USD Index Notches a New High

Last week, we covered the USD and concluded it was poised for gains. The Dollar did, in fact, gain against most of its major counterparts and the DXY notched a new high, breaking slightly above its December highs. The DXY is a weighted average and its heaviest component is the Euro. Therefore it should come as no surprise that the previous week was rather rough on the common currency. Greece is still very much in the news and not in a good way, dragging the Euro lower.

Last week's post mentioned that the USD was a win/win situation where either strong economic reports or very poor readings could send the dollar higher on expectations for higher interest rates or a flight to safety respectively. Unfortunately, it was a flight to safety that sent the dollar higher. So long as uncertainly and concerns cloud the economic skies, we are likely to see the USD trend higher. This week, however, the dollar will have to push a little harder to be able to maintain its momentum as it approaches new resistance levels. The first resistance level is right where the dollar made its new high on Thursday around 78.80-79.00. The next level the USD will need to overcome in order to march higher is 79.50. A clear break above the 79.50 level could send the dollar as high as 81.00.

An upward move for the USD this week is likely, though not as likely as it was last week. The higher probability is for some sideways consolidation while uncertainties in the economy clear and earning reports shed more light on the state of affairs.

Ladies and Gentlmen, Santa Has Left the Building

A dramatic three-day decline in the S&P brought the index down to pre-"Santa Rally" levels. The sell-off was broad and volume was high across the board as stocks were unable to fight a barrage of disappointing earnings mixed with general uncertainties in the marketplace and tossed with the certainty of an eventual pull back. Leading stocks and sectors (Financials: GS, JPM. Tech: GOOG, APPL, Industrials: X)  turned low before the S&P 500 signaling distribution and possible shifts in money allocation among the big players in the market.
A quick recap of what's weighing down the market is in order:

1. Sovereign debt - sovereign debt concerns continue to linger as Greece struggles to dig itself out of a hole and  mounting pressures elsewhere (California, Spain, Italy, Dubai, East Europe) continue to linger.
2. China - concerns over China's latest steps to curb its booming economy.
3. US bank regulations - talks about new bank regulations, designed to limit the risk big institutions can take, have been  major drag on finanacials and the broader market.
4. Uncertainty regarding the futures of Mr. Bernanke and Mr. Geithner have also contributed to the general lack of enthusiasm in the markets. 
5. US Earnings - a mixed bags of earning reports left the market underwhelmed and served as yet another indication that we are still in recovery mode.
6. S&P break trend lines and key support levels - nothing sums everything up better than price action and a quick look at the S&P is quite revealing. The broad index busted though major support and fell decisively below its 50 day MA, a prior support.
   

So what's next for the stock market? and why should we care? after all this is a FX blog, isn't it? well, the pullback in the stock market is a long awaited one. As such, we can assume that many investors who had their money in stocks were dancing close to the door, so to speak, ready to sell on a short notice. At the same time, we can assume there are many out there with dry powder who have been patiently waiting for a chance to get in. How far down will the market go is anyone's guess. However, it is unlikely to test the March lows. Instead, it is more likely the S&P will find a new, more relevant, support level from which it will trade sideways in a range until new catalysts (e.g. more stimulus, lower unemployment rates, etc) can send it higher. In my opinion, the S&P will find support around the 950-1000 level. We care about the stock market because its direction is indicative of risk tolerance/appetite and because the perception of risk has played such a dominant role in the foreign exchange markets, particularly since the beginning of the financial crisis.

USD Poised for Gains in the Week Ahead

While the US dollar index (DXY) retraced some of its December gains, it is still noticeably stronger than it was in the beginning of December 2009. Here are some signs we may see the dollar index advance in the coming week:

1. DXY failed twice to close below its 10 Week EMA:

2. Retracement in the DXY has been relatively shallow, finding support around the 38.2% level - suggesting the uptrend may resume from here:

3. USDCAD, USDCHF trade near weekly/daily support levels while AUDUSD is near a major daily resistance level. GBPUSD and EURUSD also look bearish in the short term. All suggesting we may see further strengthening in the US dollar.

4. Fundamental backdrop: last week's key earning reports disappointed. Alcoa's numbers failed to impress and JP Morgan, while profitable, signaled problems in consumer credit delinquencies that sent the broad market lower. The disappointing earnings coupled with concerns over China's attempts to slow down its booming economy provided a convenient argument for traders to shy away from "risky", higher-yielding currencies in favor of US dollar and Yen's relative safety.

As I mentioned several times in the past, there are two favorable scenarios for the dollar: strong, sustained recovery or, quite the opposite, the return of fear into the markets. Somewhere between the two lies the worst case scenario for the dollar - a long, sluggish, jobless recovery and  a stagnant US economy - the perfect conditions for the Fed to maintain low interest rates and loose monetary policies.

When the DXY climbs, Dollar/Yen ratio will usually serve as a good barometer as too which one of the scenarios above is playing out. Expectation for strong US growth will normally send USDJPY higher, while return of fear into the market will cause the dollar to gain strength against most currencies but the Yen, sending the Dollar/Yen pair lower.

New Economic Data Signal Trouble Ahead for USD

The economic data released today for retail sales and unemployment claims both came in worse than expected. I mentioned before that the dollar is a win/win if we see a strong recovery (suggesting rate hikes) or a double-dip recession (back to safety). However, a prolonged, lackluster recovery can spell real trouble for the dollar as the anticipation for rate hikes move further into the future.
It should be noted that some in the Fed are sounding increasingly hawkish. Thomas Hoenig, president of the Kansas City Fed, suggested earlier this week that emergency measures should be expired as scheduled and that the Fed should be focused on the perils of raising rates too late rather than the weak, jobless recovery. Speaking to Bloomberg's Kathleen Hays, Hoenig said that “Monetary policy is about tomorrow. It is hard to keep that in mind when you have 10 percent unemployment.”
One must also bear in mind that markets "choose" how to interpret rate hikes. A small rate hike earlier than expected could be interpreted as a sign of confidence sending the stock market (and possibly dollar)higher.
As for today's disappointing numbers, as of mid day, they seem to have had a negative effect on the dollar but completely ignored by equities as the S&P climbed a couple of points higher, flirting with its major 1150 resistance level.

Good News in the Form of Bad News Hurt Aussie

Here's the bad news: In effort to curb its explosive growth, China has imposed higher reserve ratios on its banks. And the good news? China is experiencing explosive growth.
The "bad" news from China sent the Aussie down against its major trading counterparts as short-term traders opted to focus on profit taking. But the big picture, suggested by China's latest move, is clear: China's economy is booming. And a booming Chinese economy is a boon for Australia's economy and its currency. So once the dust has settled and the last of the Aussie's willing sellers has stepped back, I would expect the Aussie to resume its stellar ascent. The markets have a terribly short memory. They were willing and able to make Greece and Dubai a distant memory as they continued to advance forward. Chances are, this lasted news from China will be faded by the markets, and maybe even re-interpreted in the future as a positive. For the time being, we will continue to look for opportunities to long the Aussie, especially against the Yen.

As One Year Ends, a New Decade Begins

Well, I guess this is kind of a heavy title but we are starting a new year and a new decade and what better way to usher them in than with the my first post for 2010! I avoided posting anything in the last two weeks of 2009 mainly because of holiday mood but also because volume was so thin across the board, leading to spikes and extreme moves which did not contribute to a clear direction in the markets. 

I figured now would be a great time to take a little survey of the major currencies and take our first baseline for the year. Before we look into individual currencies, it is important to note a major theme that emerged in the final weeks of 2009 and set the stage for 2010. The theme I am talking about is relativity. For the better part of 2009, the major currencies traded in tandem vs. the US dollar with a high degree of correlation. When the Euro appreciated against the dollar, so did the British pound, and the Canadian loonie (Yen was the exception to this rule). Gradually, however, as signs of a global recovery became more evident, some currencies emerged much stronger than others, exhibiting their relative strength against others. The competition in the world of currencies shifted from the "best of the worst" to an arena where clear winners emerged - the "best and the rest" if you will. As the GBP and EUR slid against the dollar in December 2009, the Australian and Canadian dollars kept a much firmer stance, quickly recovering most of their loses against the USD. This could be another sign of normalization. As the recovery takes hold, investors focus more on the fundamentals of the different economies and on interest rate expectations, rather then pure risk on/off trades. With that in mind, let's take a look are where the majors stand. First, the US dollar.

USD - Cautiously Bullish in the Short Term

George Soros said it best in early 2009 when he called the dollar the "fever chart" of the economy. And indeed up until December 09 as the economy got less worse, the dollar ("fever") declined. News and economic reading that came in better than expected actually pushed the dollar lower as risk aversion became less pronounced. That was the trend until December 4th, when a non-Farm Payroll report came in much better than expected, sending the dollar on a four-week rally and revealing a shift of focus from risk of a lingering and deep recession to the inevitability of interest rate increases.  

Both Economist and traders differ in their predictions for when the Fed might start hiking rates but all agree it will not happen before the middle of 2010, at the very earliest. One other certainty is that the Fed will be under significant political pressure to keep rates low due to massive unemployment figures. 

The NFP numbers released today, January 08 2010, and the market reaction that followed their release illuminated both the dollar's sensitivity to interest rates factors and the lingering bullish sentiment for the US dollar.

The NFP numbers came in much worse than expected, exactly the opposite surprise we got one month ago. The reading sent both S&P futures and the dollar down sharply but the losses were brief and mostly erased in a very short time as the market faded the news. Another bullish sign for the dollar is its ability to hang on to most of its December gains even as stock markets hit fresh monthly highs. It seems that the dollar is in a win-win situation: good news supporting the case for a rate hike will send the dollar higher and bad news supporting a double-dip recession will send the dollar higher in a flight to safety. Of course, this assumption also suggests that the dollar will slump in a sluggish recovery where neither rate hikes nor a double-dip recession are on the horizon. 

For the time being, the dollar is still showing signs of strength and a daily chart suggests it may be ready to break out of (or completely fail) a bullish flag:

Euro - the Fallen Star

For most of the first decade of the new millennium, the Euro has been on a meteoric rise against the dollar, climbing more than sixty per cent vs the greenback between 2000-2008. Who can forget the public denunciation and humiliation of the dollar as Her Royal Hotness, Gisele, made it loud and clear she was to be paid in Euros. Alas, even the richest Supermodel on the planet could not have foreseen the looming crash ignited by the sub-prime disaster. The global recession wreaked havoc across the Euro Zone and exposing cracks in Gisele's logic. Fighting its very first battle against a major economic storm, the Euro Zone faces unique challenges that set the stage as we enter 2010. The theme for the Euro Zone as we enter the new decade is fragmentation. While one can argue that the EU and the US share many similarities with respect to the Great Recession, it has become more and more evident that fragmentation and disparities in the Euro Zone's economies are a much bigger problem (or at least perceived this way) than they are in the USA. For example, one can argue that California and Michigan are to the US what Greece and Spain are to the EU. But in the market's eyes, this is not the case. The political diversification and distributed nature of the Euro Zone economy pose a much bigger challenge. 
The Euro is starting 2010 after being severely punished late 2009 for the Greek debt downgrade and lingering concerns about the quality and cohesiveness of the European recovery. Grave concerns regarding East European debt remain in the minds of investors. And the ECB will face tough decisions ahead as a strong German recovery warrants interest rate hikes while much worse conditions elsewhere in the Euro Zone will make rate hikes very tricky. At the close of the first trading week of the year, the Euro is near weekly low levels vs the dollar, monthly lows against the Swiss franc, and is at yearly lows against the Aussie dollar. We should expect to see somewhat of a bounce at this long-term demand levels but fundamentally speaking, the Euro is still out of favor until we hear a more hawkish tone from Mr. JC Trichet.  
Key levels to watch for the Euro are the 200 day MA for the EURUSD and a break below the 1.5500 level on the EURAUD.


Yen - 09's Wild Card -2010's laggard  
In 2009 the Japanese Yen proved to be one of the trickiest currencies to trade, defying both technical levels and fundamentals, due in part to swift and stark political changes. As we enter 2010, the Yen is probably one of the weakest of the Majors. The struggling Japanese economy, plagued by deflation, aging population and heavily reliant on exports is certain to keep its downward pressure on the Yen. The recent, surprising, appointment of a new finance minister, much more dovish than his predecessor, paves the way for further Yen weakness. Nowhere is the Yen's weakness more evident than in its relationship to the Aussie and Canadian dollar as the "carry trade" the last decade carries itself into the new decade. We can expect the Yen to trend lower this year, especially against the commodity currencies.


British Pound
The British economy is just about as miserable as any, recovering from a banking crisis, real-estate bubble, a huge deficit, and in the midst of loose monetary and fiscal policies. However, the implications for the British pound are not so clear at this moment and the GBP has been trending higher vs. the Euro and Yen in a "best of the worst" competition. It remains to be seen how soon will the UK start to remove some of the huge liquidity pumped into its economy during the crisis and move toward rate hikes. At this point, the GBP should be traded mostly on technical levels.


Aussie and Canadian dollars - Kings of the Hill
The run-up in commodities from copper to gold to oil catapulted the "commodity" currencies this year against all other currencies. The undisputed champion is, without a doubt, the Aussie dollar. Boasting some of the highest interest rates among the G20 and a major beneficiary of China's insatiable appetite and various stimuli induced projects around the world, the Australian economy dodged the Great Recession practically unscathed. The high yielding currency proves, once again, irresistibly enticing to would be carry traders and the Yen, once again, is the funding vehicle of choice. The Canadian dollar came in a close second. Boosted by high oil and record gold prices, the Canadian currency finished 2009 on a tear. 
Going back to the theme of relativity it is important to note how the US dollar was unable to keep its gains against the Aussie and the Loonie while pushing the GBP and EUR to weekly lows.


From Best of the Worst to Best Vs the Rest

From what we've covered so far, it stands to reason that:
1. Gisele is still hot but Euro, not that much.

2. The best opportunities this year will probably be shorting the Yen and going long Aussie and Loonie.
3. Special attention must be paid to central banks' exit strategies, timing, and market reaction to both.