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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