A nervous week ahead, especially for sterling

Friday’s ugly close in equity markets not far from the cycle lows and the US 10-year benchmark closing the week well below the pivotal 3.00% level sets up a very nervous week ahead. Arguably, the latest dip in sentiment has been driven by the arrest in Canada of Huawei’s CFO and concern that this spirals into a wider showdown and derails the ongoing US-China trade negotiations. Headlines linked to this story could drive significant short-term volatility in either direction.

The odds of a December 19 Fed rate hike dipped very slight, but remain close to 70% after Friday’s US jobs report for November, which saw a disappointing month-on-month rise in average hourly earnings of +0.2%, even as the year-on-year number was in-line and matched October’s cycle high. Also negative, if not yet statistically significant, the average weekly hours worked dipped unexpectedly and the payrolls change for the month also disappointed. More relevant as a historic indicator, the recent rise in the weekly jobless claims off record lows is beginning to look persistent and has been a better indicator of the state of the US jobs market historically. This number, released every Thursday, could begin to take on more importance.

The US dollar is caught in a crossfire of conflicting drivers, as the unwinding of Fed expectations is bearish, while weak risk sentiment drives a safe haven bid.

Canada’s erratic employment change number printed at a record high on Friday, catching fresh CAD shorts off-guard after a profound shift in the Bank of Canada’s guidance last week. Given the tendency of this data series to mean revert and the fact that employment data is one of the most lagging economic time series, we would pay far more attention to the Bank of Canada’s guidance than an unreliable and lagging indicator.

Besides risk-on, risk-off risks this week, especially if the major US stock indices dip to new cycle lows, the Brexit issue will continue to drive uncertainty in GBP and even EUR. The noise this morning is that May will look to delay the parliamentary vote and is begging the EU for a “lifeline” to provide a breakthrough. But nothing resembling the current deal is likely to pass the UK parliament, which will call the EU’s bluff that it is either May’s deal or No Deal. The EU is not willing to let the economy go down in flames just ahead of the May 2019 EU parliamentary elections. The situation will remain very fluid for now.

Chart: EURGBP 3-month volatility

As the Brexit window draws to a close, implied volatility in sterling crosses is spiking to the levels just before and after the actual Brexit vote back in 2016. The chart below shows the 3-month implied volatility, which doesn’t even take us to after the March 29 Article 50 deadline. Arguably, volatility could be too expensive and taking a directional view on sterling in the options is getting very pricey. One approach could be to trade long call or put spreads, which limits upside, but requires less of a move to realise a profit.