Sunday, September 20, 2009

Global Markets Outlook Sept 21-5 Part I: Risk Today, Safety Tomorrow?

The overall theme is risk assets continue to drift upward. As the rally stretches like an extended rubber band beyond fundamental support, plenty of signs of waning risk appetite. For example,


Continue to drift up on low volume. Overall positive news, but nothing really new—more of “the worst is over, bottoming out, modest growth expectations at best” sort of thing. Bernanke stated the recession was likely over, and even Warren Buffet announced he's going back into stocks (long or short?). However, revenues are flat or down, and jobs are still disappearing. Global equities are trading at levels unseen since 2003 relative to earnings. The world economy grew nearly 3% in real terms that year, whereas virtually every credible forecast calls for the first post-WWII contraction in real growth in 2009, pointing to lackluster revenues and overextended asset prices.

As Edward Harrison points out (It's Time to Sell Equities and Look to These 3 Areas )The S&P 500 is now up more than 60% from the lows, which is truly amazing and kudos to those who called it. But the question is whether the fundamentals will ever catch up to this level of valuation — usually after a 60% rally, we are fully entrenched in the next business cycle. Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs (as may as were lost in the entire 2001 recession).

If risk appetite is so strong, why are yields FALLING on US government bonds? It doesn’t sound like the bond market is expecting a very robust recovery. Pimco, the world’s largest bond fund, is already in this trade. They have been loading up on treasuries of late – bringing them to their highest relative weight in 5 years.


Overall rising with stocks. Gold looking ready to break out but central banks may try to cool it off. Oil is consolidating, Natural Gas soaring. Like all risk assets, likely to pull in with stocks at some point, longer term supported by hurting USD.


Getting a Temporary Technical Bounce, FOMC, G20 Could Influence, Stock Pullback the USD's Best Hope


Fundamental Outlook for US Dollar: Neutral
- FOMC (Wed) G20 (Fri) meetings could have biggest impact on the USD, but a stock pullback remains its best hope
- If recovery driven risk sentiment is so strong, so why are US bond yields dropping? Bond market apparently ISN’T expecting a very robust recovery, that may provide support for safety USD
- Continued stock rise hurting the dollar, a pullback in stocks remains its likely cause for rally
- Speculation for rate hikes deferred as fundamentals temper exuberant risk appetite
- The steady charge in risk appetite keeps the dollar on the short side of carry interests
- Sentiment can often run askew of fundamentals; but what do technicals say about the dollar?


The dollar was able to relieve the pressure of suffering its worst trend on recent record by clawing out the first bullish close in eleven consecutive trading days; but that does not mean the burdened currency is necessarily primed for a true reversal. While this currency is arguably oversold on a fundamental basis; the same drivers that ushered it to its yearly low last week are still in play. The pace of the economic recovery, growing financial concerns and a Fed struggling to keep pace are all prominent concerns when gauging the long-term health of the dollar; but all of that is overshadowed by the immediate and market-wide preoccupation of risk appetite.

While the US economy is still dealing with a weak recovery and government deficits are a genuine concern, most of the world’s largest economies are suffering with the same dilemma.

The real weight on the dollar is the steady revival of risk appetite over the past six months. Following the necessary period of consolidation after the worst of the financial crisis, capital started to slowly work its way back into the speculative arena. Initially, interest was from early adopters; but the draw of capital gains was strong enough to start the flow from deeper pools of wealth in “risk free” areas.

Where do these funds go? It certainly finds its way to US equities and other relatively-risky assets; but when it comes to the yield bearing instruments, the American products can’t compete. The benchmark, 3-month Libor rate dropped to a new record low (0.28948 percent) this past week and subsequently was depreciated to a discount against its Japanese (0.34875 percent) and Swiss (0.29667 percent) counterparts. Does the dollar realistically make the ideal funding currency? No. The Fed will certainly turn to a hawkish policy stance well before the other two, it has the potential to take a more consistent hawkish path, deficits are a problem amongst all three and the foundation for a true recovery is most stable in the US. As soon as US rates recover, risk-seeking capital will once again flow into the world’s financial center.

In the meantime, we may see a shift in sentiment that could benefit the dollar’s safe haven status. The broader markets have rallied consistently for months – despite a fundamental picture that has changed pace little since the initial reversal. Naturally, a wave of profit taking is highly probable. And, considering the advance to this point has been heavily dependent on steady capital gains, a correction could be sharp and aggressive. There are many different potential catalysts for such a turn; but in the end, the shift in optimism will likely develop naturally. Nonetheless, we should keep an eye on a few specific developments. Reports suggest that lending to consumers has dropped at its fastest pace since the Great Depression; yet leverage has returned to levels last seen since before the 2007 meltdown.

This imbalance could lead to problems later down the line if not corrected. Also, the Federal Reserve and White House have both voiced concern over the commercial real estate debt market. The former is looking into major banks’ exposure to this asset class; but the term ‘stress test’ is not being used.

Yet, if risk appetite is the driver of the USD drop, why are US government bond yields plunging? It doesn’t sound like the bond market is expecting a very robust recovery. Pimco, the world’s largest bond fund, is already in this trade. They have been loading up on treasuries of late – bringing them to their highest relative weight in 5 years. Perhaps Pimco sees a scenario in which the USD tanks and a flight to safety boosts US bonds (as well as precious metals?)?

The economic docket is light next week; but durable goods orders and housing data (existing sales, new home sales) can supply short-term volatility. It is the FOMC that tops the list – not with a possible change in the benchmark, but commentary that can move up the time table for a hike. Data aside, the US/China trade spat hints at a growing concern with protectionism which may come under scrutiny at the September 24/25 G20 Meeting. Exit strategies, financial regulation, banking compensation are all on the topic list; but not currencies.

The EURUSD May Be Overbought-More from USD Weakness than EUR Strength

Fundamental Forecast for Euro: Neutral
- Per Commitment of Traders report, Long EURUSD positions doubled
- Investor confidence hits its highest level since April 2006 as growth, equities recover
- Slow global recovery translates into the biggest trade surplus for the Euro Zone in seven years
- Has a push above December’s highs cleared the way for a EURUSD extension rally?

It was a great week for the EUR, due to a combination of positive news, hawkish Euro zone policy makers, and weak USD, though the pair was pulling back late in the week.

It seems that the market is influencing the euro rather than the euro influencing the market. Looking at the EURUSD alone, we see a six month trend, recent rally and the highest overall level for the exchange rate in nearly a year. However, the easy read on the major is clouded when we look at the crosses. Against the pound, the euro was set in its biggest rally since March (a move that was mirrored in most of those pairs denominated in sterling). Elsewhere, EURJPY was stuck in a contracting range; EURCHF was virtually unchanged in its 100-point range; and the commodity group consolidated within bigger trends. While there are fundamental concerns building beneath the surface, this relationship isn’t likely to change much in the coming week.

Few would argue that risk appetite (and its influence in currencies through carry interest) is a primary driver for the market at large; but what does that mean for the euro? To gauge any currency or asset’s response to sentiment, you need to determine where it stands in the scale of risk. High interest rates, strong growth prospects and progressive policy are a few factors that build a positive correlation to a rising demand for yield.

The euro is in the middle of the range. The benchmark lending rate in the Euro Zone is relatively high; but the outlook for hawkish progress is reserved. Growth is colored not only by the positive turn from Germany and France; but there have also been downgrades for Italy and Spain. Overall, despite the confidence of politicians and some policy officials, the economy is on the same playing field as the US, Japan and many others. Until the ECB turns up the heat on the target rate or financial troubles (like the ability for some Eastern European economies to repay their debt), this will remain the case.

Beyond the vagaries of sentiment, there are a few notable economic events on the docket to supply short-term volatility and perhaps a moderate shift on the bearing for growth forecasts. Top event risk is the series of service and manufacturing sector PMI data. While this series covers specifically the business sector of growth, it is inclusive and timely enough to act as a meaningful leader for growth speculation. Being the September round of data (the ‘Advanced’ or first measure), this will round out the forecast for third quarter activity. All of the regional, German and French numbers are expected to produce month-over-month improvement and most are seen offering ‘expansionary’ readings. This would support the central banks and government’s outlook for growth; but it still does not paint a clear picture for a return to a true expansionary trend.

While the Euro Zone industrial new orders and German factory inflation gauge threaten little more than a meager shift; the IFO business sentiment gauge could generate some fundamental interest. Optimism among German firms acts as its own unique report on the general health of the economy, and this optimism is sensitive to economic health, consumer spending, access to credit, export demand,. Watch the difference between expectations and current conditions. The outlook after a financial crisis and steep recession will certainly improve quickly; but actual health in the economy and markets will be more measured. One will have to give way to the other sooner or later.

Rising Stocks Batter Yen Like Other Safe Haven Currencies, But New MoF No Intervention Bias Should Help

Fundamental Forecast for Japanese Yen: Bullish

- Yen tumbles as S&P 500 continues to set fresh highs
- ‘September effect’ not having much of an effect on Japanese Yen

The Japanese Yen finished the week lower against all but the British Pound and the US Dollar, as impressive rallies in the US S&P 500 and broader financial market risk sentiment pushed the safe-haven currency sharply lower against major counterparts.

Vice Finance Minister Yasutake Tango stated that the administration was watching currency moves closely—implying that forex market intervention was a distinct possibility. Indeed, the Japanese Ministry of Finance has historically been an active participant in the Japanese Yen exchange rate and has repeatedly intervened in instances of excessive Yen strength. The very fact that the US Dollar/Japanese Yen exchange rate reached the psychologically significant 90 mark was enough reason to fear MoF intervention, and Tango’s comments were enough to fuel a rapid USDJPY pullback. Later commentary from newly-appointed Finance Minister Hirohisa Fujii quickly dispelled the short-term threat to JPY stability, but the damage had been done and the Japanese Yen remained on the defensive through the week’s close.

The legitimate threat of MoF FX intervention served as a clear warning to JPY bulls, but recent rhetoric suggests that there will be little in the way of further Yen strength. This leaves the currency to trade purely off of financial market risk sentiment. The fact that the S&P 500 recently registered fresh 2009 highs hardly bodes well for the risk-linked currency, for no market can rally indefinitely. Given the overwhelmingly bearish trend in the USDJPY (bullish trend for the JPY), it seems momentum is plainly in the Yen’s favor. Yet it remains critical to watch any and all moves in key financial market risk barometers.

We previously claimed that the “September Effect” could lead the S&P 500 lower and the Japanese Yen higher. Recent weeks have produced impressive equity market strength yet the JPY has remained relatively stable. Along with fellow safe haven currencies the USD and CHF, the Yen stands to gain on any subsequent pullbacks in stocks, and recent experience shows that it can hold its own despite major S&P strength. Thus we would argue that risks remain fairly bullish for the Yen. If stocks continue their aging rally, the JPY could pull back slightly. If stocks fall, the Yen will in all likelihood continue its previous ascent. While there are other factors to consider, overall JPY risks favor near-term rallies.

The wild card will come on Wednesday’s Trade Balance report. The export-dependent Japanese economy has taken a massive hit on the sharp drop in foreign demand for its own production. Any signs of continued exporter duress will once again raise political pressure on the Ministry of Finance to counteract Japanese Yen strength. Though we suspect that risks of intervention are remote, a truly shocking trade balance result could rekindle market speculation on MoF intervention.

The coming week may prove significant in determining more medium-term direction in the Yen. If nothing else, markets will definitely watch for signs that the USDJPY may finally break below the psychologically significant 90 mark.

DISCLOSURE/DISCLAIMER: Opinions expressed are not necessarily those of AVAFX. The author has positions in the above instruments.

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