A risk recovery sets up a rally for equities
There has been a decisive rebound in equity markets in the past week. With a lack of confidence-sapping bad news in the banking crisis, traders are looking at conditions that can set up a rally for equity markets.
Here’s what we are seeing:
- Volatility measures are reducing: This is a key indicator of more stable sentiment for markets
- Lower bond yields help equities to rally: With negative correlations resuming, lower US bond yields are supportive for indices
- Equity markets are recovering: Key levels of resistance are being broken
Lower volatility indicates an improvement in sentiment
There has been a decisive shift in sentiment seen over the past week.
The first few weeks of March were characterised by the fear of what a US banking crisis might turn into.
The failure of three mid-tier US banks spread to Europe with the collapse of Credit Suisse.
However, with UBS agreeing to a takeover of its Swiss rival, and supportive actions by US banking authorities, the fears have eased.
Volatility measures are beginning to normalise
This easing of fears is reflected in the reduction of volatility gauges in bond markets, forex and equities.
Although the volatility in US Treasury bonds (measured by the ICE Bank of America MOVE Index) is still elevated, it is now tracking decisively lower.
More settled bond markets help to calm sentiment across asset classes.
We can see this reflected in forex volatility (as measured by the Deutsche Bank Currency Volatility Index) also dropping back. Lower currency volatility also reflects calmer markets.
Furthermore, we can see that volatility on equity markets is also significantly reduced from where it was a couple of weeks ago.
The VIX Index which measures the volatility of S&P 500 options has fallen back to a far more normal level of around 20.
The volatility reduction is not limited to Wall Street, with the DAX volatility index (known as the V-DAX, a gauge of the volatility of German stocks) also showing a significant reduction.
This is important when compared with the German DAX Index. There is a clear negative relationship between volatility on the DAX and how German equities perform.
This is because trades rush to buy index put options (effectively downside protection for their portfolios) during times of elevated fear. When the fear subsides, the demand for put options reduces and the prices fall.
Subsequently, lower volatility reflects a more positive outlook for equities.
Finally, we also note the reduction in trading volatility too. The Average True Range levels of major markets has started to reduce.
This has implications for traders.
As the sharp daily swings settle down, it allows traders to position their trades with more conviction.
Negative correlations with falling yields are also supportive
The negative correlations that the S&P 500 futures and the NASDAQ have with real US bond yields may have broken down in recent weeks, but they are now beginning to get back on track.
Lower real yields help to support Wall Street.
We can see this in the S&P 500 futures versus real US bond yields (as measured by the US 10-year Treasury Inflation-Protected Securities).
S&P 500 futures have a very strong average correlation of -0.50 over the past 12 months. Although this correlation has been questioned during the banking crisis, in the past two weeks it is resuming once more.
It is also clear that this correlation is seen in the NASDAQ too. The average correlation in the past 12 months is also very strongly negative at -0.52.
Falling real yields are helping to support US equities once more.
Technicals show key resistances being broken
Looking at the technical analysis of major markets we see that there is a decisive recovery underway.
With markets breaking through resistance levels, the reaction to any near-term pullbacks will be key.
S&P 500 futures (SP500ft)
S&P 500 futures have been effectively rangebound since November.
However, the reaction in the past couple of weeks to the improvement in sentiment has brought a test of the range highs once more into view.
- A three-week uptrend has developed
- The market has closed above the resistance at 4082.
- The daily RSI confirms the breakout and is now consistently above 50.
This all points towards buying into weakness for a test of the 4185/4208 key range resistance.
There is a band of support between 4035/4082 to continue to play the near to medium-term recovery.
A move below 3937 aborts the recovery outlook within the range.
NASDAQ 100 futures (SP500ft)
The futures have broken decisively clear of the 12955 key resistance (from September and February highs) and is looking decisively positive now.
- Momentum is strong with the RSI in the high 60s.
- Moving averages have decisively swung higher.
The key now is the reaction to weakness.
Any unwinding move needs to build support in the 12650/13080 band to sustain the recovery momentum.
If this breakout can hold, then a test of the 13740 key August high could be seen.
German DAX Index (GER40)
The DAX has recovered strongly in the past couple of weeks and is now eyeing a retest of key resistance at 15712.
The key development this week has been:
- The move above the mid-range pivot band between 15185/15325 has been the.
- The confirmation on the daily RSI moving decisively above 50.
This opens to buying into supported weakness for a test of the 15712 March high.
A move above there would then open the way towards the all-time high at 16300.
The pivot band between 15185/15325 is initial support.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorised to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
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