Q1 Review – Equity market volatility fails to infect FX markets (for now)


The first quarter of 2018 was a shaky one for equity markets, and the start of the second quarter has been even more concerning, as highlighted in the above chart.  The S&P 500 is now down by more than 10% from its January high, and the VIX (the equity market’s ‘fear gauge’) has pushed back above 20, (which has become the de facto dividing line between a complacent market and an anxious one).


There are other worrying signs which point towards a growing risk that we are at, or near the end of the economic cycle.  Recent analysis by Bianco Research LLC has shown that the proportion of ‘zombie’ companies in the S&P 500 (companies whose earnings (EBIT) fail to cover their interest expense) is at the highest level this century at 14.6%.  In addition, the percentage of IPOs with negative earnings in 2017 reached 76% according to a study by Professor Jay Ritter of the University of Florida which was recently cited in Grant’s Interest Rate Observer.  The last time such a high proportion of IPOs were loss-making was just before the bursting of the dot-com bubble in 1999 / 2000.


You might expect that such uncertainty in the equity markets would be seeping into the FX markets, but so far, any contagion has proved to be limited.  EURUSD has been stuck in a 3 cent range (1.22-1.25) for most of the first quarter, and GBPUSD has not been much more exciting, largely sticking to a 4 cent range from 1.38 to 1.42.  (GBPEUR has been the most stable of all, effectively containing itself to a narrow 2 cent range for over six months now).      


One reason why equity market volatility has not yet transmitted itself to the FX market is because the repricing that has occurred in the equity markets has not been accompanied by any shift in underlying economic activity (or expectations).  Economic growth is continuing in all major economies, unemployment remains low (in the US it is now at its lowest level since 1973), and expectations for monetary policy normalization have not really changed (the expectations for three rate hikes this year have only declined from 26% to 25% over the past week, despite the sell-off in equity markets).


CHART: US Dollar Index (Black) and S&P 500 Index (Orange)

Source: Bloomberg


A look back at the last ‘end of cycle’ moment, the Global Financial Crisis in 2008, demonstrates that a delay in cross-asset contagion is not without precedent.  When equity markets first started to sell off in 2007, there was no change in trend in the FX market; the USD simply continued its weakening trend (highlighted by the red circle in the chart).  It was not until about a year into the crisis (green circle), once the equity markets really began to correct that we saw big moves happening in the FX markets – in this case a surge in the USD as investors sought refuge from the financial market turmoil.


The historical lesson here is that if we are at the end or getting near the end of the cycle, we could still be up to a year away from seeing this transmitted through to the FX market in any meaningful way.  Our view is that it is likely that we are approaching a turning point in the markets; the current equity market volatility is meaningful indicator.  While this will likely lead to a reversal in the USD weakness we have seen over the last year, this may take a number of months to play out.     


Author: Kevin Lester



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