Sentiment Rebounds on a Wing and a Prayer

02/09/2009 1:13 pm EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

In last week's report, I suggested "we are either very near a top in the USD or set to see a new phase of risk aversion and a safe haven surge into the USD." This past week saw the former scenario play out, as investor optimism rebounded, and the USD was sold lower alongside the JPY, sending the risky FX assets (JPY crosses) sharply higher by the end of the week. Investors are betting that the US will finally pass a fiscal stimulus package, and more importantly, the US Treasury will at noon on Monday unveil a reportedly comprehensive plan to stabilize the US banking system. As such, the nascent rally in optimism is based on hope rather than any material change in the outlook, which remains bleak at best. In terms of FX movements, major pairs have simply gone from testing range lows to testing range highs, so we do not yet have evidence of a concrete break out. However, many of the building blocks and telltale signs of a reversal are appearing, and I would caution against fading the breaks if they materialize. ("Fading" refers to trading against a directional move, such as selling into a rally or buying into a decline.) The risk this week is that the ranges are maintained and all the frothy optimism that emerged at the end of last week evaporates in the face of the long haul ahead.

In terms of the telltale signs of a potential reversal for the USD, the commodity currencies (AUD, CAD, NZD) frequently lead overall turns in the USD. Friday saw outsized price gains for all the commodity currencies against the USD, with even CAD shaking off the largest monthly job loss on record (it roughly equates to a monthly US job loss of more than 1.8 mio), even as commodity prices declined. GBP is another leader of overall USD direction, and the pound displayed significant strength throughout the week despite BOE rate cuts and grim warnings on the outlook. Also, USD/JPY closed above its 55-day moving average for the first time since the beginning of September after making a double bottom at 87.50. Importantly, other financial markets beyond FX are also showing signs of reversing, but currencies appear to be leading at the moment, which increases the potential that FX is wrong or premature in suggesting a reversal. This week promises more volatility, and traders will need to remain flexible and avoid getting married to directional positions while market conviction remains so weak.

Important Price Levels to Watch

With the global economic outlook still very weak and sentiment lacking in conviction as a result, I like to focus on price levels for directional cues, with the key frequently being a daily close above/below a particular price level. Below I highlight some key levels to watch in major FX pairs and a few other markets. Note that in many cases, the Ichimoku cloud becomes very thin over the next few weeks, which weakens its strength as support or resistance.

EUR/USD: Trading below the fastest Ichimoku line (Tenkan) at 1.3018. A daily close above suggests initial potential to the Kijun line at 1.3382. The cloud is above at 1.3524. The 21-day SMA is at 1.3062 and the 55- and 100-day averages converge at 1.3319 and 1.3298, respectively. The key support zone is at 1.2700/30, with a drop below targeting weakness back to 2008 lows near 1.23 initially.

USD/JPY: Currently trading inside its Ichimoku cloud, base at 91.26 and top at 93.85, the Tenkan line is set to cross up over the Kijun line in a few days, likely generating a moderate-strength buy signal if price remains inside the cloud, or strong buy signal if price moves above the cloud. Price closed above the weekly Tenkan line for the first time since mid-September, which is also a bullish indication.

GBP/USD: Tested into the cloud from below, but failed to close inside. The cloud base falls from 1.4832 on Friday to 1.4815 on Monday. A daily close inside the cloud would target a move to the top of the cloud, which is at 1.5513 all week. The Tenkan line (1.4387) is set to cross up over the Kijun line at 1.4438, possibly by Monday, generating a buying signal. Cable also closed above the weekly Tenkan line for the first time since mid-July 2008 when GBP/USD was around 2.0000.

AUD/USD: Trading inside its cloud, it failed to break above the cloud top at 0.6822 (rises to 0.6859 on Monday). The Kijun line is nearby support at 0.6758. The bottom of the cloud is at 0.6573 (also rising this week), and the Tenkan is at 0.6526 and rising. AUD is set to close slightly above the weekly Tenkan line at 0.6758. The 55-day SMA is at 0.6704 and the 100-day SMA is at 0.6829.

BKX ($BKX on e-Signal; banking index, key as a leader of overall stocks and JPY crosses): closed above the Tenkan line at 28.79 after making a double bottom at 25, targeting possible gains to Kijun line at 35.17.

S&P 500: Here the cloud becomes very thin over the next few weeks, but price is currently above the Tenkan line at 845 and tested near the cloud base at 874, where it remains until late February. Strength above 885/890 would break above the cloud and signal further gains ahead.

Treasury Refunding Will Gauge Appetite for US Paper

The US Treasury is poised to issue $67 billion in government paper next week in their refunding auctions. This is composed of $32 billion in three-year notes, $21 billion in ten-year notes, and $14 billion in 30-year bonds. The announcement of the size pushed Treasury yields markedly higher this past week as the massive influx of supply sent prices lower. Concerns remain widespread that the US borrowing needs will reach astronomical levels-in the realm of more than $2 trillion for 2009. This coupled with recently stirred up tensions between China and the US (on Geithner's comments that China is manipulating its currency) has seen bond prices of late come off the boil. Indeed, ten-year yields touched 3.00% recently, the highest level since late November, after putting in a 2.04% low in mid-December. The key this week will not be so much in the price/yield action, but rather in the appetite for US Treasury paper witnessed in the auctions.

Typical bid/cover ratios for the respective notes and bonds have been between 2.2/2.4 over the last few months. This means that for each $1 auctioned, there was a little more than $2 in bids. This week, we expect these ratios to remain relatively stable as the Fed's recent hints that it is willing to purchase Treasury paper if the need arises should put a floor on demand. That said, the risk remains that we get poor auctions on the back of the massive supply and that bid/ask ratios come in below two times. These outcomes should weigh on the USD in the near-term as they would likely fuel speculation that the US is finding it increasingly difficult to finance its exploding deficit. Thus we would recommend that traders keep these auctions on their radar screen this week.

Horrid Employment Report and a Bleak First Half Ahead|pagebreak|

The US employment report for January was nothing short of awful as nonfarm payrolls plunged a sharper than expected -598K after a downwardly revised -577K the prior month. The January release also meant benchmark revisions for 2008, where the BLS goes back and revises every month for the prior year. The verdict was dreadful as revisions show an additional -385K jobs lost last year. This brings the tally for the recession to -3.6 million jobs, the sharpest post-war decline. The unemployment rate was no better as it jumped to a higher than expected 7.6% from 7.2% previously, and is now at a 16-year high.

Perhaps the worst part of the report was the additional decline in aggregate hours, which fell -0.7% on the month to an annual rate of -4.6% from -4.2%. The three-month growth trend is now at a bleak -9.2% from -8.6% and at the weakest print since 1975. The rub here is that hours tend to lead bodies when it comes to employment. This suggests the pace of job losses is only likely to worsen as we muddle though the first half of 2009. Indeed, I would not be surprised to see a -1M print in NFP in the months ahead.

Hope that the fiscal stimulus will soon be passed looks to be keeping the risk trades somewhat supported near term. However, the Congressional Budget Office reported recently that the "stimulus" is likely to have little impact on economic growth or employment until 2010 at the earliest. Thus while a short-term bounce on hope is certainly feasible over the next few weeks, it looks even more likely that risk trades will test new lows before any significant secular rally emerges. In this environment, the USD still looks like the best of the worst, and risk aversion over the next few months looks likely to drive investors back to the relative safety of the greenback.

Key Data and Events to Watch This Week

The US economic calendar is modestly busy on the data front. The action kicks off on Tuesday with wholesale inventories. Wednesday sees the trade balance and monthly budget statement, while Thursday has the all important retail sales report, business inventories, and weekly jobless claims. Friday rounds out the week with the University of Michigan consumer sentiment index. Also look out for Treasury Secretary Geithner and Fed Chairman Bernanke, who will be testifying on TARP and Fed programs on Tuesday.

The euro zone is likewise not very busy. Monday starts it off with French business confidence and the German trade balance. Tuesday has French industrial production lined up, while Wednesday brings German consumer prices. Thursday sees euro zone industrial production, while Friday is busy with euro zone GDP, French employment, French GDP, and German GDP on deck. The euro area Finance Ministers meeting on Monday is also noteworthy.

It's a relatively quiet week in the UK. The RICS home price numbers and the trade balance kick it off on Tuesday. Wednesday closes out the action with employment data and the Bank of England quarterly inflation report.

Japan is characteristically on the light side as well. Sunday has the current account and machine orders due. Tuesday then sees consumer confidence, while Wednesday has corporate goods prices lined up.

Canada has little going on too, but the data is top-tier nonetheless. Housing starts kick things off on Monday. Wednesday, we'll see new home prices along with trade numbers. Friday closes out the week with new motor vehicle sales.

Finally, the agenda down under looks busier than usual. New Zealand home prices start off the week on Sunday. On Tuesday, we'll get Australian business and consumer confidence surveys. Thursday rounds out the action with New Zealand retail sales, Australian inflation expectations, and Australian employment.

By Brian Dolan of

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