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.