Volatility, a Function of Liquidity

The Asian session started highly volatile, but markets have managed to stabilize during European hours. USDJPY assumed a strong offered tone at the London open despite broadly stable market conditions, though market performance remain largely dependent on the news flow out of Japan. I'm amazed at how the marketplace searches for reasons for the spike in JPY. In my view, it is simply a lack of liquidity. With equities assets on offer, the selling curve does not have to change, when the bids come off the table, the market/asset class will fall hard. In the case of the JPY today, the shift occurred when the market is at its lowest level of liquidity, which makes the crosses highly vulnerable. Why do none of the reporters discuss this? You can see it in the price action! This is why price action rules.

The Nikkei ended the session down only 1.44% after futures had indicated up to 8% in losses, but before the North America open Japanese news wires reported that water cannon spraying was called off due to high radiation levels. So long as there is perceived information deficiency regarding the current crisis in Japan, a general tone of risk aversion is expected to remain, so we are expecting further JPY strength. In other news, the SNB held its policy target at 0.25% and we believe their statement was broadly dovish. The CHF has been the strongest performer. We were long EURCHF for a couple weeks... took a little out on the rallies and were washed on the remainder of the positions during the recent rally in CHF.
Amid all the frightening scenes from Japan's disaster-struck areas, past earthquake experiences should serve as a reminder of one crucial point: Japan will be resilient. While growth will suffer over the short term, a strong private and public reconstruction effort will follow. One wild card for financial markets is how USDJPY will fare in the face of Japanese repatriation, but the policy backdrop suggests better support for the pair than in 1995, when it fell 20% after the Kobe quake. It appears the large institutions have not yet drawn back into JPY, which may make things interesting as the pair moves lower.

The euro weakened too during the flight to safe havens. Rate expectations for the ECB have slightly pared back since the tragedy in Japan and so ECB speakers are garnering more attention as market participants want to see how central banks might react. I am not convinced ECB will raise rates in April, subject to increased volatility and lower levels on major indices, which may push back the ECB decision to raise rates.

The Spanish bond auction was considered to be strong as the bid to cover ratio for the 10-year came in at 1.81x vs. 1.54x prior. Considering the state of the market the periphery bond market is faring quite well, but we believe the market is struggling to aborb all the event risk at this stage so price action may be delayed as the market takes price back into the range.

USDJPY set an all-time low of 76.36, according to Bloomberg. USDJPY collapsed in a matter of minutes on the back of continued headlines related to the nuclear reactors in Japan, which eventually triggered a cascade of stops.
The SNB kept its 3m LIBOR target unchanged at 0.25%, though we judge the SNB statement to be more dovish and may negatively impact the franc. The longer-term trajectory of the inflation forecast was largely kept unchanged but even so, inflation is only expected to hit 2% in 2013 which is well beyond the necessities of short-term action.

In addition, EURCHF suffered heavily overnight on the back of risk aversion so any form of tightening needed is already being done through the currency. The SNB expressed particular concern about other global developments and its impact on Swiss markets, and this will likely remain the driving theme within the policymaking community at this stage.

Source: UBS, Bloomberg, Chris Lori