Wednesday, June 27, 2007
Is this more than your run-of-the-mill six hour bout of risk aversion? It's beginning to look that way. A number of stars appear to be aligning in favour of a more pronounced drawdown in risky assets. Credit looks horrible, for justifiable reasons, and equities are entering interesting technical territory. Meanwhile, official headwinds to the carry trade appear to be emerging for the first time in quite a while; an English translation of a Nikkei article articulating the detrimental impact of yen weakness is now doing the rounds.
What's interesting to note is that much of the 'valuation gap' between the SPX and the VIX appears to have vanished (in favour of the VIX, of course.) Might this mean that the market is no longer overweight downside, and thus more vulnerable to a steep correction? The 1487 double top neckline should provide critical clues. Whether that level breaks or holds, and whether such action is sustained, could well depend on whether the FOMC sends an overtly dovish or hawkish message tomorrow night.
Market focus remains on the swirling subprime issue and the potential for mark-to-market shockers as we end the quarter. What's interesting is that, as one might suspect given market correlations over the past year, most measures of volatility have risen substantially. VIX, MOVE, and credit spread indices are all back at or near their highs of February/March. One exception is USD/JPY vol, which has lagged markedly despite the historically strong correlation. While the chart below compares USD/JPY 3 month implied vol with the VIX, rest assured that MOVE, crossover, and ABX indices all look a lot more like the white line than the green one.