With so many moving parts and so many highly correlated markets, 2016’s market sell it’s difficult for many traders and investors to know where to look and what’s actually driving markets.
But SocGen’s global cross asset team, lead by Patrick Legland, says there are three markets, risk indicators, which investors can watch to monitor the market storm.
The three, which include the price of buying insurance against a bank default (CDS), expectations of inflation in the future, and the ratio of gold and oil against the US stock market volatility index (VIX) are coincident in nature. But because of that they almost perfectly gauge the pulse of markets.
Here’s what Soc Gen says about the three indicators.
1. Banking CDS – A big part of the weakness in markets has been fears about the business model and its sustainability of European banks. That’s meant that even thought US and Australian banks are in a much better position they have also seen their share prices dragged lower in the maelstrom.
Legland says that European “banksâ€™ subordinated debt CDS (is) edging back towards euro crisis levels.”
That’s not going to end in a hurry, he says, given “sentiment remains downbeat due to a number of negative factors, including concerns over global growth and China, exposure to the oil and mining industries, negative rates in Europe (impacting profitability), NPLs, specifically at Italian banks, and regulatory constraints.”
But if there is a turn in the CDS traders will know fear is easing.
2. Inflation expectations and long-term yields – Inflation is the bogey central banks are fighting at the moment. More so than anaemic growth because if low inflation slips toward deflation then the world, the developed world at least, is at serious risk of following the path of Japan’s weak growth and inflation performance.
That all means that central bankers take the fall in inflation expectations – where markets expect inflation to be in the future – and the concurrent fall in longer term bond rates.
It’s also a clear sign that markets don’t believe central banks are winning the battle on either growth or inflation.
So Legland’s team says, “If financial conditions keep deteriorating, we would expect the ECB and BoJ to step up easing at their March meetings (respectively on 10 and 15 March)”.
You’ll know markets are turning if, it’s a big if currently, the next round of central bank actions gain traction and these measures of inflation expectations turn higher.
3. Gold/ oil ratio – Gold surged as oil crashed recently a reflection that markets were “pricing in a lower rate path and systemic fears rising,” Legland says.
That ratio of the price of gold to oil is, as a result, “becoming an indicator of systemic risk, moving closely with volatility,” he said.
He’s bearish on gold with a target of $955 an ounce. So expect this ratio to crash as, when, markets settle down.