STOCKS
Last week we questioned whether last Friday's market pullback, despite overall upbeat earnings reports, suggested that the risk appetite was losing steam, if for no other reason than that stock prices were already high and that the recovery picture was already priced in. This week's action seems to confirm our impression that at minimum the market needs some time to digest gains and/or get some news to raise expectations further. While we believe a pullback is due, markets have been very resilient, and so a period of range trading rather than strong pullback is quite possible as well if nothing comes along to move sentiment in either direction.
GOLD AND OIL
Gold
Gold continues to rally, though at a slowing pace. It has yet to significantly retrace its surge over the past two weeks and yet neither have we seen a new record high after the $1,070.80 benchmark was set back on the 14th. A steady, rising trend channel calls up congestion at the end of a very prominent bull run.
This is the same general chart pattern that can be seen in the Dow Jones Industrial Average and (the inverse of) the US dollar. From this, it is clear that all three are responding to the same driver: sentiment. Should optimism give way, the lack of any yield income to offset the potential capital losses will likely mean a sharp correction from profit taking. At these levels, demand is largely speculative. According to the COT figures, commercial positioning is 383,718 short contracts to 86,225 long. Non-commercial long positions, however, have hit a record high of 286,864 contracts.
Oil
Crude closed its fourth consecutive bullish week, extending the initial surge sparked last week, pushing to new 12-month highs. A closer look at market’s health however, reveals that doubts and suspicions may have started to weigh on the steady rally. We can see the hesitation to carry prices to new highs, with congestion below the recent high of $82 and the trend low $80. A break is inevitable; but direction is uncertain.
The affects of fundamentals on oil has not been very clear lately. If underlying supply and demand were the only facet of price determination, crude would likely have collapsed these past two weeks rather than rally to new highs. This past week’s US Energy Department inventory figures reveal the glut of supply that has refiners reducing imports. Through the week ending October 16th, crude stockpiles rose 1.31 million barrel to 339.1 million – 9.4 percent above the average levels for this period over the past five years. Further down the refinement line, gasoline supplies unexpectedly contracted 2.3 million barrels to 8.95 million; yet supplies are still significantly higher than the five year average. If demand were robust enough to absorb excess inventories while production levels continued unchanged, there would be a reasonable argument to be made for further appreciation. However, demand for fuel actually dropped 1.4 percent last week and consumption has largely struggled to recover despite the consensus that an economic recovery is underway.
Clearly the true driver for price action will almost certainly be risk appetite and the pace of the US dollar. With the broader market recovery, confidence has led funds not only to yield bearing assets but also to those that can only provide capital gains. An optimistic outlook for steadily advancing markets is the foundation to stability. Should risk appetite falter, profit taking and a fundamental equilibrium set well below current price would act to accelerate crude’s plunge.
CURRENCIES
USD
Ready to Rise on Tired Stock Market?
Summary
Outlook for US Dollar: Bullish/Neutral
- The Fed’s Fisher maintains the bank’s efforts to deflate any and all rate speculation
- Risk appetite continues to drive the USD
- Is there an extreme to the dollar’s steady tumble?
Analysis
Now considered the ideal funding currency to the recuperating carry trade, the USD continues to move in the opposite direction of risk appetite, and is unlikely to shake that role and its downtrend until there is a fundamental reason to hold the currency, or to dump its chief crosses. While the downtrend to new lows with rising risk appetite continues, this week’s action in equities could signal the first stage of a reversal in yield appetite, recovery in the US dollar, and allow a positive surprise for the Q3 GDP to raise hopes for US recovery, an increase in US interest rates, and provide fundamental justification to hold the USD.
The Big USD Event – Advanced GDP
We’ve just seen two very contrasting third quarter growth readings from major economies. China missed expectations with annual growth of “only” 8.9%. while, the UK surprised the market by reporting “only” a 0.4 % contraction through Q3, extending the economy’s worst recession on record. This Thursday the US reports Q3 GDP. If it can meet the projected 3.2% annualized pace of growth, which would be the best in 2 years, it might show the markets that it really is shaking the recession and boost hope for a solid recovery.
To determine whether the US is really growing, we need to see the breakdown of growth in the major sectors. While government spending can temporarily fill a gap, recovery in jobs, consumer spending, house prices and the financial sector are essential for real sustained growth. Housing sales are improving and construction activity is stabilizing. Earnings through the second and third quarters suggest businesses will pick up production and start spending once gain. Yet consumer spending is about 70% of US GDP. Confidence seems to have already turned the corner; but without substantial improvement in employment and personal income, consumption and planned purchases will remain weak, and so will the banks that ultimately depend on these.
Adding another complication to the high level release, we need to determine whether the dollar will respond in its usual safe haven role (down on good US news, up on bad), or based on how the GDP result depicts the underlying US economy. The answer depends as much on what is happening in the markets heading into the release as on the data itself. For example, if risk appetite is in retreat and GDP disappoints, the USD would likely rally as a needed safe haven and repayment currency to unwind carry trades. If there is some other mix of sentiment and GDP result, the affect on the USD will be harder to divine.
Remember that the dollar does not have the characteristics of a long-term funding currency. Depressed market rates and benchmark yields are temporary; and policy officials will eventually be able to work down deficits when they have the will to do so. Also, the US is not an export based economy and thus does not depend on a cheap currency as part of its basic business model. Should the US return to growth with this 3Q reading, roles will start to reverse as fundamental realism dawns. On the other hand, a disappointment like of the UK’s GDP could strengthen the unwanted inverse correlation to risk appetite in the short-term.
Note that whatever happens with the advanced GDP reading, the following week climaxes with Non Farms Payrolls. Even if GDP this week meets expectations, the NFP report can outweigh it, especially if it disappoints again. Sustained US GDP growth requires consumer spending, which in turn requires improving employment and incomes. No one will believe in sustainable GDP growth if unemployment stays dismal.
T-Bond Auctions
Note also that it's a busy week for Treasury bond auctions, and any signs of slackening demand could quickly introduce volatility, though it's unclear how the scenario would play out. Would markets see rising rates and thus a rising USD? Would they see another blow to US recovery, falling stocks, and a flight to safe haven currencies like the dollar? Or would the blow to the underlying fundamentals of the US economy hurt the dollar further still?
Prominent earnings announcements for the coming week include:
Monday 10/26: Corning (GLW), Electrolux AB (ELUXY.PK), Lorillard (LO), Plum Creek Timber (PCL), RIOCAN REIT, SOHU.com (SOHU), Sunoco Logistics Partners LP (SXL), Verizon (VZ), Winn-Dixie Stores (WINN),
Tuesday 10/27: Baidu (BIDU), Bayer (BAYRY.pk), BE Aerospace (BEAV), Boston Properties (BXP), BP plc (BP), Canon (CAJ), Celanese (CE), Daimler AG (DAI), Honda (HMC), Valero Energy (VLO), Wynn Resorts (WYNN)
Wednesday 10/28: Aflac (AFL), Coca-Cola Ent. (CCE), ConocoPhillips (CON), Eni (E), General Dynamics (GD), GlaxoSmithKline (GSK), Goodyear Tire & Rubber (GT), SAP (SAP),
Thursday 10/29: Aetna (AET), Colgate-Palmolive (CL), France Telecom (FTE), Hertz Global (HTZ), Hitachi (HIT), MetLife MET), Moody’s Corp. (MCO), Motorola (MOT), Proctor & Gamble (PG), Taiwan Semiconductor (TSM), Waste Management (WM),
Friday 10/30:
EUR
The EURUSD Continues to Defy Expectations for a Pullback, Awaits ECB Rate Forecasts
Summary
Outlook for Euro: Bearish on overextended rally
- Riding Risk Sentiment Higher
- Hits fresh annual highs on bullish Euro Zone economic data
- European Central Bank (ECB)on alert as key indicators continue to show recovery
- EUR, Dow stay above key levels
Week’s Recap
The Euro finally broke above the psychologically significant $1.50 mark for the first time in 14 months. Unlike previous weeks, however, the EUR held up against the safe-haven US Dollar despite a struggling S&P 500 and other key risk sentiment barometers. We have repeatedly said that the EURUSD needed support from risky assets to continue its impressive rallies. Yet the S&P 500 finished the week 0.75 percent lower and yet the Euro traded higher.
A surprisingly bullish run of key European economic data seems to have made the difference, and fundamental forecasts for domestic growth remain bullish. A relatively important string of economic releases could force shifts in Euro forecasts.
Solid German IFO Business Confidence figures and Euro Zone Purchasing Manager Index numbers have supported optimistic growth forecasts which in turn have led traders to price in rate hikes from the European Central Bank.
Events
The lure of higher yields has undoubtedly played a part in Euro/US Dollar rallies, but the extent of Euro appreciation leaves it at clear risk of pullback. ECB watchers will keep a close eye on the coming week’s German and Euro Zone Consumer Price Index figures for important surprises. Current consensus forecasts call for yet another negative year-over-year change in Euro Zone Consumer Prices, but the rate of contraction is expected to narrow to a meager 0.1 percent. Suffice it to say, any material disappointments could make a considerable dent on ECB interest rate expectations. Wednesday’s German CPI figures could subsequently set the tone for near-term Euro/US dollar trading.
Traders will otherwise keep a close watch on global risky asset classes—especially with the Euro’s correlation to the S&P 500 trades near record highs. The US Dow Jones Industrial Average’s close below the psychologically significant 10,000 mark suggests that financial market risk appetite is not quite as robust as previously believed. Yet we would hardly call for a market top without a more substantive pullback across a broad swath of indicators. FX Options market volatility expectations have come down since last week’s peak, but it should be yet another week of eventful price action out of the Euro and US Dollar in the face of noteworthy event risk.
JPY
Losing Ground on EUR, USD
Summary
Outlook for Japanese Yen: Bearish
- USDJPY rises as stocks fall now that USD is new safe haven king
- Is the dollar to remain the top funding currency?
- Key Events: Retail Trade m/m, Industrial Production m/m, Jobless rate, Housing Starts
The Japanese Yen fell against major forex counterparts for the third week in a row, slipping further on outperformance across key risky asset classes. Yet the 20-day correlation between the US Dollar/Japanese Yen pair and S&P 500 actually turned negative for only the second time in two years—emphasizing the dollar’s new role as premier safe haven and funding currency for carry trade. Until recently, the Yen was the reigning safe haven currency and, by extension, the first to fall through financial market booms. As the lowest-yielding currency in the industrialized world, investors aggressively borrowed JPY to fund investments in sources of higher income. The surprising shift is the central reason for the USDJPY pair’s new inverse correlation to key risky assets, and it will likely remain a major factor for the Japanese Yen through the foreseeable future.
We have repeated that financial market risk sentiment, as perhaps best represented by the S&P 500, would be the major determinant of USDJPY price action. With stocks moving down, and the USD as the new prime safe haven currency, the USDJPY should indeed rise.
Against other counterparts, the Yen’s continued losses are typical for the lower yielding currencies when risk sentiment is up. FX traders avoid buying Yen unless they absolutely must, that is, when they are forced to cover JPY short positions. Then, they typically do so in a hurry. Thus we believe that the Japanese Yen is likely to continue drifting lower against the Euro, British Pound, Australian Dollar, and New Zealand Dollar, though there may be some hard fast rallies when fear takes over. The wildcard remains whether we can expect a noteworthy correction in broader financial market risk sentiment.
Impressive performance and fresh highs across key barometers leaves markets at prime risk of pullback and likely yen rally against the higher yielders. However, until we see plausible signs of market turnaround, we have little reason to believe in a yen recovery. The admittedly unpredictable dynamics between the US Dollar and Japanese Yen make the USDJPY an especially challenging pair to trade. If nothing else, however, its recently bullish momentum is likely to keep it aloft through the coming week of trade.
GBP
BoE “Hawk Talk” is Not Enough-GBP Jawbone Driven Rally Collapses Under the Weight of Reality
Outlook for British Pound: Neutral
Summary
- GBP rallied on pure BoE spin, plunges when Q3 GDP shows “hawk talk” is just that
- Bank of England’s October meeting minutes signal neutral interest rate policy
- The UK economy unexpectedly contracted in Q3, dashing hopes for recovery
- GBPUSD rallied too far, too fast, on too little. What is the technical picture of this major pair?
Analysis
When currencies (or any assets) are badly oversold, they can rally on the slightest good news because there are usually some nervous traders ready to take profits ahead of the growing herd. That’s the main explanation for the pound’s recent rally. All the BoE did was restate the obvious, that one day, it too would raise interest rates. However, once confronted with actual facts to the contrary, the deception fails and the real trend resumes. In this case, the unpleasant reality was that UK GDP stank and rate increases still lay in the distant future.
When the news came out, the reaction was immediate and the candlesticks got very red, very long, very fast. The British pound racked plunged 1 % against the Japanese yen and nearly 2 % against the US dollar, after UK GDP unexpectedly showed that the nation did not emerge from recession during Q3, and instead, the economy contracted for the sixth straight quarter at a rate of -0.4 percent. Likewise, the annual rate of growth edged up to -5.2 percent from -5.5 percent, falling short of expectations for a move to -4.6 percent.
A breakdown of the GDP report showed that nearly every UK business sector remained in recession, as the services industry component fell by 0.2 percent while the production industry component tumbled 0.7 percent.
Note that GDP is a lagging indicator and the release’s impact on interest rate expectations is the most important part. Indeed, the British pound fell sharply because Credit Suisse overnight index swaps shifted to price in a 10 percent chance of a 25 basis point cut by the BOE during their next meeting. Furthermore, expectations for rate increases over the next 12 months fell to 88.1 basis points from 93.4 basis points.
The Monetary Policy Committee (MPC) is looking for reasons to justify either winding down or expanding their target level of asset purchases. The minutes from their October policy meeting showed that the "forecast round ahead of the November Inflation Report would provide an opportunity to assess more fully how the medium-term outlook for activity and inflation had evolved since August," and if the latest economic data has any bearing on the MPC’s bias, it looks there is still some bearish potential for the British pound.
Events
Looking ahead to the next week, UK data shouldn’t have too much of an impact on rate expectations, but there is always the lingering risk that BOE MPC members will make comments that could impact trade. Thursday is really the only day with scheduled indicators on hand. Net consumer credit in the UK is anticipated to remain negative for the third straight month at -0.2 billion pounds, but on the other hand, UK mortgage approvals are projected to hit a more than one-year high of 53,600, suggesting that lending levels remain low but housing demand is growing. Meanwhile, GfK consumer confidence is forecasted to climb to a nearly two-year high of -14 from -16, indicating that sentiment is still pessimistic but improving, albeit at a slow pace. The GBPUSD’s direction in the coming week will likely have more to do with US dollar trends than UK fundamental forces, but a break below the 50 SMA at 1.6265 opens the door to much steeper declines.
CHF
Will SNB Intervene or Let the CHF Hit Parity with the USD?
Summary
Outlook for Swiss Franc: Bearish/Neutral
- Rising with risk appetite, likely to fall with it if stocks continue down
- Swiss exports fell 2.3% in September following a 2.0% rise the month prior
- Technical outlook calls for potential USD/CHF reversal
Analysis
The Swiss Franc trended higher against the dollar over the past week as risk sentiment continued to drive price direction. Strong corporate earnings from Apple, JP Morgan and DuPont sparked risk appetite to start the week but concerns over valuations led to diminishing returns for bullish investors as equities struggled to hold onto gains. A disappointing U.K.3Q GDP reading, -0.4% versus 0.2%, has raised concerns that other G-7 nations will follow with dour growth results. The U.S. GDP report will cross the wires next week and a similar result could lead to support for the pair. Although Swiss fundamentals have little sway over Franc direction, the 2.3% drop in exports and 3.1% gain in imports during September could be influential if they lead to more SNB intervention.
Events
Two significant fundamental releases are on this week’s economic docket with the UBS consumption indicator and the KoF leading indicator on tap. Rising unemployment hurt domestic demand as the labor market remains weak as declining orders keep companies in cost cutting mode. Nevertheless, the outlook for the next six months is forecasted to rise to 1.10 from 0.85 on the back of an improving global economy. Regardless, traders should take their cue from risk sentiment as depicted by the S&P 500,
If risk appetite returns the pair could test parity, but reversals can often follow tests of significant psychological levels. Also, traders must beware of possible intervention from the Swiss National Bank as they continue to fight against Franc appreciation and its negative implications for the economy.
CAD
Moving with Oil, then Risk Appetite, But May Feel Pressure from BoC Decision
Summary
Outlook for Canadian Dollar: Bearish
- How far can the USDCAD rally?
- The Bank of Canada warns interest rates will held “until the end of the second quarter of 2010,” but its Monetary Policy Report raises its exchange outlook, warns of intervention
Analysis
What has been the fundamental basis for the Canadian dollar’s strength over the past weeks and months? Most analysts will say:
• Rising energy prices
• Much stronger underlying economy than most
• USD weakness prompting US capital to head north
However, the comprehensive assessment from the central bank indicates that growth seems to be at the heart of the matter.
Referring to the central bank’s forecasts this past week, it seems the world’s eighth largest economy is on track for an impressive recovery. A 2 %annualized pace of growth in the third quarter and 3.3 percent in the fourth quarter is a considerable improvement over Canada’s performance through the first half of the year, much of it due to rising energy prices. As domestic conditions further improve and the US enjoys its own recovery, the economy is seen further expanding 3 percent through 2010 and 3.3 percent in 2011.
Events
This Friday, Canada will report its GDP report for the month of August. A modest 0.1 percent increase is projected for the August reading; but there were hurdles to overcome over this period.
• The US ‘Cash-for-Clunkers’ program expired during this month and the impact on Canadian manufacturing will be significant
• the economy ran a record trade deficit
• the unemployment rate hit an 11 year high
Scanning the rest of the Canadian economic calendar, there are no other major market moving economic indicators to be concerned with; but that doesn’t mean fundamental activity will start and end with the Friday release. It is important to recall two more highlights from this past week’s policy announcements.
Interest rate plans: The first is the reiteration by the Bank of Canada that the benchmark lending rate would be maintained at its current level “until the end of the second quarter of 2010”on the condition that inflation does not force their hand. While inflation is at a 56-year low and core pressures are tame, overnight index swaps are pricing in 85.4 basis points of tightening over the coming 12 months. This is generally on the same level as the dollar, euro and pound; and yet the Canadian dollar is still showing general strength against these counterparts.
Intervention threats: Repeating concerns from the past; the central bank said the high level of the national currency could offset other, positive growth factors going forward. This is a relatively weak effort to talk the currency down – one that speculators have become acclimated to. So, to increase pressure on the CAD, BoC Governor Mark Carney said in commentary following the release of the Monetary Policy report that “intervention is always a possibility.” While the threat remains low for now, this stronger language suggests a level of frustration that could lead to action later.
AUD
Expectations for Coming Rate Increases Keep AUD Rising
Summary
Outlook: Bullish/Neutral
- Events could keep AUDUSD confined to narrow range
- RBA Minutes Spark Speculation For Further Rate Hikes
- Keep watch on the S&P, the pair continues to follow it regardless of other news events
The Australian dollar rose to a fresh yearly high of 0.9326 against the USD and the Aussie may continue to appreciate going into the following month as investors speculate the Reserve Bank of Australia to tighten policy throughout the second-half of the year. Credit Suisse overnight index swaps shows market participants are pricing a 131% chance for a 25bp rate hike in November and expect the central bank to raise borrowing costs by more than 200bp over the next 12-months, and the Aussie may continue to retrace the sell-off of the prior year as policy makers hold and improved outlook for the economy.
The Reserve Bank of Australia Minutes has plenty of hawk talk to please Aussie bulls. Saying:
• the “very expansionary setting of policy was no longer necessary”
• it may be “imprudent” for the central bank to hold the interest rate at the 49-year
• keeping borrowing costs at “very low levels” could raise the risks for inflation
• the “trough in inflation was significantly higher than earlier thought”
Moreover, RBA Assistant Governor Philip Lowe stated that the rebound in economic activity would “gradually lead to a normalization of interest rates,” and said that the country is likely to have “a higher average exchange rate than we’ve had over the past couple of decades.” However, the central bank expects the marked appreciation in the Australian dollar to temper the risks for inflation, and the central bank may adopt a wait-and-see approach over the remainder of the year as the outlook for global growth remains uncertain.
Events
The following week is likely to spark increased volatility for the Australian dollar and may drag on the exchange rate as market participants anticipate price pressures, and thus the need to raise rates, to weaken further in the second-half of the year. Consider:
• economists forecast consumer prices to grow at an annual pace of 1.2% in the third quarter after rising 1.5% during the three-months through June
• producer prices are project to fall to an annualized rate of 0.5% from 2.1% in the second-quarter
• private-sector credit is anticipated to increase 0.2% in September following the 0.1% rise in the previous month
• bank lending is expected to grow at an annualized pace of 2.0% from the previous year
As a result, the slew of mixed data may leave the AUD/USD confined in a narrow range as investors weigh the outlook for future policy but nevertheless, as risk trends continue to dictate price action in the currency market, a rise in risk appetite may lead the Aussie to hold above 0.9300 over the following week.
NZD
Rally Vulnerable to Pullback in Stocks, or Rate Disappointment
Summary
Outlook for New Zealand Dollar: Neutral/Bullish
- Weekly Technical Outlook: New Zealand Dollar Top May Be Ahead – Depends on Global Stocks
- Sentiment Outlook Undecided as Speculators Vacillate
Analysis & Events
The interest rate announcement tops the news calendar. As is so often the case, the market moving news or surprises will be in the accompanying policy statement, which may provide hints about future rate hikes. Few believe a rate hike is coming, with a Credit Suisse index of priced-in expectations showing traders see no chance of a hike this time around.
Specifically, traders will be looking to gauge whether the timetable for the withdrawal of monetary stimulus has been accelerated from the previously given “latter part of 2010” estimate after consumer prices unexpectedly surged in the third quarter.
The hawks may be in for a disappointment however considering policymakers will be wary of acting on rates to protect the still very fragile export sector. As we have noted in the past, New Zealand is not Australia in that its recovery is not as robust. Indeed, both the central bank and government have warned about the detrimental effects of a higher Kiwi dollar in driving away foreign demand. Overseas sales make up over 30% of the economy’s total output, so any policies that stand to hurt firms catering to foreign markets will likely stunt the fledgling economic recovery of recent months.
September’s Trade Balance figures are set to be released less than two hours after the central bank announcement crosses the wires, with exports expected to match the 23-year record drop recorded in the previous month even as the overall deficit narrows on lackluster import demand.
In fact, the RBNZ may have already embarked on a somewhat covert tightening campaign aimed at checking inflationary pressure while minimizing the impact on the NZD exchange rate. The central bank “leaked” an announcement that it would end some of its emergency lending programs enacted amid the credit crunch in November, a fact that it did not officially confirm via an official news release until about a day later. This move will gradually slow the flow of liquidity into the economy, reduce the pace of money supply growth and act against inflation.
This subdued approach suggests that they were consciously trying to avoid sending the New Zealand Dollar higher. It also hints that perhaps this approach to tightening will be seen as sufficient to keep rates at current levels until the second half of next year as scheduled.
Looking beyond the economic calendar, the outlook for risk sentiment is likely to remain a key catalyst for price action. Indeed, a trade weighted average of the New Zealand Dollar’s value remains over 95% correlated with the MSCI World Stock Index as traders’ appetite for returns boosts stocks, commodities and high-yielding currencies alike. Thus traders should keep an eye on a handful of high profile third-quarter earnings reports including those from consumer goods giant Procter & Gamble, big oil names including Exxon Mobil and Chevron, and US Steel.
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. The signs of waning risk appetite have already been showing for the past week, as earnings beat estimates but revenues and valuations remain a concern for stocks and other risk assets.
With US GDP this coming Friday, and Non Farms Payroll the next, earnings news has another few days to hold center stage before regular news events once again hold sway over global markets.
For now, stay with the rising trends, but be ready to take profits and / or take short positions on most risk assets and get long on the safe haven currencies.
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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