Dubai Reminds Us What Greece Would Like Us to Forget

Renewed concerns regarding Dubai's debt remind us what we need to remember about Greece and the EU - a quick fix is not going to make the problem go away. On a day we see a 20 point rally on the S&P, and the dollar and yen receding, it is tempting to think that the worst of Greece is behind us. But then Dubai reminds us - not so fast..... First, the S&P is rallying straight into a resistance level at 1100. Even if it manages to break this resistance, it still has to retest a much stronger resistance at 1150, so let's hold the celebrations (See chart below). Second, let's be aware of our human nature - we like to see that glass half full.

As humans we have been blessed with  a short, selective memory. This unique feature helps us surmount life's most excruciating . Individuals and societies alike are programmed to leave behind painful memories and march forward toward a better future. This mechanism can help us overcome personal or national tragedies. Unfortunately, this same mechanism can also condemn us to repeat our mistakes, as we conveniently forget the undesirable consequences of our actions. So what can we do? we need to stick to the facts and not trade on "hope". Remember that markets reflect expectations and not necessarily current, underlying conditions. As such, markets can fluctuate wildly as expectations change but fundamentals remain more or less the same.

Filling In the Gap

No, not the price gap - the blog gap!
It's been a while since my last post so it's time to fill in the gap. Luckily the themes we've touched upon in the last several posts have played out nicely over the last couple of weeks. They are: (1) Dollar strength, (2) Euro weakness, (3) Equities weakness. So let's examine each theme in light of recent events. Since so much of the market's action has been determined by the Greek crisis, let's begin with taking a look at Greece and the Euro.

EU - On the Horns of a Dilemma
We've already discussed the issues in Greece so a detailed intro is not needed - but here's a brief recap anyway. Grave concerns over Greece's sovereign debt have been at the center of an unfolding drama as of late 2009. The Greek story has dominated headlines and opened the floodgates of fear that came gushing into the markets. Not long after Greece hit the spotlights, concerns over sovereign debt spread like wildfire to Spain, Portugal, Italy (and let's not forget Ireland), wrecking havoc in the "Club-Med" nations' bond and equities markets.

When Greece first made the headlines in November '09, EU leaders and the ECB chose to distance themselves from the center of attention, as Greek officials struggled to reassure nervous markets that everything was under control and that swift austerity measures could rein in a runaway deficit. However, as hopes for quick fix vanished and fears of contagion arose, it became obvious that EU leaders had to step in. But what to do? Each options seemed worse than the next. Letting the IMF step in was just too humiliating. Not doing anything was just too dangerous. Outright bailout posed a moral hazard and opened the door for more bailouts (Portugal, Spain, Italy). The unique structure of the EU, a monetary union with no fiscal or political unity, made the uncertainty even worse. For the first time, the EU was being put to a test for which the Euro was punished severely as traders piled in record numbers to short the single currency.

OK - so much for the "brief" recap. Fast forward to Thursday, Feb 11. European leaders at an EU summit meeting finally spoke up. During a much awaited press conference EU leaders served the markets a big dose of disappointment saying they stand ready to take coordinated action to protect the stability of the EU if such action was needed. At the same time, they insisted Greece did not need external help at this point.

The lack of clarity and conviction projected by EU leaders weighed heavily on the Euro as it plunged to test its recent lows against the dollar and the yen and made fresh, multi-year, lows against the aussie. After its massive slide following the press conference, the Euro managed a small bounce against the dollar and the yen but remained largely in the bears' hands. And in overnight trading, the Euro slid further against the dollar to break yet another level, this time stopping just shy of 1.3500.

Euro sentiment remains largely bearish. So long as uncertainty concerning the Club-Med nations lingers, the Euro will remain under pressure. With so many piled on the short side, it is likely we see some contrarian move to the upside, a move which may provide a profitable opportunity to re-short the Euro.

USD - Raging Bull
US dollar reversed its multi-week slide late last year and has been on tear since then. The initial strength in the dollar was due to signs of a recovering US economy. Since then, however, the rise in the dollar was strongly associated with flight to safety as fears over Greek debt, China's monetary tightening, and pending US banking regulations contributed to risk aversion among traders and investors. In the land of the blind, the one-eyed man is king. And so it is in the forex markets where the USD was the least worse of a pretty bad bunch.

The USD is approaching another congestion area which may act as a temporary roadblock. In the chart below, you can see the DXY reaching a resistance zone between the blue and red lines:

A major milestone for the US economy and the US dollar went almost unnoticed this week as Chairman Bernanke's testimony got canceled due to a heavy snow storm in the DC area. Bernanke's prepared testimony was released to the media. It outlined the Fed's exit plan for withdrawing the emergency measures it had put in place in the early days of the financial crisis. While repeating the Fed's mantra of "exceptionally low for an extended period" referring to the near zero interest policy, Bernanke's testimony definitely sets the stage for tightening. The question is, how will the market interpret tightening moves when they are finally announced? Depending on many factors, markets are likely to have one of two reactions: 1. interpret tightening as a sign of strength (risk back on) or 2. devastating blow to a fragile economy (risk off). A third and least likely scenario is a mixed reaction somewhere in between. Given a mildly positive parade of economic data and earning reports, option one (interpretation of strength) seems the most likely - but not by much.

S&P - a Long Awaited Correction
Most market participants were caught off guard in March of 09 as a massive rally in equities emerged from the rubble of the financial disaster. By the time it became evident that the rally was real, traders were faced with two options - chase the market or wait for a pullback. Well, for those who opted for the latter, a generous amount of patience was needed. The much anticipated pullback stubbornly refused to arrive - that is, until January 2010, when The S&P 500 climbed back to 1150 and finally met a resistance strong enough to send stocks lower.

Concerns over sovereign debt provided a perfect backdrop the S&P's decline. However, it would seem that other forces were in play, specifically, large market participants booking profits for 2009. A quick look at the charts reveals that 09 market leaders such as financials and materials, actually turned lower before the broad market sell off, suggesting profit taking and sector rotation.

Keeping Things in Perspective
With all the gloom out there, one must keep things in perspective. For example, fourth quarter earning season has been, thus far, quite positive with most companies meeting or beating expectations. Jobs, unemployment, and inventory numbers also continue to show signs of improvement. Greece is unlikely to default on its debt. And China's monetary tightening is a response to a booming economy - not exactly a bad thing! Moreover, companies have reduced bottom line costs and are well positioned to show bigger net income gains as top line   revenue streams return to normal levels. That is not to say everything is rosy. Of course there are lingering concerns (record foreclosures, commercial RE, weaker consumer demand, to name a few) but on the whole, a double-dip recession seems a less likely scenario than a moderate recovery and a range bound equity market.

A quick look at a weekly chart of the S&P 500, shows that the weekly uptrend, while losing momentum, is still intact and that the 1250 (generally accepted) target is still in sight.

Thoughts for the Week Ahead
Subtle disparities in market action on Thursday and Friday, may hold some clues for the week ahead:

1. Euro pummeled as US equities rise - we are used to seeing US equities and the Euro trade in tandem. However, last week saw a rise in US equities and a slumping Euro. 
2. Yen easing against the Canadian and Aussie dollars and, to a lesser extent, against the USD- this is another sign of risk abating to some degree.

Given last week's market action and news coming out Europe, we may begin to see Greece's problems contained within the EU, keeping the Euro depressed. In this scenario, we should continue to see the S&P basing around its recent levels and the yen easing further against the Aussie and Loonie. The US dollar is likely to see some consolidation this week as it hits a new level of resistance. Any further comments from the Fed regarding its exit strategy should help maintain dollar strength, especially vs. the Euro and British pound. 

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.

 

Like Rain on Your Wedding Day

Alanis Morissette will probably disagree but in my opinion, rain on your wedding day is hardly ironic. It could be sad, annoying, or, in the event of an indoor wedding, a non-issue. Similarly, a fly in your chardonnay is simply off putting and in the grand scheme of things, not that big of a deal. What is ironic, however, is Greece's debt rating getting downgraded for the fourth time this year, and Greek equity and bond markets cheering the news.

Greek sovereign debt was downgraded twice this year by Fitch (Oct 22 and again Dec 08) and once by S&P (Dec 15). But it was Moody's downgrade on Dec. 22 that sent Greek markets into a "celebratory" rally. It's really all about perception: Moody's downgraded Greek debt by only one notch as opposed to the two-notch downgrade the market feared. Moody's also commented that near-term crisis is unlikely, which helped ease investors' fears.