Risk Premium

The cries for going totally crazy are growing louder... the lunatics are running the asylum. One shouldn’t underestimate what they are capable of. The only consolation is that the day will come when the monetary cranks will be discredited again (for the umpteenth time). Thereafter it will presumably take a few decades before these ideas will rear their head again (like an especially sturdy weed, the idea that inflationism can promote prosperity seems nigh ineradicable in the long term – it always rises from the ashes again). The bad news is that many of us will probably still be around when the bill for these idiocies will be presented.

Eurodollar curve captures the mechanics of Fed expectations in a simple way. Away from the very front end, the curve dynamics is displays a rather rigid structure where a single risk premium parameter explains bulk of the spreads movement in different sectors of the curve. Typically, in anticipation of Fed hikes or cuts, the market makes up its mind about the terminal Fed funds (Greens) and begins to price in the rates path around that. The more aggressive the initial hikes are, the less they will have to do later

"Our model indicates the US equity market could potentially drop by 30% in the event of an ‘EM lost decade’ and by 60% in the event of a China hard landing (i.e. S&P 500 back to its lows)."

The results from Portugal's elections are beginning to trickle in and according to exit polls, Coelho's coalition has prevailed. According to Bloomberg, the ruling coalition of Prime Minister Pedro Passos Coelho has won 38%-43% of vote and 108-116 seats.

With deflationary pressures rising in the Eurozone, Japan and China, the Affordable Care Act levying higher taxes on individuals, and labor slack remaining stubbornly high, a continuation of a "struggle" through economy is the most likely outcome. This puts overly optimistic earnings estimates in jeopardy of being lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting becomes less effective.

Tomorrow's FOMC decision is the dominant topic for investors and traders across all asset classes, with FX, perhaps, the most sensitive to perceived changes (and instigator of trades via carry). As Credit Suisse details, FX volatility remains notably elevated and along with the uncertain flows surrounding so-called "risk parity" trading strategies, and the fact that 2y Treasury yields at around 0.80% are at their highest levels since 2011 - despite the less than 30% chance of a Fed hike priced in for tomorrow - only adds to the sense of uncertainty about the Fed's reaction function. In this light, how do we see the various possibilities that could emerge from tomorrow's FOMC? Here are Credit Suisse's 5 scenarios...

Will she raise or will she not? As financial markets focus on whether we will see a Fed rate hike this week, investors may be in for a rude awakening.

"August Sucks," concludes MIT Quant guru Andrew Lo, reflecting on the systematic-trading strategy effects on markets, and it's not going to get better any time soon. As he explains to Bloomberg, "algorithmic trading is speeding up the reaction times of these participants, so that’s the choppiness of the market. Everybody can move to the left side of the boat and the right side of the boat now within minutes as opposed to hours or days." As we have noted many time, Lo explains how "crowded trades have got to the point of alpha becoming beta," warning that volatility-targeting strategies (such as Risk-Parity) are not only "exaggerating the moves," but he cautions omniously reminiscent of the August 2007 quant crash, "I think they are creating volatility of volatility."

Stocks in Asia and Europe have fallen sharply again this morning and gold remains robust on safe haven demand

As Deutsche Bank put it on Tuesday, we've officially reached the end of the "Great Accumulation" as slumping Chinese growth, plunging crude, and an imminent Fed hike have put enormous pressure on emerging economies’ accumulated stash of FX reserves and that means that buyers of USD assets are becoming sellers at the expense of global liquidity and the perpetual bid for some core paper. Now, Goldman has weighed in, noting that the rise in foreign FX reserves held by non-G-7 countries that started around 2003-04 (at around US$1trn) appears to have ended for good.

The current VIX level of 26 is equal to the median VIX level over the last three recessions. As Goldman warns, while extreme VIX levels periodically occur, our analysis shows that VIX levels in the high-twenties to low-thirties for extended periods of time are rare outside of recessions. Furthermore, this was foreseeable as equities were ignoring potential warning signs from other asset classes prior to the recent sell-off.

The similarities between the current crisis and that which unfolded in 1997/98 were so readily apparent that many analysts began to draw comparisons and that may have added fuel to fire over the past week. Now, there seems to be a concerted effort to calm the market by explaining that while there are similarities, there are also differences. And while some of the world's imperiled EM economies may be in better shape to defend themselves this time around, when attempting to cope with a meltdown it may be more important to look at where things are similar and on that note, here’s some color from Morgan Stanley and BofAML.

These are Goldman's four reasons why the bank expects the S&P 500 will end 2015 unchanged from the current level: High starting valuation, negligible earnings growth, outflow from domestic equity mutual funds and ETFs, and modest economic growth. Offsetting these headwinds to a higher market, buybacks remain robust and serve as a pillar of support in the current environment.

... and the ECB printing presses!