Volatility May See Range Breaks across Markets but Trends Might be Short-Lived
Going into the second quarter, the macro environment for financial markets is characterized by stubbornly high inflation and an evolving banking crisis. Will volatility continue to evolve?
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While separate, they are related. The ultra-loose monetary conditions of the pandemic era created circumstances that allowed for a large amount of spare capacity of liquidity. That led to building price pressures and excessive availability of capital that enabled risk-taking that would otherwise have been challenged by the market.
The inflation problem is well documented, but the unfolding banking crisis has created uncertainty around the viability of some institutions. The banks that have failed so far have done so for two different reasons. The first is the mismanagement of their balance sheets which saw a mismatch in assets and liabilities. Silvergate Bank, SVB Financial and Signature Bank could be in this category. The second is weak balance sheets that are exposed when financial conditions tighten to make capital harder to obtain and more expensive. Credit Suisse and Republic Bank could be in this category.
How many more impending collapses there might be is the great ‘known unknown’. Observing equity indices and FX, the long, drawn-out trends that prevailed through the pandemic era appear to be over for now.
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However, elevated volatility from this uncertainty can be seen across several asset classes. This scenario has seen ranges build over time and often break to one side before either establishing a new range or folding back inside the prior range.
In this type of trading conditions, false breaks could set up an opportunity. This type of trade requires robust risk management and is generally typified by smaller position sizes and wider stop loss parameters to allow for excess volatility when markets break the range.
An example of this kind of market is gold. It has been in a wide range of 1,615 – 2,075 for almost 3 years. It broke below an ascending trend line and then broke below the prior low of the range at 1,677. It made a new low at 1,615 In September last year before rallying back inside the range.
This price action is difficult to trade as many stop losses were cleaned out to the downside and it was unclear if a new range was being established or not.
Looking at the topside, the peak in August 2020 of 2,075 was unable to be eclipsed in the rally of March 2022. This made a double-top formation.
The current price is heading toward that high and this may present an opportunity. If selling near the prior peaks. A small position size may allow for a higher stop loss level in the event of a false break.
It should be noted though that past performance is not indicative of future results.
— Written by Daniel McCarthy, Strategist for DailyFX.com
Please contact Daniel via @DanMcCathyFX on Twitter