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When will volatility pick up?

Volatility in US Treasuries is at its lowest level since 2007, so too is volatility in the FX options market for short-term EURUSD products and the Vix has fallen sharply since peaking in autumn 2011. Yet Europe's sovereign stresses remain as strong as ever, Spain and Italy are struggling to sell their sovereign debt to anyone bar their domestic banking sectors and election risks are enormous as Greece and France go to the polls on Sunday.

So why is volatility so low? The answer lies with central banks and fairly tight FX ranges. When central banks come in and pledge that interest rates will remain extremely low until 2014, as the Fed has done, this limits the amount that yields can rise in the near-term. When multiple central banks are likely to remain on hold for some time, including the Federal Reserve and the ECB, this reduces the range in which the major currency crosses like EURUSD are likely to trade in, hence reducing the chance of volatile price moves.

This is the main reason why the single currency has been so resilient especially against the US dollar in recent months and traded in a 1.30- 1.35 range. If central bank inaction is not going to generate volatility in the market, upcoming events in the currency bloc may be more of a risk to volatility. This Sunday 6th May France and Greece hold elections. The French second round election will determine the next President and the latest polls suggest that Socialist candidate Hollande will beat incumbent Sarkozy, although the current President has seen his ratings creep higher in recent days and so he can't be ruled out entirely at this stage.

The prospect of a Socialist victor is concerning for the markets since could threaten relations between Germany and France. Although Merkel has said she will work with whoever becomes the next President of France, there are definitely tensions with Hollande, especially around the timing and scale of fiscal consolidation. Thus, a Hollande win is likely to bring tensions within the currency bloc about Germany's insistence on strict fiscal austerity into focus. It's hard to see how this spat will be resolved, and political instability in the upper echelons of power in the European Union at this stage of the sovereign debt crisis could be enough to trigger market volatility.

The Greek elections this weekend are another signal that the private-sector debt restructuring back in March didn't put Greek default fears to bed for too long. Sunday's election is extremely hard to predict since there are no pre-election polls in the two weeks leading up to polling day. Of the total 300 seats in Parliament, the last poll before the blackout suggested that the two major parties could win 158 of the seats, enough to form a coalition. However, the worrying thing is that just behind the Pasok Party are the Communist Party of Greece and the Coalition of the Radical Left who have seen their support surge in the last six months as politics have become fragmented across the country. These two parties could win 52 seats between them which would leave them a formidable force in Greek politics.

But why this result matters for investors and traders is that the two left parties have not signed up to the IMF's Memorandum of Understanding agreement that said whoever got control of the government at this weekend's election would implement current and future austerity plans in return for more bailout funds. It is hard to see the Communists or Radical Left signing up to more austerity, when there manifestoes have been anti-austerity in the lead up to the election. The IMF MOU includes extra tax administration improvements to the tune of 1.5% of GDP this year, and a further 5.5% of GDP in spending measures in 2013-14 to reach the goal of having a primary surplus of 4.5% of GDP by 2014. If the new government looks like it may waver on these targets then it would be hard for the IMF to give Greece more money, which makes a default more likely. Reports already suggest that government departments are running into arrears this year already, so the need for extra funds is urgent at this stage to avoid a messy default that would probably cause contagion across the periphery. The new government has until June 30th to come up with new spending cuts for the IMF, thus the outcome of this weekend's election could determine if Greece stays or has to leave the Eurozone in the medium-term.

Greece was where this crisis started and it could be where it ends, so if there is a surge in support for the radical parties in the Greek election this could be the trigger event that causes volatility to spike and the euro to break out to the downside of its most recent range. We would note that the market is not good at pricing political risk, so the 1.30-35 range may persist post the results of next week's elections, however an adverse outcome in Greece makes a break to the downside more likely.

Digesting payrolls:

The US payrolls data surprised to the downside as the economy created 115k jobs in April versus an expected 160k. The unemployment rate declined to 8.1% from 8.2%, although this is not as positive as the headline number suggests since the decline in the rate was partially down to a 500,000 drop in the participation rate. Adding to the confusing labour market picture was the upward revision to the March data to 154k from 120k originally reported.

So what does this mean for the markets? Until the US starts creating 200k+ jobs per month then you can't take the prospect of more QE from the Fed off the table. However, the three month average for US payrolls is currently 185k, which is sufficient to keep the economy growing at the 2.2% rate registered in the first quarter. Wage growth slowed last month, after expanding by 0.2% in the March. So-so employment figures and no earnings growth suggests there is room for the Fed to move, but the question the market needs to ask is when this will happen? QE from the Fed has had an enormous impact on the markets in the past, so it will be important to listen out for Bernanke, who is speaking next week along with a host of other Fed members, to see if the deterioration in the labour market has shifted the Fed's stance. Next week's producer prices data will also be important to determine whether or not the Fed could provide more stimuli to the economy, the market expects producer prices to have remained fairly muted last month.

Essentially this means that the Fed is still a long way from tightening policy, which could limit dollar upside in the medium-term, thus leaving it to Eurozone political risks to cause a significant shift in the EURUSD 1.30-35 range. Likewise, this data along with muted Treasury yields has weighed on USDJPY. It is currently below 80.00 as we edge towards the end of the European week. If we get a weekly close below 80.00 in this pair this is extremely bearish. Good support lies at 79.60 - the 100-day moving average, and then 78.40 - the 200-day moving average, which are two key levels that the markets are watching closely.

The oil price was a major mover post the payrolls data. US oil declined $7 to below $100 per barrel at the end of last week as the weaker US economic outlook caused investors to ditch commodities. Support lies at $97.50 - the 200-day sma - below here opens the way to $95. The bigger picture suggests that the uptrend is over for oil for now.

Will there be more QE for the UK this week?

The economic data out of the UK in the past two weeks has, on balance, surprised to the downside. The economy plunged into recession in the first quarter, the April PMI surveys were all weaker than expected (although they remain above the crucial 50 mark) and bank lending data was dismal after the latest lending data showed a 3.5% decline in the annual rate.

This makes the outcome of this Thursday's Bank of England meeting slightly less certain than it was when we got the BOE minutes, which showed that the Bank's most dovish member had shifted to a neutral stance at the start of April, leaving only one member voting for more QE. We continue to think that the Bank will refrain from adding to its current asset purchase programme that will end in June. However, if the economic data continues to deteriorate then we could see Adam Posen and others return to the dovish camp this summer. However, there is a slight chance of more QE in May, and if the Bank was to go for it, even if only by a small amount of say GBP25 billion, we would expect a sharp move lower in the pound. This is because the pound rallied hard last month when BOE member Posen refrained from voting for more QE. In GBPUSD 1.6060 is a key support level as below here the uptrend weakens significantly.

Our base case is that the Bank doesn't add to its asset purchase programme yet and the uptrend in the pound remains, although it may slow down as we head towards 1.63. The pound has proven resilient to the negative economic data surprises in the UK, and it is also benefitting from safe-haven flows out of Eurozone bonds and into the Gilt market, which we expect to continue in the medium-term. Thus we see GBPUSD as a buy on dips towards 1.6100 this week.

Data Watch:

There is not much top-tier data out of the Eurozone next week, leaving the market time to digest the election results in France and Greece, although bond auctions in Italy on the 11th and 14th of May will be worth watching especially after Italy's PMI data plunged even further into contraction territory in April.

Apart from the BOE decision in the UK on Thursday, producer prices and industrial data are the key releases. China releases CPI for April. The market expects a decline in the annual rate to 3.4% in April from 3.6% in March. Industrial production is also expected to pick-up slightly and expand at a healthy 11.7% rate relative to a 11.6% in March. The economic data in China has surprised to the upside in recent weeks, which takes some pressure off the prospects for global growth especially as signs of weakness have crept into the US labour market in recent months.

Australian employment data for April will also be important next month. The RBA cut rates by 50 basis points last week and released a very dovish Monetary Policy Report with reduced growth and inflation forecasts. Employment is expected to drop by 5k, pushing up the unemployment rate to 5.3% in April from 5.2% in March. Retail sales are released on Monday; they are expected to have increased by 0.4% in the first quarter. Any signs of weakness could cause another leg lower in AUDUSD, which slipped below 1.0200 on Friday to its lowest level since January. Watch for a weekly close below 1.0150 - the bottom of the weekly Ichimoku cloud - as below here signals the start of a more profound technical downtrend.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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