Rising Yields Cement Dollar's New Highs

Positive developments yesterday (Thursday) sent stocks and the USD higher. While stocks gave up their gains during the last hour of trading, the dollar remained strong. The greenback gained against all its major counterparts, including the commodity currencies, aided by rising Treasury yields. Here's a quick recap of yesterday's news:

1. Unemployment numbers came in slightly better than expected.
2. Strong earnings/guidance from Best Buy and Qualcomm.
3. Citi gained on news suggesting the Treasury will unveil a plan to sell its stake in the bank.
4. Bernanke gave the market another fix of its favorite drug - commitment to keeping easy, cheap money flowing.
5. France, Germany find common grounds for Greece assistance package involving the IMF (but euro makes new lows)

Perhaps the most important development is the sharp rise in 10yr Treasuries which soared after a less than stellar demand for the notes during recent auctions. Would be buyers are already bloated with US government debt and concerns over sovereign debt do not make T notes any more appetizing. Add the potential of inflation to the mix and you have a market demanding higher yields. Higher yields on Treasuries may entice new buying which could keep the yields in check. However, if buyers remain reluctant and demand even higher yields, the Fed may be forced to raise rates sooner than later. Any way, this scenario is largely bullish for the dollar but may or may not be bullish for stocks and commodities (for example, premature rate hikes may hinder the recovery and therefore be negative for stocks and commodities. Likewise, rising yields may push mortgage rates up. Couple that with the Fed ending its MBS purchase program and the eventual demise of the home buyers tax credit - and you might have a recipe for double-dip in housing).

 The potential Greece rescue deal continues to expose deep divides within the EU. It's getting pretty clear at this point that the clock is ticking and something must be done to prevent contagion. After all, the EU cannot afford to let Greece go down the path of Lehman Bros. Therefore, it is safe to assume that under pressure, EU leaders will announce a detailed deal within the next 48 hours. Depending on its conditions, the deal may provide a short relief to the euro but any rally is likely to fade quickly. Greek/German spread have actually come down since late January as the euro continued its precipitous decline. So a fix for Greece may not be a cure for the euro. So much of Europe's destiny is riding on perception. There will be buyers for Greek (Italian, Portuguese, Spanish) debt. The question is, at what cost? If risk perception is high, the cost of borrowing will be high - perhaps high enough to actually drive some of these sovereign nations to the brink.

As noted in previous post, 1175 was seen as the next resistance for the S&P and, indeed, the broad market index was unable to sustain this level. It is important to mention that this was more of a "psychological" level rather than a purely technical resistance/supply zone. The S&P finished the day with a very bearish candle formation, suggesting more downside may follow. After a nearly two month wild rally, and a rising VIX we should not be surprised to see a 1%~2% pullback to the 1150-1130 area. Falling stocks should weigh on commodities and commodity currencies and we may continue to see the Aussie and loonie lose more ground to the almighty (for now) dollar. AUDUSD chart indicates downside risk:

A Market Climbs a Wall of Worry

 -----------------Weekly Summary------------------
1. S&P to retest 1150 - expected to consolidated sideways from 1150 or pullback to the 50 day MA.
2. USD - expect a pullback to 79.55-78.62 on easing concerns over Greece and a milder than expected NFP report.
3. Yen - expect to see continued weakness, especially against the Aussie and Canadian dollars.
3. Euro - may see a limited move to the up side but expected to be capped at 1.3850-1.4000
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The S&P 500 finished the week up 34 points (3.1%) after rising six days in a row. Stocks climbed despite widespread concerns over Greece (and other "Club Med" nations), unemployment and dismal housing sales reports (new, existing, pending). But now what? well, we're about to find out.  The S&P has rallied straight into it's January resistance level. A confirmed break above 1150 is needed in order to see the S&P advances to new highs. But a retest of the 1150 level is more likely to end in sideways consolidation or a pullback to the 50 day MA.

DXY - USD Due for a Pullback
We repeatedly stated here that for the dollar, the worst case scenario is a lackluster, slow economic recovery with mild inflation. That is to say, a scenario in which risk levels are contained, but so are rate hike expectations. Last Friday's NFP number, although better than expected, was still negative. It was exactly the kind of "less worse" reading that is negative for the USD - enough to dissipate some fear, but not strong enough to invoke serious thought about interest rate increases.
Technically, the dollars bull run that started late in 2009 seems ready for a pullback. We should expect a pullback to at least 79.55 (10 day EMA) or 78.62 (38.2% retracement). A record number of short positions against the euro and GBP created the perfect set up for a short squeeze in either or both currencies. Any positive news coming out of either the UK, the EU or both, should prove negative for the US dollar, at least in the short term.

 

Japanese Yen

As usual, the biggest loser in a "risk on" environment is the Yen. The Japanese currency has several good fundamental reasons to weaken. You can check out Marc Chandler's blog for more information. If risk appetite prevails, and we see the market continuing to fade bad news, we can expect the yen to continue to weaken, especially against the loonie and Aussie.

Euro - licking the wounds

The Euro may finally get a few days of rest to lick its wounds as tensions over Greece ease a bit. But look at the following headline: 

"Greek crisis deepens as S&P downgrades sovereign debt" 

Sounds familiar, right? But consider this: the story is dated January 14th 2009 - more than one year ago! so what is my point? the point is that sovereign debt issues cannot and will not be resolved over night. It took months for the Greek crisis to peak but it was already well in play by early 2009. We can only assume that Dubai, California, and more relevant to the euro, Spain, Portugal, Italy, and Ireland will continue to dominate the headlines with a fresh supply of debt crises. Sovereign debt problems in the EU have had a more severe affect on the single currency due to the political and financial complexity of the EU. Neither German nor French citizens want to see their tax euros used to bailout Greece - and this is causing extra pressure on Merkel and Sarkozy. However, they cannot leave Greece completely neglected as inaction will undoubtedly increase the risk of contagion. The point is, again, there is no simple solution and euro rallies will be subjected to selling pressure. We should expect to see any upward moves capped at 1.3850-1.4000 level.

Euro, Trashed

The Euro just can't seem to get a break these days. The beleaguered currency fell out of favor, only two weeks after testing its yearly highs against the USD, following the Greek debt and credit crisis which sent shock waves across the Euro Zone and the currency markets. As storm clouds gathered over Europe, signs of accelerating recovery dominated the US market. And so, in a swift and dramatic change of perception, the USD emerged as the winner. 

A shift of such magnitude and velocity in what is probably the most widely traded currency pair in the world (EURUSD) has a serious affect on all other major currencies. The USD traded considerably higher against all major counterparts. Even this year's superstar "commodity currencies" (e.g. Aussie, Loonie) finally succumbed to the dollar's powerful rise and are now trading at multi-week lows against the dollar. The sharp rise in the dollar became self propelled as it brought an end to weeks and months of USD funded carry trades which had to be covered (which, in turn, contributed to the decline in EUR and Aussie). As for the EUR, it is trading lower against most major currencies, even against the less-than-stellar Pound.

The question on everyone's mind now is how much farther does the EUR have to go? and the answer is not that simple. First, one must take into account the possibility of an exaggerated market reaction due to year-end / holiday mode. After all, fundamentally, not too much has changed in 2-3 weeks. Technically, however, the picture is a little different since major support levels for the EURUSD and major resistance levels for the DXY were easily breached in rapid succession. If we attribute at least some dislocation due to year-end dynamics, then we may expect to see some dollar weakness as early as January, especially against higher yielding currencies such as the Australian dollar. But technical levels alone, leave room for the dollar to continue rising and for the Euro to continue its decline.The next firm support for EURUSD is at 1.4200 although we may start seeing some consolidation around the current level of 1.4300.

For the Euro to get some reprieve, we would first need to see some encouraging signs from Greece and some degree of assurance that other problematic EU members (Spain, Austria) have their issues in order. Any Hawkish statements from Mr. J C Trichet, certainly won't hurt either. Other things that might give the Euro a lift are SNB intervention or the very unlikely event of a credit downgrade for the UK. One thing is for sure: it's hard to imagine anyone in the EU is terribly upset about a declining currency. A weaker Euro is a boon for European exporters and Europe's vast tourism industry.