4 Big Currency Themes Playing Out Now

11/07/2011 9:25 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Aside from lingering Eurozone risks and central bank policy measures, bearish developments across four correlated asset classes could soon cause a major selloff in risk assets.

While Greece has drawn all the attention this past week, there are other indications that suggest markets are ripe for a potentially significant relapse in risk sentiment. Despite reports of the European Central Bank (ECB) buying Italian and Spanish government debt, Italian yields are at all-time highs and Spanish yields are at their highest levels since August. This suggests to me that markets remain unconvinced that the EU’s ostensibly comprehensive solution will actually work for countries "too big to bail."

Two-year government bond spreads between troubled EU nations (Italy, Spain, Portugal, and Greece) and Germany are all at euro-era record highs, offering another vote of no confidence on the EU plan. As well, most risk markets were only able to retrace about 38.2% of the selloff even after the idea of the Greek referendum was scrapped. So while the Greek tragedy plays out in the foreground, keep an eye on the background of Italy and Spain.

What the Central Banks Didn’t Do

Adding to the pressure on risk assets is an underlying deterioration in recent economic data—especially in Europe—in contrast to more robust numbers just a few weeks ago. Key Eurozone PMI’s fell below the 50 expansion/contraction level, and Germany’s unemployment rate unexpectedly ticked higher to 7.0%. Perhaps ECB member Yves Mersch summed it up best, saying the economy is practically "in freefall," adding the odds of a recession there are more than 50%.

In response to the weakening outlook, and in an uncharacteristic display of economic reality, the ECB surprised markets by cutting interest rates by .25% to 1.25%. But more important is what the ECB failed to do.

Newly installed ECB president Draghi flatly declared that the ECB would not be the lender of last resort for banks or governments and could not stabilize the debt markets of beleaguered Eurozone countries, like Spain or Italy. Without ECB support, debt investors are left looking at highly indebted national governments promising to borrow more to guarantee earlier borrowings, and not feeling especially comfortable.

In the US, October jobs data provided little support for the notion that US growth was picking up momentum, leaving the brief euphoria following the 3Q GDP report as a distant memory. The Fed this week issued downwardly revised forecasts for 2012-2014, expecting anemic growth and high unemployment to persist over the period. In response to this bleak outlook, the Fed did nothing.

Bernanke indicated that QE3 remains an option and that it was discussed, but he also seemed to suggest that it wasn’t going to happen any time soon. It’s unclear what the Fed is waiting for given its moribund economic outlook, but for now, expectations for QE3 are dwindling rapidly, providing yet another headwind to risk assets.

NEXT: 4 Big Warning Signs for Risk Assets

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Charts Suggest Risk Assets May Soon Take a Dive

Following on the political and fundamental risk negatives outlined above, charts across multiple assets suggest there is potential for a possibly serious decline in major risk markets in the weeks ahead. High correlations persist across stocks, commodities, and risk FX, so many of the following observations can likely be seen on many other assets, but here are four particulars to focus on:

  1. EUR/USD has formed a bear flag consolidation pattern on short-term charts after the early decline last week and could also be forming a head-and-shoulders (H&S) bearish reversal pattern following the recovery from below 1.3200. The breakdown levels for both patterns are converged in the 1.3650/1.3700 area and both suggest downside targets around 1.3100/1.3150. Strength beyond 1.3950/1.4000 would invalidate those patterns.
  2. USD/CHF has a mirror-image bull flag similar to EUR, with the breakup level in the 0.8900/0.8950 area and about a 300-point target to 0.9200/0.9250. A drop below 0.8700/0.8750 would negate that set-up.
  3. The S&P 500 also sees a potential H&S top forming on intraday charts, with a break below 1215/1220 targeting a move lower to 1140/1145. Strength above the 1255/1260 area would void this set-up.

  4. Gold (XAU/USD) appears to be in an ascending wedge (bearish reversal pattern) and possibly stalling below key September breakdown levels at 1760/1765. A drop below the 1715/1720 base of the wedge may see lower to the 1650 area.

Finally, we would note that with interventions in JPY and CHF, the USD is the go-to currency if risk sentiment collapses.

See related: Always Bet Against Intervention

By Brian Dolan, chief currency strategist, FOREX.com

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