Today’s themes – Currency cross rates, U.S. Treasury notes, gold & Novagold Resources Inc.
Currency Turmoil, Cross Rates and More
In our last weekly update we focused on rising yen volatility as investors shunned risk and reversion of appetites for carry trades sent the yen on its upwards trajectory. Increasing press interest in this development helped send the yen towards 107.50. Implied option volatility also rose further, squeezing short yen players out of the game. As equity markets around the globe fell, they reached 10% correction levels, causing further liquidation of currency holdings in currencies traditionally associated with risk-loving investors.
This week we thought it would be useful to isolate the U.S. dollar and focus on some key cross rates to see where the relative strength in individual currency plays was coming from. First up is the euro/yen rate. Both currencies have shown extreme strength against the dollar lately and only by looking at the cross rate can you get a sense of where you’d be better off allocating your capital.
Chart: InteractiveBrokers
After the August credit crunch the yen lost out to a rallying euro, which gained from 148.75 back to 168.00 and close to its 2007 peak. The latest bout of rising volatility in the yen has created strong appeal for the yen even as the euro creates an all-time high against the dollar. One has to wonder whether the euro will regain its poise against the yen after the recent rise in German and French business confidence. Furthermore, German inflation rate is at an eleven-year high, prompting the question of whether the ECB might even raise interest rates. On Tuesday, options implied volatility slipped from 15% to 14% and if that trend continues, one might reasonably expect the path of least resistance to favor a resumption of the summer move higher for the euro.
We’ve noted over recent weeks how the fortunes of the British pound might falter, given that the economy is slowing and that the Bank of England might ease monetary policy.
Until the recent bout of risk aversion hit home, the two traditionally favored short-play candidates were the yen and the Swiss franc. Take a look at the performance of the British pound versus the Swissy of late.
Chart: InteractiveBrokers
The pound has bought between 2.36 and 2.50 Swiss francs for 90% of the last six months – until it broke down lately. Demand for the Swiss franc to liquidate short plays was clearly large, while the easier tone as expressed through interest rate futures for the U.K. has only exacerbated this move in the sterling/Swiss pair. Recently the pound bought just Sfr 2.25. Unlike the potential for reversal in the yen, the local trend in sterling/Swiss may yet continue to feel for new lows.
The biggest losers in the recent currency upset have been the Canadian and Australian dollars. Fears over global growth have upstaged the previously bullish commodity dollar underpinnings and pulled a strong pillar of support away from them both. Look at the sharp ascent of the euro against the Australian unit in the following chart.
Chart: InteractiveBrokers
The euro rose from 1.55 to 1.725 in the space of two weeks. It wouldn’t even take a demand for carry trades again to reignite the Aussie unit as much as it would take real demand for copper and gold. But before that happens, we might easily see a retest of the 1.75 high from August.
Treasury notes
The slide in the value of the U.S. dollar courtesy of the potential for recession has shown itself up in the government bond markets as we noted last week. This week we have a chart to compare the performance of the S&P 500 index with the rise in treasury prices and therefore the fall in yields. When the equity market looks towards recession, it can be quite a bullish phenomenon. That’s because recession is likely to deliver lower fed funds rates, meant to kick-start the economy. However, even as bond traders look to ever-lower interest rates, equity traders have panicked, sending benchmarks to official correction levels of as much as 10% below the recent euphoric highs.
Chart: InteractiveBrokers
Back in August, the S&P index slumped to 1424 on initial weakness spurred by the potential financial market meltdown coupled with confusion over Fed comments regarding the need to address the credit crunch. At the time, the yield on the 10-year note stood at 4.72%, which was around a half percent beneath the short rate of 5.25% at that time. Similarly, the two-year note yield stood even lower at 4.28% and so indicated the market’s conviction that a full 1% easing of policy was on the cards. But see in the chart two key developments. First, the Fed did ease mid-September, which in turn spurred equity traders to embrace the combative recessionary measure and look forward to some resolution. The market ultimately rallied by 15% from its mid August low to a mid-October peak at 1576. So the follow-on point is the changed market sentiment towards both note prices and equities following that peak.
The bottom line is that the Fed’s action, while admittedly necessary, has left investors feeling some sense of impotency surrounding the Fed’s ability to maneuver looking ahead. The equity market’s correction saw a full 10.8% off the S&P 500 index, while note yields plunged for fear of a deeper and more protracted slowdown. When equities plunged on Monday of this week the two-year yield had fallen 1.39% further than its August low to stand at 2.89%, while the yield on the benchmark 10-year note had fallen to 3.84% or 88 basis points below the last fever-pitch low for yields.
Some reversal in the dollar’s fortune, coupled with affirmative action from financial institutions that seem prepared to face the maximum write-down today by dragging currently worthless deals onto their balance sheets, have helped instill a bullish rebound in the stock market.
The more that investors get used to the fact that homebuilding and the housing market won’t be able to attend the consumer-binge for the foreseeable future, the more likely it will become that equity markets will stabilize. If that mindset becomes entrenched, we can all look forward to a positive close to trading between now and the end of 2007.
German Bunds
Several weeks ago, we noted the potential for weakness in German bunds – the European benchmark equivalent to treasury notes. However, after a small correction to the downside, bund prices continued higher and have managed a fresh contract high (December basis). We did note at the time that U.S. yields were likely to slide beneath German yields and that view did pan out well. When U.S. ten-year yields slid to 3.83% this week, German yields stalled at the 4% barrier.
Chart: InteractiveBrokers
In the accompanying chart we’ve taken the liberty of adding what looks like a rather bearish formation for bund prices. Note the “rising wedge” as indicated by the support and resistance lines. The wedge formation breaks counter to the prevailing trend such that when prices are rising traders look for a break to the downside. When prices are contained in a downward wedge, short-term traders look for a reversal to the upside. Interestingly the buying climax coincided with peak flow into bonds globally and subsequent action from the financial sector is undoing the flurry into the safe haven of bonds. Second, German business confidence has increased while consumer confidence declined. Net-net bunds still fell today and look to have set off a potentially ugly pattern with an objective of 112.50 from the current 114.50.
Gold
The writing is perhaps on the wall for gold its recent push at a fresh peak thwarted two days ago. The recent November 8 surge in the December future to $847.80 took place prior to climactic selling of the dollar index on November 23, when the basket slumped to a weak reading of 74.65 also in the December contract. Three days later as is shown in the following chart, gold attempted a rally but failed to break higher than $831.70 per ounce.
Chart: InteractiveBrokers
That failure could mark a failure-top for gold with a clear lower peak right shoulder occurring in the picture. If the dollar’s rally does continue, there will be less natural demand for this alternative asset to protect against dollar weakness.
U.S. Equity Options Activity
We thought we’d stick with our golden theme today and follow-up with some interesting action on options on U.S. listed gold miner, Novagold (Ticker: NG) where our options market scanners picked up on heavy trading volume earlier this week.
Chart: InteractiveBrokers
Our market scanners piqued interest in bullish plays on the stock despite a loss of around one-half of the company’s capitalization on Monday. Near-term bad news on a gold project seems to be accompanied by good-as-gold confidence in a happy resolution for the company next spring. Options in Vancouver-based NovaGold traded at 14 times the average volume Monday after it was announced that NovaGold and its Vancouver associate, Teck Cominco would shelve construction on their Galore Creek copper and gold mine project, having failed to accurately gauge estimated time and labor costs for the project. NovaGold has reportedly sunk $400 million to date on the project, which it now says is “no longer viable” given current metal prices.
The chart shows the build in open interest, as option traders appear to take a forgiving tack toward the company’s admission. The March 25 calls attracted fresh long positions on a volume of more than 19,600 lots as these contracts traded at a 75% discount from Friday’s premiums. Call buyers also piled into the June 17.50 calls on a volume of 8,000 lots. Open interest in both series did build but shareholders will have to wait and see since the share price has not offered any sign of a rebound just yet. The episode once again highlights the perils of investing in gold through individual companies.
So what is the likelihood that these bullish plays will pay off in spades on Novagold? Well, by looking at the delta on both strike prices we get some valuable insight. Delta gives the change in the price of an option for a dollar change in the price of the underlying and broadly speaking gives the probability of an option landing in the money by expiration. That of the March 25 calls currently reads 12% or a one-in-eight chance that shares will rally by 168% over the next four months to expiration. In this case, that probability seems rather lofty and is possibly over stated thanks to the fact that implied options volatility, or the option market’s view on the future path of the share price, currently stands at 112%. As for the March calls at the 17.5 strike the option market currently assigns a likelihood of 40% that shares will reach the strike by expiration. In order to reach $17.50 the share price needs to rally by 88%. Just to draw a comparison here, for a similar move in the underlying stock over the same time period, the March 35.0 call options on homebuilder Toll Brothers (Ticker: TOL), whose share price is currently $19.20 are practically worthless at 5 cents each. The delta on those is just 3.4% indicating that the options market assigns practically no chance of the shares returning to where it stood in February 2007.
Andrew Wilkinson and Rebecca Engmann Darst
ibanalyst@interactivebrokers.com
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