FOMC Gives Direction
Leading into today’s FOMC decision, the dollar has been sold hard against every currency or commodity listed for the last few weeks, partly because of a rally in equities, but also because the Fed and the treasury have demonstrated that recovery is their top priority even if it means disregarding the dollars’ value. So the most important factor became the Fed’s perspective on recovery and whether they believe increased easing is necessary.
Hours before the Fed decision, all markets began gaining slowly on the dollar as they anticipated a sell-off and new highs. The knee jerk reaction was to continue to sell it shortly after the release. But then the market realized quickly that the release was optimistic and did not say that rates would remain low as previous releases had stated. Three and six month Fed fund futures began to price in rate hikes, the dollar gained on all currencies, and equities fell into the red for the day.
We believe that the larger dollar bearish trend is still intact and we look forward to a possible correction here as an opportunity to buy EUR/USD and AUD/USD on the cheap. The economy still has gaping craters in unemployment and bank stability which will stifle lending for some time to come. The idea that the economy is improving enough to allow the Fed to raise rates soon is wishful thinking and we will be looking for confirmation of this on our charts.
Some areas to keep an eye on in the Euro:
1.4700, 1.4670, 1.4647 for a minor correction
1.4570, 1.4516 for a major correction
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What Do They See That We Don’t? Global/Domestic Risk Divergence
Over the course of the credit crisis global risk aversion has led domestic risk aversion. Even though the fundamentals in the domestic economy triggered the sell off, such as the failure of Bear Sterns and the following revelation of subprime exposure, equities markets refused to believe the bad news even as the carry trade began to collapse. As the US government rushed to the aid of the financial sector in August-October of 2007, equities traders took this as a sign that all was well and pushed stocks to new highs in October of that year. However the carry trade did not rise and it was clear the market was extremely long on risk.
At that point I knew that the divergence I was seeing illustrated a very serious situation which the equity markets were not taking seriously due to their perennially bullish bias. I got very bearish on the stock market and took a large short position in GBP/CHF at the beginning of November 2007. I made about 200 pips and left 18,800 on the table. I only would have had to wait a year.
In the subsequent months to follow, the GBP/JPY kept pushing lower as risk was liquidated and borrowed yen was repaid en masse. Each new low was followed by a new low in the stock markets. Failing to see the global picture, they continued to believe the situation was better than it was. When stocks bottomed out in March, they climbed hard dragging global risk assumption with them.
But recently as the S&P 500 has broken above 1000, we are seeing balance-sheet bankrupt financial companies being bought like candy, very poor PE ratios, and a downturn in global risk again. You can see this divergence on the chart below. The green line is the GBP/JPY, representing global risk. The red candles are the S&P 500. You can see at the very end how global risk has chopped lower but equities have risen. I am guessing that the market anticipates a bullish third quarter and so they have positioned themselves for it. If past correlations are any indication, September may show a sharp correction.
This week’s fundamental news will be a key indicator. If bad news is taken seriously or if good news gets a weak response, we are probably in for a correction. If bad news is shrugged off and good news is bid hard, then this bull leg could last longer or range. Either way this week will be pivotal because this divergence cannot last.
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A Tale of Two…Tales – Has Risk Run Its Course?
For the last two years the Forex market has been controlled by two stories. One is the dollar/anti-dollar story based on the US dollar’s status as world reserve currency, and the other story is risk assumption and liquidation. The question of the dollar’s sustainability as the world’s reserve currency is by far the bigger story in the Forex market as 90% of currency transactions pass through the dollar, and many countries hold our dollars as savings and collateral for issuing their own fiduciary medium of exchange. When this story moves to the background, then the risk on/risk off trade dominates the market. So whenever China or Russia make statements objecting to the US debt and threaten to diversify their dollar holdings, the dollar will depreciate for a few weeks until the fear cools off and traders and investors return to swapping risk back and forth.
The US Dollar Move
From April till June the dollar lost ground on speculation of Chinese diversification and unwinding of dollar longs from the dollar appreciation that took place from July 2008 until January 2009. Over the last eight weeks it has struggled to make new lows, moving into monthly and weekly resistance levels on the EURUSD and GBPUSD at 1.4300 and 1.7000 respectively. Strong reversal patterns have formed on daily and weekly charts indicating that the dollar/anti-dollar story might be due for a relief retracement and bring the other major story to the fore: risk.
The Risk Trade
The S & P 500 has been in a strong uptrend along with the dollar depreciation, as it has followed the risk assumption direction of currencies. Bad news has been shrugged off and any good news has been bought up quickly. However, even after the best non-farm payroll report in months and promises of more easing than the market believed it would receive, equities failed to make new highs and currency risk began dropping off substantially. This is a clue that the trend might be changing and a sustained break of the 966 level would probably see the S & P 500 revisit 870 and a short term dollar depreciation. The wild card is that the market is quite thin across the board right now, and if new money with a bullish outlook stepped in to buy a pullback it could easily reverse the retracement. This is why the outlook remains short term.
Currency Outlook
The British pound is my favorite pair and it tends to be the best gauge of which story is dominant, since the Bank of England’s monetary policy is similar to our own. Its economy is even more dependent on finance than ours, and so it will lose ground quickly when risk is being liquidated, but gain it back when risk is being assumed or the dollar devalued. Those two factors dominate this pair to a greater degree than any other.
GBPUSD Analysis
After encountering monthly resistance from November 2005 at 1.7040, the pound is challenging a steep uptrend line on the daily chart. After a daily close below this line, a retracement to support in the 1.5700 area is likely, and possibly even the 1.5350 area. Those support areas also coincide with the 38.2% and 50% Fibonacci retracement levels of the pound’s move from 1.3501-1.7041. There is another shallower uptrend line in the 1.6300 area which would give some support but would not be likely to hold. There would be very strong support in the 1.5065 area.
Conclusion
If the above technical conditions occur, we expect a near term appreciation of the dollar across all assets that will be accompanied by a corrective move in equities. Unless the Fed were to issue another round of new expansionary monetary policy or the Chinese were to begin open diversification, most currencies except the yen and exotics will be hard pressed to gain on the dollar.
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USD/JPY - Are Happy Times Here Again?
After last Friday’s Non Farm Payroll report came in better than expected, the USDJPY was the strongest mover of the pairs, gaining 250 points in a few hours. At the same time, both the Pound and the Euro toppled from their monthly resistance levels, making it a pure dollar move across the board. This is a strong indication that there is real dollar buying with the intention of investing in the American economy because normal risk co-relations were violated. Even if this buying is overly optimistic, a solid follow through move is very likely as sideline money will be itching to get in for fear they are missing the recovery.
The USDJPY has broken above the 100 DMA, 200 DMA, and a weekly downtrend line, which is a strong bullish signal. The former highs are in the 95.80 area and we expect stiff support there. Real buying ought to protect our stop, and anything in the 95.00’s will probably be considered a bargain. The first target is the four hour pivot zone at 97.15, and the second target is a break above the recent highs through the 98.00 figure.
Sentiment is the true wild card. In the hours leading into the NFP report, USDJPY eased lower on the expectancy of risk aversion. The market was clearly too short and the result was a tremendous short squeeze. Because of the low open interest, new money will now have a stronger influence on direction than positions already in the market. This is how bubbles are created and warns of coming maturity in a move. Should new money come in and follow this move through with all the hype of this long awaited “recovery,” we will profit from the ride, but watch out for a reversal because it will then be heavily long and the new money will have to cover.
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Risk Weakness Starting to Show
In spite of the gain seen on equities so far today risk has started to waver in the Forex market, which creates an interesting divergence. Risk was bought up leading into Bernanke’s speech, which is a strong indication that price action will go the opposite direction in the aftermath as the short term buyers are forced to cover when price fails to follow through in their direction. It is the same idea as when a cartoon character runs off a cliff in a straight line, then looks down and sees only air.
The S&P 500 has tagged the 950 mark, and has not been able to push any higher, so a technical retracement is probably in the works. Most of the news that is supposedly driving this rally has been mixed, leading us to believe that it is more of a technical move than solid buying. We are sellers of the weaker pairs against the yen, which at the moment are EUR/JPY, GBP/JPY, and possible CHF/JPY, as the Swiss nears previous intervention levels against the dollar.
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