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?
STOCKS
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.
US earnings 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.
Later, 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 largely anticipated as poor jobs data continues to undermine consumer wealth.
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.
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.
There were some reports that the market liked, however. Google (GOOG) bested its consensus EPS ($5.89 versus $5.42 consensus), and seemed more upbeat about the economic outlook, and Intel (INTL) was also upbeat about the future.
After earnings, a major driver of trade was commodities and the dollar. 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. Crude prices also benefited by a smaller-than-expected increase in inventory levels. In turn, energy and commodity companies outperformed, with oil & gas equipment & services surging 7.8%.
Economic data had a modest impact on the market this week. Retail sales surprised to the upside with a softer-than-expected decline of 1.5% versus the -2.1% consensus. Excluding autos, retail sales increased a better-than-expected 0.5% versus the +0.2% consensus.
Initial jobless claims for the week ending Oct. 10 totaled 514,000, which was a bit below the consensus forecast of 520,000 initial claims and down 10,000 from the previous week. Continuing claims slipped below 6.0 million for the first time since March by coming in at 5.99 million. The consensus called for an even 6.00 million continuing claims, and many believe any coming declines are more due to expiring benefits than improved employment.
The Empire State Manufacturing Index for October , came in at 34.57, which beat the 17.25 consensus and boosted stocks.
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.
COMMODITIES
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.
CURRENCIES
USD
Ready to Rise?
Outlook for US Dollar: Bullish/Neutral
Summary
- 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%
Analysis
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.
Events
Tuesday as US housing starts and building permits are projected to have risen for the second straight month in September to 10-month highs, with starts anticipated to hit 610,000 from 598,000 while permits may rise to 590,000 from 580,000. While the unemployment rate is still in the process of rising, the federal government’s tax credit for first-time home buyers of up to $8,000 is likely to remain supportive of demand through the end of the year. However, if the program expires as planned on December 1, the growth we’ve started to see in the housing sector could fade. Temporary government incentives can often simply shift current demand forward rather than actually increase it, resulting in far worse sales once the incentives end.
The Wednesday release of the Fed’s Beige Book report rarely moves markets but can provide some useful statistics on how the central banks 12 districts are faring economically.
Thursday’s leading indicators index is projected to rise for the sixth straight month, this time by 0.8 percent. However, gains are likely to be mostly the result of stock prices and the interest rate spread, while gauges of genuine recovery, employment and business investment should remain weak.
Friday’s National Association of Realtors’ index of existing home sales is expected to rise 5.9 percent for the month of September to an annual rate of 5.4 million, the highest in just over two years.
Supply levels and median prices have both fallen steadily to 8.5 months and $177,700, respectively. As with housing starts and building permits, the federal government’s tax credit for first-time home buyers of up to $8,000 is likely to remain supportive of demand through the end of the year, though surprise declines, as we saw in August, are not out of the question.
Prominent earnings announcements for the coming week include:
Monday: AAPL (tech), HAS (toys), TXN (tech)
Tuesday: BIIB (biotech), CAT (building equip.), DD (chemicals), PFE (drugs), SNDK (tech), SYK (medical), CO (consumer), UALUA (airlines), YHOO (internet)
Wednesday: MO (consumer), AMGN (biotech), AMR (airlines), EBAY (ecommerce), LLY(drugs), FIADF.pk (int’l autos), FNF (financial services), FCX (copper), GNZ (biotech), NVLS (chips), BA (aerospace), USB (financial)
Thursday: AMZN (ecommerce), AXP (financial), BDK (consumer/construction), BGG (light gas engines), BMY (drugs), BRCM (tech), DAL (airlines), DO (oil drilling), ESV (oil drilling), MCD (consumer), MRK (drugs), PNC (financial), POT (fertilizer), HOT (hotel), DOW (chemicals), UNP (railroad), UPS (freight), GRA (chemicals)
Friday: EXC (utilities), HON (tech), IR (industrial), WHR (consumer durables)
EUR
The EURUSD Continues to Defy Expectations for a Pullback
Summary
Fundamental Forecast for Euro: Bearish
- Market response to US earnings is the key near term driver, as the EUR rises with risk appetite
- Falling Consumer Prices force Euro Losses
- EUR/USD Sell Recommendations coming out around the 1.5035 level
Analysis
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. Global equity indices posted yet another week of gains, and the US Dow Jones industrials Average traded above the psychologically significant 10,000 mark for the first time in nearly a year. 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, and 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.
Events
Traders will keep an eye out for German IFO business confidence data and Industrial New Orders report, but the center of attention will likely remain the US S&P 500 and broader risky assets. The rolling 50-day correlation between the EURUSD and S&P currently trades just short of record highs—emphasizing exchange rate sensitivity to broader financial flows. Key indices have likewise set fresh 2009 highs and remain ripe for corrections.
Thus the safer bet is that the Euro trades near a major top versus its US counterpart, but anyone attempting to time that reversal over the past months has paid the price, because the popular trading cliché - that markets can remain irrational for far longer than you can remain solvent – has held true for months, any sane trader will wait for some kind of reversal signals before playing the short side.
However, they should be ready with a plan for when that time comes. Given the overbought nature of risk assets vs the USD, with the EUR prime among them, the selloff could be hard and fast.
JPY
Losing its Prime Funding Currency & Safe Haven Role to the USD
Summary
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?
Analysis
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.
The yen’s relationship to market sentiment was once among the clearest fundamental relationships in the FX market. When the market wanted risk and yield, the yen would be sold against higher yielders, when fear reigned, the opposite occurred. However, the even lower USD 3 month LIBOR rates has made the USD the top funding currency for the ever-present carry trade. Thus we need to ask
- which direction will risk appetite take?
- how will the yen respond to sentiment trends?
- will economic news override the influence of market response to US earnings news?
To answer the first question, we saw decreasing in risk appetite through the end of this past week; but no reversal. In fact, the seven-month rise in optimism looks as stable. However, the fundamental drag on this speculative run could soon tip the scales, as risk assets seem fully valued Capital is still finding its way into the market – and there is a lot of sidelined money to be reinvested – but the majority of those funds that are still in relatively ‘risk-free’ assets belong to those that 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 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.
Regarding the second question, the yen has hardly abandoned its funding currency status. Taking a look beyond current conditions (where the Japanese Libor is at a premium to 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.
Events
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
GBP
Can Bullish Momentum Overcome Fundamentals?
Outlook for British Pound: Neutral
Summary
- 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
Analysis
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.
Events
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.
It’s been a long time since upcoming news could produce a meaningful change in the underlying trend of the British pound (short of extending the currencies painful tumble). However, the economic calendar ahead certainly has that potential. There are notable economic indicators on deck. In particular:
- 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. If his outlook was for something later, then no mention of a change from the status quo could send a bearish ripple through the sterling crosses. The reversal that we saw last week was borne out of sheer sentiment. To sustain such a move, we need a real fundamental backing. The other scenario would be confirmation that the purchasing program has indeed been put on hiatus which would be the first genuine change in the bank’s policy tone since the financial crisis picked up steam. Such an event could truly alter the currency’s standing in the FX market.
- The other major event for the week is Friday’s third quarter gross domestic product release. It is unfortunate, from a traders’ perspective, that this report comes out just before the weekend; because if it was released on a Monday there would be far more liquidity and time for the reaction to play out. However, as it is, there are mere hours to trade on the data before the weekend drains liquidity and rational minds can take over. This is not to mean this is going to be a non-event. Far from it. The bleak economic outlook for Europe’s second largest economy has been the source of the sterling’s weakness over the past 12 to 18 months. Should the 3Q reading report growth in the period through September, it would be a major step towards seeing a more meaningful recovery. A positive reading will be considered bullish; and the bigger the upside surprise, the more aggressive the pound’s run will be.
CHF
Lack of News Means CHF Likely to Move in the Opposite Direction of Risk Assets
Summary
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
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. The USD had slipped nearly 16% against the Swiss unit.
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.
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 which will put firm upward pressure on the US Dollar at the expense of most of its major counterparts, including the Swiss Franc.
Events
September’s Trade Balance report is the only item of interest on the docket. Traders will be looking for clues that the central bank’s deflation-minded policy of keeping a lid on the value of the Franc, particularly against that of the Euro, is helping exports. Over 60% of all Swiss exports go to the Euro Zone.
CAD
Moving with Oil, then Risk Appetite, But May Feel Pressure from BoC Decision
Summary
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
Analysis
The Canadian dollar eased back on Friday after the release of the nation’s consumer price index (CPI) fell for the fourth straight month in September, the longest series since 1953. Indeed, the annual CPI rate fell to -0.9 percent, but on the other hand, the annual rate of the Bank of Canada’s core CPI eased back less than expected to 1.5 percent from 1.6 percent. Still, it makes interest rate increases less likely, because the BoC has repeatedly stated that it has no plans to raise rates soon unless inflation becomes a problem, though the CAD’s strength against the USD is also a concern. Furthermore, the data highlights the Canadian dollar’s main source of event risk this coming week - the Bank of Canada’s rate decision.
Events
The BOC is expected to leave rates unchanged at 0.25 percent once again. After the Bank left rates unchanged on September 10, they said that they would maintain a neutral stance through June 2010. Overall, however, the currency is more responsive to changes oil and equities, both of which are the more likely source of CAD volatility for the coming week. Oil is hitting new highs on speculation for increasing growth driven demand, despite continually swollen inventories born of lax compliance with production quotas by OPEC members seeking greater current revenues.
That said, the key to price action will be surprise revisions, as upward changes to GDP 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.
AUD
Taking a Hike?
Summary
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
Analysis
The Australian dollar was once again a top performer to finish the week’s trade as speculators poured into the progressively higher-yielding Aussie currency. 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 the pace of Australian Dollar appreciation has been nothing short of impressive, and one has to wonder whether the currency can continue to meet expectations and keep up its recent advances.
Events
An effectively empty economic calendar means the AUD will likely go with the risk sentiment flow, which thus far has been very kind to the AUD. However, the AUD long positions are at such extreme levels that they are comparable to a rubber band pulled to near its limit, leaving us wondering how much longer the extension can go, or last.
Markets are now pricing in a 50 percent chance of an aggressive 50 basis point (0.50 percent) rate increase through the November meeting.
Expectations are running high for Australian Dollar yields and the currency itself.
Yet near record-high Aussie correlations to key commodity prices suggest that AUD forecasts may depend on broader moves in key financial asset classes.
NZD
Even More Vulnerable to Pullback than the AUD, Which Has Stronger Fundamentals
Summary
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
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 a strong start to corporate earnings season with several blue chip names beating estimates. However, as noted above in the stocks section of this report, the Dow Jones Industrial Average hitting the psychological level of 10,000 and some Friday earnings disappointments led traders to take profits on fears that the rally may be a bit overdone in light of current prices.
A strong retail sales report started the week on a strong note for the high yielder as the 1.1% increase in consumption more than doubled estimates of 0.5%. The strong consumer demand calmed fears that domestic growth would lag the rise in demand from abroad. New Zealander’s increased ate out more often and increased their purchases at department stores as they sought out new clothing and furniture. The pattern of shopping demonstrates reflects the rising consumer confidence which reached a four year high in the third quarter. An improving global economy has boosted demand for exports which pushed the manufacturing industry into expansion in September for the first time in eighteen months. Strong gains in new orders and employment are strong signs that growth will continue.
Unfortunately rising prices followed the gain in growth as consumer prices rose 1.7% during the third quarter which will put the RBNZ in a difficult situation. An increase in costs for transportation and household goods may force the central bank to start tightening monetary policy sooner than they planned.
Traders are now expecting 202 bps of rate increases in the next 12 months, up from 154 before the inflation report, according to a Credit Suisse index based on swaps trading. Therefore, we may see continues support for the New Zealand dollar as long as risk appetite remains firm.
If concerns of the sustainability of global growth start to weigh on demand for risky assets then the unwinding of the carry trade will lead the NZD/USD lower. The question becomes is Dow 10,000 a catalyst to sidelined traders to seek higher returns or a barrier until growth risks subside.
Events
Fundamentally we will not have the amount of event risk as last week, with credit card spending and performance of services on tap which should leave price action to the risk sentiment. If pessimism gains momentum then a retrace back to the 20-Day SMA at 0.7270 is a possibility, especially with 0.7500 providing formidable resistance. However, rising yield expectations and an improving growth outlook may send the pair higher with a test of resistance at 0.7765-7/15/08 high a possibility
Conclusions
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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