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18/12/2014: Appetite for risk is back, but will it last?

The outlook has changed dramatically in the past day or so. Suddenly equity markets have stormed higher, and the US dollar has regained some lost ground. There have been two big central drivers behind this more, support for the oil price and a supportive Federal Reserve meeting.

The plummeting oil price has had global investors running scared and the “fear” gauge, as popularly depicted by the VIX volatility Index of S&P 500 options, has spiked as a result. In all likelihood, investors are just looking for support in the oil price which would suggest a stable market (and therefore a more stable outlook for demand). Yesterday this is what we began to see. Whether this is just a near term element of support remains to be seen, but the market is reacting positively now. The chart below shows support coming in for oil.

WTI   18122014

The market is also reacting positively to last night’s FOMC meeting. The Fed has introduced a new term of “patience” which Janet Yellen notes that this suggests that the committee is “unlikely” to be raising rate in the next two meetings. That take us to  at least the meeting on 30th April but probably more realistically June or July for the first time the Fed could start to hike rates. This has given the market more clarity on what the Fed is thinking and effectively keeps the ultra-loose monetary policy stance in play for what is likely to be another 6 months.

US10YT   18122014

There has subsequently been a move back away from safe haven assets. Treasuries have been sold off (rising yields, see in the chart above and below) and this has also benefited the dollar. Although the FOMC made no significantly hawkish shift, the US dollar bounced strongly. The chart below is one which I have shown recently but continues to reflect the negative correlation between the VIX Index and the yield on the US 10 year Treasury yield. It also shows how the US dollar has also been correlated with Treasury yields.

VIX   10YT   DXY   18122014

So if the VIX can start to fall back suggesting that demand for portfolio insurance (i.e. S&P put options) is decreasing, then conditions are set for a market recovery. The chart below shows the strongly negative correlation between the VIX and the S&P 500.

VIX   SPX   18122014

So declining volatility reflects rising Treasury yields, a strengthening US dollar and positive equity markets. Let’s just hope that it can all continue then. Support holding in the oil price will certainly help.

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At Hantec Markets Ltd we provide an execution only service. Any opinions expressed by analyst Richard Perry should not be construed as investment advice or an investment recommendation. This report does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions.