury yield curve, Brexit uncertainties and rising risk premia in emerging markets portends a volatile year-end,” says Samarjit Shankar, head of iFlow and Quant Strategies at BNY Mellon, in a note Friday.

Shankar’s assessment is based on outputs from BNY Mellon’s iFlow IQ model during the last week, which analyses flow data and churns out trading signals across asset classes. 

The model captures trade flows on the day that trades are placed and so its signals are more timely than those of models that rely on settlement data. Settlements do not take place until at least three days after a trade is placed.

“What had initially seemed to be a brief bout of USD profit-taking activity in early November now appears to have been prolonged as US lawmakers vigorously debate the tax bill, US Treasury yields remain subdued after their retreat last week and the US Treasury yield curve maintains its flattening trend, “ Shankar notes.

According to iFlow IQ, the US Dollar saw its first week of net-outflows since the summer, at the beginning of November. This has continued into the second well into the month but, notably, US Treasury yields have fallen at the same time despite outflows from the Dollar.

This means enough investors are buying US bonds to keep prices moving higher, and yields in decline, despite more money leaving the US than was going in. That could suggest a domestic flight to safety is taking place among American money managers.

“Meanwhile, ongoing Brexit negotiations remain an area of investor concern amid rising friction between UK and EU lawmakers, political disquiet in the UK Parliament, underwhelming UK economic data and uncertainties surrounding how all this may impact the BOE’s monetary policy framework,” says Shankar. “Against this backdrop, it is not surprising to see the pound under renewed selling pressure.”

The Pound fell between 0.5% and 1% against the Swiss Franc, Japanese Yen and Euro over the week as markets responded initially to press reports of a possible challenge to Prime Minister Theresa May’s leadership, and latterly, to rising and falling hopes of a breakthrough in the Brexit negotiations.

But Sterling and the US Dollar have not been the only developed world currencies to take a knock in the last week.

“Among G10 currencies in particular, Australian dollar has weakened the most vs USD since the beginning of November,” says Shankar. “Our iFlow cumulative AUD FX flows confirm investor sentiment toward the currency has undergone a sea change since last month, in sharp contrast to the bullish phase during the May-July period.”

The Australian Dollar has been sideswiped by persistent weakness of inflation during recent months and, during the current week, by weaker than expected wage growth figures that left any previously-surviving hopes of a near-term Reserve Bank of Australia rate hike in tatters.

“Last, but not least, we draw our readers’ attention to the surge in Japanese yen inflows we have observed in the past week, Shankar adds. “The two yen crosses that have lost the most ground month-to-date have been AUD/JPY and GBP/JPY.”

Japan’s Yen, despite being a long suffering posterchild of the world’s most unconventional of monetary policies, is a solid safe haven always quick to benefit during times of global turmoil.

The recent sell off in risk assets and an apparent flight to quality could be enough to suggest a volatile end to the year is in store, but the biggest wildcard for global financial markets in the weeks ahead is whether the Dollar’s recent weakness turns out to be temporary.

“If so, a stronger turn in the dollar will further weigh on riskier assets,” says Shankar. “In any event, tighten your seatbelts as we approach year-end.”

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