Sunday, October 18, 2009

Global Markets Outlook Oct 19-23: Risk Appetite Becoming Indigestion? Short Version

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. Could risk appetite finally be turning into indigestion?
For details see full version at or .

Stocks & Commodities

See full version for details. Earnings, commodities, and the USD, in that order, drove global equities this week, as economic data took its usual backseat role when major earnings announcements begin, and could have only minor impact on markets for the next week or so until the overall theme of US earnings clarifies, barring any major surprises.
Predictably, the first real week of major US earnings announcements mostly overshadowed economic news throughout the week, with added attention on how the market would respond to revenue misses. The market overall reacted positively to several earnings beats, though it is clear that expectations have been raised as shares of GE (GE) and IBM (IBM) tumbled after their quarterly results.
Earnings got off to a strong start, with JPMorgan Chase (JPM) reporting a hefty earnings beat, with Q3 EPS coming in at $0.82 versus the $0.51 consensus. Goldman Sachs (GS) and Citigroup (C) reported earnings the next day, both topping estimates. But both shares came under a pressure in a "sell-the-news" trade. Google (GOOG) and Intel (INTL) also offered upbeat reports Friday.
However, Bank of America (BAC) broke the trend of upside earnings surprises from the major banks, posting Q3 EPS of -$0.26 per share versus expectations of -$0.20. Banks continue to be hampered by increasing credit losses, though this was anticipated as poor jobs and income data continues to undermine ability to service debt.
Similarly, IBM and GE fell despite EPS beats. IBM's disappointment came due to relatively weak services orders, while GE's revenue was well short of expectations ($37.8 billion versus $39.5 billion).
Risk Appetite Turning to Indigestion?
Last Friday’s sharp decline across the spectrum of risk correlated assets on the back of disappointing earnings from Bank of America (BofA) and lower than expected revenues from General Electric (GE) could prove to be a significant signal of risk appetite turning to indigestion. The BofA has long been seen as a relatively weaker link amid the big US financial firms, so the result was not so bad for the sector as a whole considering the much better outcomes from other leaders earlier in the week; meanwhile, the GE report offered few surprises and beat expectations on the actual earnings portion of the report. Overall, it seems the fast, violent selloff that followed may have reflected a market that was looking for an excuse to take profits as recent gains increasingly look overextended.
Because much of the newly invested money is looking to ride the steady rally; there is significant risk that a modest pull back could trigger a wave of profit taking that develops a new trend. The third quarter earnings season in the US could potentially fill this role if the mood turns sour, or simply doesn’t stay good enough to support higher prices. So far, the numbers have been hit-or-miss. Non-financials show the real trajectory of growth (and the comparisons to activity just two years back shows how weak conditions truly are); but the banks are what traders are really looking at. Earnings have surprised for Goldman Sachs and Citigroup; but the first owes its income to trading and the second is likely rolling loan losses into the future. Bank of America’s reading was likely the better reflection of the real health of the group. A $1 billion loss was led by significant lending right offs. If write downs are just being pushed backed and loan loss reserves not bolstered, the pain is just being delayed.
Equities have jumped to the highest levels since 2003 relative to earnings, which seems more than a little overdone in a year when the world economy is set to see the first contraction in global output since the Second World War. If bullish momentum has in fact been exhausted, a deep correction lies ahead for risk assets in general, and so very oversold USD and other safe haven assets could move up fast.
After earnings, a major driver of trade was commodities and the dollar. With earnings most of the week driving risk appetite higher, the dollar tumbled to a fresh 52-week low at 75.21, giving a lift to commodities (+5.2%). As a result, gold hit an all-time nominal high of $1070.20 per ounce, and oil surged to the highest levels in 2009 at $78.75 per barrel. Though energy prices are being driven by speculation and not glutted inventory data, energy and commodity companies outperformed, with oil & gas equipment & services surging 7.8%.
Economic data had a modest impact on the market this week. See full version for details
Earnings will remain in focus in the upcoming week, with added attention placed to companies' top lines and commentary regarding the economic outlook for the coming quarters.


The overall theme is clearly that risk currencies are rising as long as US earnings keeps market moods upbeat. If Friday’s pullback is a sign that markets see stocks overpriced relative to earnings prospects, this week’s winners and losers could see sharp reversals.


Ready to Rise?


Outlook for US Dollar: Bullish/Neutral
- World Demand for Long-Term US Financial Assets Up In August, Japan Ups Treasury Purchases for 3rd Month Straight
- US advance retail sales fell 1.5% in September, led by drop in auto sales
- Fed meeting minutes indicated that Bernanke & Co. were open to expanding MBS purchases in September
- US inflation reports continue to give mixed signals, with headline CPI at -1.3% and core CPI at 1.5%


As stock markets and risk appetite continued to rise, it’s no surprise that the safe-haven USD was the second weakest currency last week, with only the bigger safe-haven JPY faring worse. Signs abound of extremes in optimism:
  • The DJIA index reclaiming the 10,000 level and the media’s effusive response
  • Other US and Global stock indexes remain at or near new highs
  • Gold hitting new highs
  • High yield currencies continue to hit new highs against the USD
  • High yield currency longs vs. dollar shorts remain at extreme oversold levels
  • USD weakness is now becoming a cover story on popular magazines such as Time and Business Week
However, with extreme optimism comes the risk of reversal.


Barring big surprises, economic data is likely to be overwhelmed by market response the following big name earnings announcements Q4 guidance. See the Full Version for details and likely impact and who reports when.


The EURUSD Continues to Defy Expectations for a Pullback


Outlook for Euro: Bearish/Neutral -
- Market response to US earnings is the key near term driver, as the EUR rises/falls with risk appetite

- Falling Consumer Prices force Euro Losses

- EUR/USD Sell Recommendations coming out around the 1.5035 level


The Euro finished the week considerably higher against the US Dollar, but late-week pullbacks showed that traders were not yet willing to push it above the key 1.5000 mark. A strong week for major corporate earnings predictably more than offset fairly disappointing Euro Zone economic data, as the risk-sensitive Euro has relied on rallies in broader financial risky asset classes instead of trading off of domestic developments The key question going forward is whether the Euro can trade higher on its own merits.

Traders are likely to scrutinize Euro fundamentals as it approaches fresh highs against the US Dollar. The fact that net Non-Commercial Futures positioning is at clear extremes suggests that the probability of a major EURUSD top has increased considerably. A relatively quiet week of economic event risk gives us little in the way of foreseeable volatility, but Forex Options markets volatility expectations have nonetheless jumped considerably on recent US Dollar tumbles.


See full version for details and implications.

Given the extreme long EUR/USD positions, the safer bet is that the Euro trades near a major top versus its US counterpart and thus short the pair, but anyone attempting to time that reversal over the past months has paid the price, because the popular trading clich̩ - that markets can remain irrational for far longer than you can remain solvent Рhas held true for months.

Thus any sane trader will wait for some kind of reversal signals before playing the short side.


Losing its Prime Funding Currency & Safe Haven Role to the USD? Not Yet, but Getting There


Outlook for Japanese Yen: Bearish
- Like most currencies, moving with earnings driven risk appetite
- Will thus continue to drop with other safe haven assets until the fundamental and technical extreme reverses
- USD becoming the top funding currency
- How far will the yen’s slide go?


What is the most influential driver behind the Japanese yen? The same underlying current for all capital markets: risk appetite, which is currently tracking market reaction to US earnings reports.
Key Questions for the JPY
  1. Which direction will risk appetite take?
  2. How will the yen respond to sentiment trends?
  3. Will economic news override the influence of market response to US earnings news?
For details, see the full version. The key points are:
To answer the first question, we saw decreasing in risk appetite through the end of this past week; but no reversal. However, as noted above, concern about valuations relative to performance could soon tip the scales, as risk assets seem more than fully valued. There is still a lot of capital sidelined– but the majority of those funds belong to those who are justifiably skeptical of the rally to this point or need true interest income rather than the promise of capital gains.
Because much of the newly invested money is looking to ride the steady rally; there is significant risk that a modest pull back could trigger a wave of profit taking from the latecomers.
Regarding the second question, the yen has hardly abandoned its funding currency status. Looking beyond the Japanese Libor’s premium to that of the United States’, many believe the Japanese rate is likely to be held at near zero for the longest of its peers. What’s more, the availability of funds is no doubt going to be much higher for Japan. A naturally high savings rate, loose monetary policy and deflation are all buffers of cash.


Finally, there are few major market moving news items scheduled for release this week, so the JPY, like other safe haven currencies, should move in the opposite direction but to roughly the same magnitude, as risk sentiment.


Can Bullish Momentum Overcome Fundamentals?


Outlook for British Pound: Neutral
- GBP so oversold that a few optimistic comments from BoE’s Fisher spark the sharpest rally in months
- UK jobless claims rise by the smallest amount since May of 2008
- GBPUSD rally gone too far, too fast?
- If BoE minutes and Q3 GDP don’t surprise, then overall risk sentiment should drive the GBP


With just a few comments from a member of the Bank of England, we have seen the pound shoot higher against all of its major counterparts. When any asset reaches an extremely oversold position, it doesn’t take much to spook some latecomer profit taking from those who want to beat the crowd out the door with some profits.
Just to give some perspective as to the strength of this rally, the sterling set its biggest one day advance against its primary counterpart (the euro) in eight months. BoE Markets Director Paul Fisher’s remarks were relatively ambiguous and have neither been confirmed by any other officials, nor has there been any action to support his claim that the BoE would in fact slow its bond purchasing program to preserve options in the face of a tentative recovery from recession.


However, we will soon see whether these remarks meant anything with both the BoE minutes and the advanced reading of 3Q GDP due over the coming week. We may be looking at one of the most fundamentally influential periods for the pound in months.
The economic calendar ahead certainly has some market moving potential.
See the full version for details. The 2 key events:
  1. The minutes of the central bank’s last rate decision due on Wednesday should be the most influential of all. If there is any merit to Fisher’s forecast for the MPC to put a pause on their quantitative easing program, it could very well come from this report.
  2. The other major event for the week is Friday’s third quarter gross domestic product release. Should the 3Q reading report growth in the period through September, it would be a major step towards seeing a more meaningful recovery. The bigger the surprise either way, the bigger the move up or down.


Lack of News Means CHF Likely to Move in the Opposite Direction of Risk Assets


Outlook for Swiss Franc: Bearish/Neutral
- Swiss Retail Sales Unexpectedly Fell in August
- ZEW Survey Shows Investor Confidence at Record High
- Speculative Sentiment Hints Swiss Franc Rally to Continue

Analysis & Events

The Swiss Franc sees little currency-specific event risk in the week ahead, with price action likely to fall in with broad trends in financial markets’ sentiment and the US Dollar. The Franc has trended firmly higher against the US Dollar since March, as sheer USD weakness in the face of rising risk appetite overcame CHF fundamental troubles such as continuing deflation, rising unemployment, sluggish demand in key export markets, and active central bank intervention
Risk Appetite Turning to Indigestion?
See stock section above for details:


Moving with Oil, then Risk Appetite, But May Feel Pressure from BoC Decision


Outlook for Canadian Dollar: Bearish
- Canadian CPI fell for the fourth straight month in September, the worst series of declines since 1953
- Crude oil could be setting the stage for a reversal, and will likely take the CAD with it


Lower than expected CPI data made any early rate increase less likely, slowing the USDCAD fall late in the week.


For details see full version.
Surprise upward GDP revisions will lead the markets to aggressively price in rate increases in 2010. From a technical perspective, daily USDCAD charts show that RSI rose from oversold levels, which has typically yielded at least a few days worth of gains since the start of 2009.


Taking a Hike?


Outlook: Bullish/Neutral
- As leading currency beneficiary of risk appetite, it’s at the most risk from a shift to risk aversion
- Australian consumer confidence at highest in two years
- Australian Dollar technicals may of reversal


The Australian dollar was once again a top performer to finish the week. The good news just keeps rolling in:
  • Hawkish rhetoric by Reserve Bank of Australia Governor Glenn Stevens underlined the bank’s resolve to tighten monetary policy sooner than later, with more rate hikes on the way.
  • Overnight Index Swaps are now already pricing in an impressive 200+ points of rate hikes in the coming 12 months—by far the most of any G7 central bank.
This should provide solid Australian Dollar support against lower-yielding counterparts. Yet one has to wonder whether the currency can continue to meet expectations and keep up its recent advances.


See full version for details. An effectively empty economic calendar means the AUD will likely go with the risk sentiment flow.


Even More Vulnerable to Pullback than the AUD, Which Has Stronger Fundamentals


Outlook for New Zealand Dollar: Bullish
- Tracking risk appetite, but finally showing some fundamentals improving too
- New Zealand retail sales rose 1.1% in August, doubling expectations of 0.5%
- 3Q Consumer prices surged 1.7% from 0.6% the three months prior.
- Business NZ PMI to 51.7, the first expansion since April, 2008.

Analysis & Events

See full version for details. Climbing risk appetite and a week of bullish fundamental data unsurprisingly helped drive the Kiwi to new highs last week, as equity markets continued to trend higher on positive reactions to a strong start to corporate earnings season. Any reversal of that sentiment, for reasons noted above, should send the Kiwi lower.


Barring major news surprises, expect risk assets and currencies to follow market response to the big name earnings announcements detailed above. If stocks can beat estimates AND grow top line revenues, risk appetite could continue to rule the day. Anything less makes the long extended rally in stocks, commodities, and higher yielding and commodity currencies very vulnerable to short squeeze driven pullbacks.
Disclosure and Disclaimer: The opinions expressed herein are not necessarily those of AVA FX. The author holds positions in the above mentioned instruments.

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