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This past week marked a possible turning point in the current financial crisis. It seems all of a sudden the world has awakened to the risk associated with the rescue efforts of the Federal government, primarily the oversupply of dollars. The trigger for this sentiment change was S&P's decision on Thursday to lower Britain’s outlook from stable to negative. This resulted in a major sell-off across all asset classes. Yields on 30 Year treasuries jumped up by 31 bps, the US Dollar lost almost 3.5% against the Euro, and equities gave up most the week’s early gains.

U-Turn in Risk Appetite

Since the fall of Lehman Brothers, the US was seen as the safe haven with treasuries being bid to astronomical levels, and the dollar strengthening. As news of stabilization of economies across the world trickles in, investors are now looking beyond the safe haven and focusing on the end-result of government policies.

Thanks to the numerous bailouts, and the extensive spending plans of the Obama administration, the US Treasury will have to issue a lot of debt to finance Government spending. Coupled with the Fed efforts to flood the system with liquidity, there is a fear of inflation and the subsequent loss of the Dollar’s purchasing power. As a result, US based assets, which were the safe-haven of choice a few months ago, are being dumped like hot potatoes.

Some of the movement is purely due to trading momentum. As equities have become range-bound, and no longer trending, traders are looking for new trends. US treasuries and foreign exchange markets are seen by many as the next trending market, and with each move up, more trend-followers are jumping into the fray.

Selling Overdone?

My personal view is that the reaction of the market is overdone. This is especially true when it comes to the EUR-USD exchange rate. This fact is being acknowledged by world leaders. Eurogroup Chairman, Jean-Claude Juncker came out with a statement that the rise in the Euro is not line with fundamentals, and economic recovery in Europe is still some way off.

The White House also reaffirmed that it sees no risk to the US’ AAA rating. One argument in favor of the White House’s statement is that Americans are taxed at a lower rate than Europeans, and the US Government (unfortunately) has the ability to service the rising level of debts, by raising taxes.

A part of the selling in the bond market was driven by bond dealers taking up short positions, before they bid on the large amount of Treasury bonds which will be issued next week.

Euro-Zone: In a Much Worse Shape

As I have written in earlier articles, the Euro-zone is facing a financial crisis similar to the US, but with a smaller set of tools to work with. This article in the Washington Times goes into details of the problems, including the specter of a complete collapse of major banks whose liabilities are often greater than their government’s ability to bail them out.

I had an interesting exchange with well known commentator Ashraf Laidi on the forum on his web-site, ashraflaidi.com. Ashraf wrote:

making a claim such as the "US is the best of the worst" opens up a whole new discussion that tend to reach socioeconomic boundaries that are beyond the scope of Forex market supply and demand. The hard currency discipline of the ECB may have some macroeconomic hardships but not on its currency, while the Fed is now suffering the worst of corroding home values, contracting credit, soaring unemployment each underlined by severe consumer deleveraging. a country that depended on credit for so much longer than E(e)urope is now having that "drug" taken away from it. And the consumer has now left a void in aggregate demand. And that’s not good for the consumer/debt-dependent US dollar.

My take-away is that right now, there is a flight out of US Dollars in the Forex markets, which tend to trend and in the short term the flight will continue. The ECB is constrained by its ability to act in an aggressive manner due to conflicting stake-holder interests, a limited charter and also a fear of doing too much. A smaller central bank role may allow market forces to work their way through; however it also increases the risk of the crisis worsening.

The ECB’s hard currency discipline may come back to haunt it if it is forced to act in a much more aggressive manner further down the road. So far the ECB has been behind the curve in reacting to the crisis, erring on the side of less intervention. However, they have been forced to follow the US Fed’s lead after some time. If the same trend continues, the very factors which are pressuring the US Dollar right now may also come to bear on the Euro-Zone. This does not bode well for the intermediate term outlook for the EUR-USD, once the current anti-dollar surge in the market subsides.

My Portfolio

I continue to day-trade without establishing any significant position. On Friday I primarily traded the EUR-USD futures (6E), along with some equity futures. My IYR puts are doing fine. I also opened a small bearish put spread position in the TBT. I expect some pull-back in long bond yields next week and an option spread is a low-risk method of taking that view.

Trading Macro Events: A Lesson

I had also opened a short Euro position Thursday, based on some topping patterns I had observed. What I had not accounted for is that much of the Asian markets were closed when the news about S&P's cut in the outlook for Britain came out. As a result, after pausing around the close of the US markets, the Euro continued to rise once the Asian markets came on-line, and caught up with the selling.

The Euro traded within 2 ticks of the stop on my position. I decided to add to the short position within a few ticks of my stop. This strategy lowers your average cost of the position and with the stop close to the entry price, the additional loss is limited. As of close of trading on Friday, the Euro had pulled back $.50 from the intra-day high, close to my break-even point. I plan to exit the position on any weakness, with the focus on being break-even.

My view is that the market will take a pause over the long weekend and after they digest the news, the US Dollar will recover at least some of its losses as political jaw-boning and the risk of government intervention leads to profit-taking.

Market Outlook

The Friday before a long-weekend is a low volume day and there can be a lot of volatility and quick price movement. The equity markets were range bound but sold off strongly at the end of the day, showing the re-emergence of risk aversion. The risk-aversion is originating from the currency and the treasury markets. Some stability in those markets next week will likely help the equity markets find their footing. However, if the appetite for US based assets continues to collapse, the equity markets are likely to follow.

Source: Appetite for U.S. Assets Crashes