Is the correction beginning?

The long-lasting low tide of liquidity created by the US Federal Reserve’s monetary policies may, finally, be coming to an end.

Recent weeks have seen a ratcheting up of price volatility, in particular in the precious metals – Gold and Silver and also in the wildly overbought Nikkei (something we flagged just days in advance, see here – http://www.spreadbetmagazine.com/blog/the-japanese-bubble-reaches-new-technical-extremes.html). For now, however, the UK, European and US equity markets continue to sail on unperturbed… Many are asking however when the tremors seen in the Japanese and precious metails markets will hit their shores?

Until today, and especially since September of last year when QE3 was first announced, equity prices have been rising steadily, in a very predictable and somewhat too stable a manner… Central banks seem to have eliminated equity risk and have succeeded in pushing people out of bonds and into equities. The commitment from central banks to this purpose is strong. Probably the strongest, ever. They will seemingly do whatever it takes and print as much money as necessary to avoid a crash and  a consequent economic retracement. In short, they have painted themselves into a box.

Unfortunately for the central bankers, the frequency of fires doesn’t depend on the willingness of the fireman to extinguish them. Thus, no matter the strong willingness to avoid crashes, they are an inevitable part of the landscape and in recent years have been occurring with increasing frequency. We have already had two sharp shake downs this year: one in gold, the other in Japanese equities. These crashes were the result of economic distortions created by artificially inflated price increases.  Price increases created by the central bankers policies of print and be damned. They provide a small foretaste of how a ‘big one’ can hit, despite the apparent quietness all around as evidenced in the volatility stats going into these routs. They are alarming and may, just may be an earlier signal for the major tsunami to come.

After a twelve year rally that has led the gold price from less than $300 per troy ounce in 2000 to a record high near $1,900/oz last year, the sheen has certainly come off the yellow metal in recent months (something we flagged at the start of the year in our 2013 outlook – see trading guides).  Uncertainty about QE’s finality and the recent ever-rising equities valuation has made investors rethink about the value of investing in gold. With this in mind, and in a somewhat unexplained session on April 12 this year, gold dropped 5.2%. As if that was not enough to churn a few stomach’s, gold then declined a further 8.7% over the next session. The precious metals 1-month annualised volatility spiked to 40% after this event and currently sits around 20% after many months being at just 10%. Another example of how the current equity market very low volatility figures can deceive and provide a false sense of security…

Weeks after the gold crash, we experienced an aftershock of the major quake hitting gold. This time, the Nikkei was the victim. In a single session, Japanese equities declined 7.3%. It happened last Thursday. After a YTD rise of more than 40% on top of a 23% 2012 appreciation, Japanese equities were well and truly exposed. Monetary policy in Japan has resulted in material debasement of the Yen and which has helped exports and will certainly be a boost to GDP. But, a rise of the magnitude seen in the equity markets in such a short period of time and under the current unfavourable international picture, was a correction waiting to happen. Again, following the sharp decline, 1-month annualised volatility spiked to 34%, a level not seen since march-April of 2011.

After Gold and Nikkei, who will be the next?

The sudden declines in both gold and Japanese equities has led to rising volatility in these instruments but the volatility of other commodities and US equities remains low – an ideal time to begin to place Put options perhaps? When one looks at US equities we see an eternal calmness with volatility sitting at just 10% since QE3 was unfolded. The disconnection between equities and the real economy won’t last forever though. Indeed, the put-call ratio is already peaking as the smart money is preparing for a sudden reversion to the mean it seems. Given the time of year, the alarm bells are beginning to ring…