Blame it on the Weather

So, it was a really amazing weekend in New York and I was out and about, which explains the absence of my weekly summary/forecast post on Sunday. I have been pretty disciplined about writing my weekend review so I almost forgot how important it was. It is absolutely imperative to review the week that was, study the weekly and monthly charts, take into account recent fundamental developments and anticipate the markets direction based on the charts and calendar of economic events. Then, it is important to take all of that and formulate a working hypothesis for the week - a set of assumptions to frame our trading decisions. Personally for me, it is also important to do all of this on the weekend, when the market is closed and after spending at least 24 hours away from my monitor.

Well, better late than sorry so in lieu of the Sunday review, here's a little mid-week recap - a sort of Tuesday night quarterbacking, if you will. Here we go:

S&P 500 
The S&P finished last week above 1150. This was largely seen as a bullish sign with a Friday confirmation close above a strong resistance level. However, until today (Tuesday) the S&P was not able to close above 1166, the resistance level we've identified days ago. Today's break above 1166 was decisive and happened toward the end of the day. It definitely looked like a good number of stop entries triggered on a break above 1170. At any rate, the next short term support/resistance levels for the S&P are 1175 and 1150. A break below 1150 might accelerate selling pressure with support seen at 1130 and 1115. This means that we are currently just a fraction of a point from another resistance level. A pullback at this point is all but certain. But hey, I could be wrong. The question is, what is the catalyst to push the market up or down. For sure, the Fed's commitment to keep rates low is a major factor. On the other hand, the Fed will end its MBS (mortgage backed securities) purchase program this month. No one knows for sure how it will impact mortgage rates and, in turn, real-estate prices but we already know that uncertainty and risk appetite do not go hand in hand. At any rate, if I set my bearish bias aside and just look at the chart, it looks like S&P is set to drift higher to 1200.

USD Index (DXY)
The strong inverse correlation that dominated the relationship between the USD and the S&P for much of 2009 seems like a distant memory. The relatively strong  US recovery stands in stark contrast to the situation in the EU and the UK. This macro environment allowed US equities to rise to new monthly highs in tandem with the US dollar. One can only imagine that in a risk aversion scenario, the gap between the USD and the euro/GBP would be even greater - arguably, in such environment, the USD will stand to gain not only against the weak euro and GBP but also against the strong loonie, aussie, and Swiss franc.
As previously noted, the euro and GBP make up nearly 70% of the basket of currencies against which the DXY is calculated. This means that most of the recent strength in the DXY is due to weakness in the euro and pound, both of which face lingering issues and may suffer further weakness.

Euro - Greece
Germany's Merkel changed her stance a couple of days ago when she asserted that the IMF may be the only way to extend help to Greece. At the time the news came out, I thought a good chance for some relief to Greece and the euro was on the cards but that was not the case. A new round of political bickering commenced which helped push the euro even lower. The euro declined to new monthly lows against the Aussie and Swiss franc. As I write these lines, EURUSD is flirting with its 1.3450 support. A break below this level will most certainly trigger some stop sell orders waiting to be activated and send the euro even lower.
Only a clear plan for Greece and a cohesive EU stance can save the euro from sliding further. Euro sentiment remains bearish until then.

British Pound
The GBP suffered a massive slide on the backdrop of a weak UK economy coupled with an upcoming elections and accented with dovish BoE comments. At one point the pound even weakened against the euro. New economic data released today didn't help. Technically speaking, the pound looks the most vulnerable for further decline. At this very moment (3/24/09, midnight), GBPUSD seems well on its way to retest recent support at 1.4880 - 1.4800.

Japanese Yen
The yen maintained most of its strength despite the new highs in equities. As previously noted, at least some of the yen's strength should be attributed to repatriation which should abate by the end of the month, leaving the yen (risk appetite permitting) vulnerable.

Commodity Currencies
The loonie and Aussie continued to dominate the scene, with the loonie outpacing its Australian counterpart. The thought her is that the Aussie is vulnerable to further Chinese tightening but the Canadian dollar is less so. In addition, BOC has yet to raise interest rates while the RBA may not be willing to go much higher at this point.

OK - That's all for the time being. To be continued tomorrow....

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.

 

Trapped in the Rate Race

Recent market action signaled a shift in focus from risk to rate expectations. As previously noted, this was first observed on December 4th when a better than expected non farm payroll report was released sending the USD higher.

A Very Tight Rope

Central banks around the world are walking a very tight rope, balancing a fragile recovery on the one hand and looming inflation on the other. This is an uncomfortable situation with wide political implications: hike rates too soon and you risk a lagging economy and prolonged, high unemployment. Raise rates too late and you will have unleashed a monster inflation. Either scenario is a losing proposition for any administration but the prospect of hyper inflation is by far worse with much broader implications to the economy.

As Mr. Greenspan will probably tell you, maintaining low rates for a long time will eventually result in market distortions in the form of asset bubbles and/or inflation . This is when one nation keeps its rates low - but what happens when the world's leading economies slash rates in an unprecedented, coordinated move? We've yet to find out, but we do know that there's just a lot more money out there, and isn't that the definition of inflation?

Do You Speak Fedish?


Even on a week filled with economic data fanfare, the FOMC is guaranteed to give the best show in town. Higher than expected reading of PPI and CPI in the US and UK respectively sharpened global focus on the possibility of future rate hike. The Fed is highly unlikely to announce rate increases any time soon. However, with the release of the FOMC minutes, scores of commentators all over the media will immediately begin the amusing process of translating the minutes from Fedish to English. Traders, investors and economists alike will scan through the release with a fine-toothed comb in effort to discern even the slightest change in sentiment in order to glean even the faintest hint regarding where rates are headed. 

So what to look for? The Fed is unlikely to raise rates before other emergency measures such as the TARP, TALF, and bond purchasing, are wound down. Therefore it is important to look for any signaling or intention to remove these measures. In addition, it is important to pay attention to any changes in sentiment regarding the recovery and comments regarding the prospects of inflation.

In my free time, I took some Fedish lessons, call it Fedish 101. I was able to discern, with moderate certainty that by repeating the point of a "jobless recovery", Mr. Bernanke is setting the stage for rate hikes prior to any noticeable improvement in employment numbers - a move that, unless gently delivered, can deal a blow to a market struggling with a new breed of consumers who simply spend less.

Can You Spare a Buck?

It's been a tough ride for the USD since March, not so much of a roller-coaster as a Double Black Diamond slope. The USD peaked earlier this year due to extreme levels of fear and uncertainty in the global financial markets. The end of the world seemed like a done deal and the all-mighty Dollar was everyone's bet (mostly in the form of US treasuries), in what was dubbed the "risk aversion" trade. Since March, however, the  USD declined, in a twisted way, on every piece of good news that would normally make a currency stronger. And thus came about the "risk trade". With historically low interest rates and generous QE, the dollar was left alone and defenseless, surrounded by some very scary bears with their claws sharpened and ready for the attack.

Vociferous pros eulogize the greenback daily on various financial media outlets and foreign governments diversify their reserve holdings with gold (India) and Canadian Dollar (Russia). Indeed, the currency has not been able to stick its head above the 10 EMA (weekly, see below) since May. However, even among the big bears out there, there seems to be a growing consensus that a bear rally is in the cards and Friday's market action could have signaled the opening shot.

Fundamental, meet Technical

Fundamentally speaking, there are two scenarios in which the USD slide can reverse, even if only for a relatively short period, and they are (1) deterioration of financial markets and return to risk aversion or (2) interest rate hike by the Fed. Technically speaking, the DXY (aka dollar index) is entering a support level (see weekly chart below) in the 74.50 to 71.50 range.
It always astonishes me when trend-shifting fundamental news "magically" coincide with major technical levels. Over the past two weeks, the DXY came close to a major weekly support level and, wouldn't you know, we got a taste of both bullish scenarios for the USD.
The first came in the form of financial turmoil in Dubai (risk aversion). The second came a week later in the form of much better than expected NFP numbers, causing markets to expect rate hikes earlier than previously predicted.
Of the two events, Friday's NFP report was much more significant because while the reaction to Dubai World's woes was according to expectations, the reaction to the NFP numbers marked the first time in months when a good economic reading led to a stronger dollar signaling a possible break from the inverse relationship between the dollar and the state of the economy (and the equities marker).

Obviously, it is too early to to tell if the dollar rally will fizzle or sizzle and the dollar bulls should hold off on the champagne - at least until New Year's.