Beware Seasonal Reversals in FX Markets

Although currencies ended up adopting their usual path of following the swings in risk appetite, it's worth explaining Wednesday's earlier spikes in EUR/USD and GBP/USD.

The moves were a result of broad dollar selling (also seen in a $25 rally jump in gold) on reports that Iran was pushing ahead with its nuclear program. The International Atomic Energy Agency stated an increasing build up of enriched uranium stockpiles, which could be converted into weapons-grade material. Despite the Iran element of the dollar decline, caution is urged of renewed selling waves in the greenback vs. all majors except the yen, as seasonal reversals in FX markets usually emerge in the last five to six weeks of the year, paring the flows prevailing in Sept.-Oct.

These reversals emerge from end-of-year position squaring, with dealing desks functioning on skeleton staffs. The chart below illustrates this phenomenon for EUR/USD over the last three years. A repeat of these trends could see reversals in EUR/USD, GBP/USD and USD/JPY towards $1.33, $1.62 and 100.00.

click to enlarge

Nonetheless, one reason that 2008 might prove an exception to these reversals would be if bank dealing desks added in more hours than is usually the case in year-end, in order to maximize trading revenues and ease the operating losses posted throughout the year. And as long as the laws of risk appetite continue to dictate Forex flows, proprietary desks will have no choice but to pursue lower yielding currencies, especially as stocks are resolved to retest the lows of October 2002.

FX Flows Remain Enslaved to Risk Swings

Despite GBP/USD's surge past the $1.5090 resistance onto a one week high of $1.52, I warned CMC clients that "caution is urged due to GBP/USD's knack for notorious pullbacks at the end of the London session." Ultimately, cable peaked out at $1.5245 before tumbling 300 points as risk aversion soared amid the 6% tumble in U.S. stocks. Remarks from Bank of England's John Gieve indicated prolonged rate cuts, due to the possibility of inflation falling below the 2.0% target in 2009 (from current 4.5%). Recipients of the Intraday Thoughts were informed that $1.5275 would remain intact as it presented the trend line extending from the Nov. 3rd high. Similarly, EUR/USD gave in at the trend line resistance of $1.2780 (four hour chart) extending from the Nov. 10-13 highs.

Falling inflation and contracting home building remains the hallmark of the current economic landscape as U.S. CPI tumbled 1.0% in October (the biggest on record), exceeding expectations of a 0.8% decline, while core CPI fell 0.1% vs. forecasts of a 0.1% increase. Year-on-year figures show a 3.7% increase in the headline and 2.2% in the core. October housing starts up at 791K, building permits at 708K. Although the deepening price erosion in all inflation indicators could be perceived as a positive for U.S. stocks on the basis of prolonged Fed easing, the negative impact on profit margins remain considerable, as pricing power disappears in an already poor demand environment.

Adding the element of weak foreign demand and the negative impact of currency translation from lower non-USD currencies, U.S. multinationals are set for a multi-dimensional earnings slump, thereby, adding to the fundamental argument of the equity selling.

Fed's Forecast Chases Reality

In stark illustration of another central bank outlook falling behind the real economy, the FOMC downgraded its economic projections for 2009 and 2010 from those made in June. The range of forecasts for 2009 GDP growth was lowered to -0.2% -1.1% from June's 2.0-2.8%, core PCE was lowered to 1.5-2.0% from 2.0-2.3%, while the unemployment rate was revised to 7.1-7.6% from 5.3%-5.8%. The Fed's continued downgrades of the economy not only show the central bank's miscalculation of the real economic risks to the economy, but once again underestimate their assessment ahead. The unemployment rate for instance is widely expected by private economists to reach 8% in 2009, a figure that isn't even included in the higher end of its forecasts.

The forecasts highlight the increasing probability that the Fed funds rate could reach 0% before end of Q1, a possibility already echoed by San Francisco Fed's Yellen. But at least the Fed's excessive preoccupation on inflation is diminishing markedly. The latest projections noted:

The majority of participants judged the risks to the inflation outlook as roughly balanced, and a number of others viewed these risks as skewed to the downside - a marked shift from June, when the risks to inflation were generally seen as tilted to the upside.

The latest study from the World Gold Council showed an 18% increase in Q3 demand, due to safe haven flows, resulting mostly from financial market turbulence. Investment demand showed solid support from ETFs, jewelers' demand advanced on falling prices, while industrial demand fell on broadening economic slowdown.

Gold's decline, relative to most currencies, has been primarily a function of the rising dollar emerging from the globalized nature of the economic slowdown and the massive liquidation in dollar shorts of the first half of the year. This point was especially highlighted by the $100 spike on September 17th when Lehman Bros' (LEH) failure and AIG's (AIG) woes were considered a largely U.S.-centric risk.

Nonetheless, during the past month, gold continues to outperform oil prices, consolidating around the $740s, and is seen as a prime candidate for rallying on the earliest signs of stabilizing risk appetite and nascent signs of a recovery in Europe and the U.S.