Don't Look Now, but the Worst for the Markets May Be Over

02/23/2009 10:59 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Last week saw all the key risk aversion indicators continue to gain ground, indicating eroding sentiment, but by the end of the week, many of them had seen potentially significant reversals, suggesting an improved risk environment may lie ahead. The USD pressed higher for most of the week on ostensible safe haven buying, with the USD index nearly reaching the November 2008 high at 88.45, only to reverse course sharply on Friday. As a result, the weekly candlestick formed a shooting star, complete with a gap open higher, a strong reversal pattern after an advance, with confirmation coming from further declines next week. The high at 88.25 effectively leaves a potential double top at 88.25/45, providing another possible reversal pattern. In EUR/USD, the 1.2500/50 area proved resilient, and the breakdown below 1.2720/30 that started the week was negated by the weekly close back above 1.28, which also saw EUR/USD close above the Tenkan line at 1.2794, the initial signal of a directional reversal.

The JPY crosses also delivered a subtle signal that risk aversion was likely abating. Even as global stock markets plumbed the lows, the JPY crosses gained ground and finished out the week nearer to their highs for the year. EUR/JPY is set to close above both the Tenkan and Kijun lines at 117.63 and 117.14, respectively, while GBP/JPY tested the bottom of its cloud several time and finished out above its Tenkan and Kijun lines. Elsewhere, gold continued to gain ground on safe haven buying, testing above the $1000/oz on Friday, but failed to hold on a closing basis (see more on gold below). In stocks, the S&P 500 based out above its low from last November, potentially setting the stage for a double bottom from around 750, while the Nasdaq managed to close nearly flat on the day. WTI crude oil prices have now tried three times to break below the $32-$33/bbl level, only to rebound again.

With the fundamental outlooks still bleak globally, any rebound in risky assets is likely to be sentiment driven and thus inherently fragile. However, within the recent ranges, I think we have room for the USD to weaken in coming weeks against all but the JPY. In EUR/USD, strength over 1.2950 opens up potential to the 1.33-1.35 area. GBP/USD gains over 1.4500/20 suggest potential back up to the 1.5000 area. USD/CHF may see lower toward the 1.1330/50 area. USD/JPY maintains upside potential while it holds above the key 92.50/75 break level, but needs to overcome resistance between 94.50-95.00 to signal likely gains higher. A daily close over the 94.65 high from January would constitute a break of the neckline in a potential double bottom formation and target gains to the 102.00 area. Between a steady to higher USD/JPY rate and likely advances in non-JPY dollar pairs, the JPY crosses also have further upside potential.

More JPY Weakness Likely as Data Worsens

Economic data out of Japan next week is likely to be closely watched as market participants attempt to gauge the future direction of JPY, which we believe is discernibly weaker. The most important of these is the trade balance due up on Tuesday. The market is looking for continued deterioration in January to -Y1179.5B from -Y320.7B prior. This would take out the January 2006 record low of -Y353.5B when USD/JPY was trading at around the 120 mark. Looking at the relationship between annual returns in JPY and Japanese trade suggests USD/JPY could be on its way up there once again.

Apart from the obvious headwinds to trade the country faces from the overvalued currency, the economic situation continues to worsen. Indeed, the government of Japan downgraded its growth assessment for the fifth consecutive month just last week. Leading indicators look bleak with employee overtime hours down near 2002 levels. Hours lead bodies when it comes to employment and this metric suggests that the jobs situation is about to get a lot worse. The ultra-important Tankan index really did tank in 4Q to -24 and is also at 2002 levels now, suggesting business confidence is in the dumps.

Now a lot of the recent rally in JPY has been attributed to the notion that the yen is a safe haven trade. Frankly though, I don't see how a country that holds more than 170% of GDP in gross debt and has a mere AA credit rating from two of the three major rating agencies can be considered the ultimate destination for risk aversion. In fact, the rally in JPY can ultimately be attributed to the massive unwinding in the carry trade as global equity markets melted down in the second half of 2008, along with huge repatriation from Japanese investors as global yields collapsed. With the carry now virtually nonexistent as global rates continue to converge, it looks like the top in JPY has been reached, and that weekly double bottom in USD/JPY near 87 comes to mind. In the next few sessions, we would look for a break above 95 to trigger some decent near-term strength here.

The Bullion Bull Run Continues...for Now

Gold made another monumental move higher last week and briefly took out the psychologically important $1000/oz barrier. Global risk aversion continued to push prices for what is now being called the world's second reserve currency into fresh highs. With equities melting down across the world and demand for physical gold at all time highs, it is no wonder that the trend for this precious commodity remains up. Indeed, demand has increased to such an extent that it was recently reported that US and European investors scooped up nearly 150 tons of gold in 4Q 2008—a more than 800% increase from 4Q 2007. Do an Internet search for physical gold and you are met with multiple Web sites where coins and bars are "out of stock." Indeed, it now looks as if we have entered the euphoric phase of this bull run. That said, asset bubbles only really become obvious in hindsight, and thus we will look to technical levels for guidance.

Perhaps the most obvious bearish indicator is the potential double top we are setting up right near the $1000 mark. Failure to break above here in earnest should take some of the luster off the rally in the near term. The support zone we'd like to keep in mind the most over the next few trading sessions is the $935/$930 area. This is trend line support drawn from the 15-Jan and 10-Feb lows and also looks like the short-term pivot that initiated the move higher back on 12-Feb. A break below here over the next few sessions should solidify the double top near $1000/oz. We would look for a break of major daily trend line support, which lurks by $875 currently to indicate that the current up trend has come to an end. In terms of the upside, resistance comes in at the 2008 intraday highs by $1030/$1035, and we would expect good option interest in that area. Above there, we are really entering uncharted waters and would look for barriers at $25 intervals.

Key Data and Events to Watch This Week|pagebreak|

The US calendar has some important data and events on deck in the week ahead. Tuesday starts it off with consumer confidence and multiple home price reports. Wednesday has existing home sales and the weekly oil inventory numbers, which have led to a pickup in oil price volatility in recent weeks. Durable goods orders, initial jobless claims, and new home sales highlight a busy Thursday. Friday rounds out the week with GDP, the Chicago PMI, and University of Michigan consumer sentiment. Noteworthy as well is Fed chairman Bernanke's semi-annual testimony before the Senate on Tuesday and the House on Wednesday.

The euro zone is bustling with top-tier data. French consumer spending, French housing starts, French consumer confidence, the euro zone current account, the German IFO surveys, and euro zone industrial new orders all kick off the week on Tuesday. Wednesday is light with only German GDP of note. The action returns on Thursday with German GfK consumer confidence, German employment, euro zone business climate indicator, euro zone consumer confidence, and German consumer prices. Euro zone consumer prices close out the week on Friday.

It is pretty light in the UK, and given the poor news of late, this is probably a good thing. Total business investment gets it started on Monday. Tuesday has GDP on deck, and Thursday sees nationwide home prices. Also look for a speech by the Bank of England's Blanchflower on Wednesday. He is arguably the most dovish member on the BOE, and thus, his speech should elicit some market attention.

Japan has an important week coming up with a plethora of top-tier reports. On Monday, look for the Bank of Japan meeting minutes. Tuesday has the crucial trade balance report (more on this above), while Wednesday sees small business confidence. Thursday is busy with manufacturing PMI, employment, household spending, and consumer prices all due. Friday ends the week with housing starts and construction orders.

Canada's calendar is ultra light. Retail sales are the highlight on Monday, and then we wait until Friday to close out the week with the current account and industrial product prices. In other words, look for the moves in USD/CAD to be mostly driven by the USD side of things.

The action down under is also characteristically light. New Zealand credit card spending starts it off on Monday. Wednesday has Australian wage costs and the New Zealand trade balance due up. Thursday closes out the week with New Zealand business confidence, New Zealand building permits, and Australian private capital expenditures.

By Brian Dolan of

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