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The major paper currencies have an ongoing problem - many of the financial authorities in charge of preserving their "value" are actively trying to drive that value downward, jawboning for a decline, and/or wishing beyond hope for a decline. Currencies are an active component of economic recovery programs and likely will remain so until the global economy returns to trend growth. As a result, very few trends have emerged in the major currencies since the financial crisis as traders have bounced from one momentary theme to the next.

Move the clock forward to 2010, and the only currencies to demonstrate a sustained trend up to now are the Japanese yen (NYSEARCA:FXY) and the Swiss franc (NYSEARCA:FXF). Given the devaluation theme in paper currencies, it is no surprise then that the Bank of Japan (BoJ) and the Swiss National Bank (SNB) are amongst the most eager/desperate of the central banks to figure out how to devalue their currencies. Of course, the Swiss franc is only in a trend because of its extreme strength until the SNB established its floor versus the euro a year ago. (Note that the Australian dollar's strong uptrend ended in late 2010. It has gone almost nowhere against the U.S. dollar since then).

Here are the trends using representative currency pairs - the solid black lines define the overall trend from late 2008.

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The Japanese yen has show relentless strength

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The franc's trend was accelerating until the SNB stepped in with a floor

Source for these and all other charts except where otherwise noted: FreeStockCharts.com

This landscape produces a lot of landmines for currency traders looking for reasons to maintain bullish positions on any currency. I provide this backdrop as a reminder that almost no emerging trend in currencies can be expected to last beyond the short-term. On the other side of every long idea is a central bank and/or other assorted authorities who are actively interested in working against that long. In other words, the clock is ticking on almost every trade. Thus, my currency setups to start the fourth quarter must be interpreted as plays for "right now"; most are not long-range forecasts or extended projections.

I start this exercise with my favorite currency highlights from the third quarter:

  • The resilience of the Australian dollar (NYSEARCA:FXA) - presumably mostly from a "risk-on" carry trade.
  • The recent peak of the U.S. dollar (NYSEARCA:UUP) at its QE2 reference price, and its subsequent rebound AFTER QE3 was officially announced.
  • The recovery in the euro (NYSEARCA:FXE) as the ECB promised to do what it takes to save the beleaguered currency.
  • The sharp rally in the British pound (NYSEARCA:FXB).

Of course, these highlights have some relationship to each other with the underlying theme of recent weakness in the U.S. dollar. However, the U.S. dollar has had bouts of strength and weakness since 2008. The U.S. dollar is a great example of the trendless meandering of most major currencies against each other.

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The U.S. dollar has essentially gone nowhere for over four years

The trade-weighted index has also bounced around without trend with 2011 matching the low from 2008.

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Trade Weighted U.S. Dollar Index

Source: Federal Reserve Bank of St. Louis, Economic Research

With this backdrop, here are the setups I am watching to start the fourth quarter:

Australian dollar
The Reserve Bank of Australia (RBA) makes its next statement on monetary policy on October 2nd (Australian time). This announcement should establish the next theme for trading the Aussie. I am doubtful that the RBA will lower rates or even hint at doing so soon. This should create a rally that lasts until traders start pricing in a rate cut at the next meeting. I am marginally bearish on the Australian dollar mainly because it seems things cannot get better for Australia in the short term. However, the most intriguing setups are against the euro, where a long-term downtrend remains intact as Europe's prospects are likely worse than Australia's, and against the pound where it seems the downtrend has ended (more on the pound later): short EUR/AUD, long GBP/AUD.

The charts below show the long-term context and the short-term set-ups.

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The Australian dollar has continued to strengthen against the euro

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The euro's recent rally against the Australian dollar has stalled at the 200DMA

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The pound appears to be printing a lasting bottom against the Australian dollar

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The pound has already found support at the 200DMA against the Aussie and looks ready for a breakout

Note that the Australian dollar's uptrend against the U.S. dollar ended in late 2010. The currency has traded in a wide range ever since, including an all-time high in 2011. That high now anchors a slight downtrend.

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The uptrend in the Australian dollar essentially ended in late 2010 although it did hit record highs in 2011

The euro
Europe is descending back into recession, so traders should expect a bias toward weakness. However, alternating euphoria and despair about the sovereign debt crisis buffets the currency causing streaks of weakness and strength. Currently, the euro is in the middle of a strong relief rally as the ECB has removed tail risks for a breakup with the euro, promising to do what it takes to prevent such an outcome. The ECB's bond-buying plan punched a major bottom in the euro on July 26th. This relief rally peaked at the same time equity markets peaked in mid-September. Despite this, EUR/USD is setting up for a new surge upward. The 200-day moving average (DMA) sits directly below. I am sure every trader is watching to see whether the 1.28 level will hold. Even if it does not, I am expecting the 50DMA to provide firm support as it is now turning upward. Thus, I am looking for an opportunity to get long the euro. However, if the euro falters, it will become a great funding currency for other trades (I might increase bets short EUR/AUD for example).

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The ECB has underwritten a bottom in the euro

Despite all the periodic angst about the euro since the financial crisis, the euro has simply bounced in a wide range against the U.S. dollar. This is not the look of a currency that is about to blow up… unless of course the U.S. dollar is blowing up first.

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The euro has experienced waves of despair and euphoria against the U.S. dollar over the past 4+ years

Note well that if I go short EUR/AUD and long EUR/USD, I effectively drop my marginal bearish stance against the Australian dollar.

I am also watching EUR/GBP for range-based trading. The pair recently faced perfect rejection from the 200DMA and is resting on its 50DMA.

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The euro has bottomed against the British pound, but will not likely make much more progress from current levels

When it comes to the euro, its relationship to the Swiss franc is of greatest interest to me. Above I showed the longer-term downtrend that was arrested by the SNB's intervention. Recently, EUR/CHF has finally pulled away from the 1.20 floor set by the SNB. As I have stated in earlier posts, EUR/CHF is a handy litmus test for sentiment on the euro. After almost five months hugging the 1.20 floor, EUR/CHF has managed to stay aloft for almost a month. If the SNB is correct about the franc's over-valuation, then going long EUR/CHF should provide a low risk opportunity to bet on the euro's sanctity.

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How far can the euro continue to lift over the Swiss franc?

British pound
I have spent a lot of time in bearish territory with the British pound given its weaker economic prospects versus the United States. This sentiment finally switched to bullish when I wrote "The British Pound is Back in Fashion" almost a month ago as follow-up to a piece noting the pound's breakout. In fact, unless (or until) the Bank of England (BOE) expands its program of quantitative easing, the British pound will be one of my favorite currencies for the fourth quarter. To me, it is now one of the least problematic of all the (major) pieces of paper floating around the globe. I have already stated my bullishness on the pound versus the Australian dollar and my expectation for range-bound trading against the euro. The charts below show the pound's strong run against the U.S. dollar that has currently stalled around the 1.63 level and a slow and steady rise against the Japanese yen. Note that GBP/USD has been mostly range-bound since late 2008; a breakout above 1.63 would be extremely bullish. At that point, I will likely expect the upper part of the multi-year range to break as well.

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A tightening range for GBP/USD that seems bound to break soon to the upside

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The pound experienced a swift run after the Olympics ended but now needs to break resistance at 1.63

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It is subtle, but the pound is actually slowly lifting off major lows against the Japanese yen

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Both the 50 and 200DMAs are now supporting the overall uptrend from the lows

Japanese yen
The Japanese yen has often been used as a gauge of investor fear and desire for safety. That gauge broke down a while ago as the U.S. stock market has managed to grind higher even as the yen continues to grind higher as well. Periodic bursts of fear have generated intense interest in the yen that have consistently provided short-term opportunities to bet against the currency. Now, with the yen struggling to hold the 78 level against the U.S. dollar, I am most interested in watching for intervention. The BoJ followed the Federal Reserve with its own expansion of money printing. Like so many other attempts to devalue its currency, the BoJ has seen no reward for its efforts. Regardless, I do not like going long the yen, and prefer to short it, especially with the British pound (as shown above).

Here is the short-term zoom on USD/JPY. Notice the trading around the 78 level. The third quarter ended appropriately with a surge back to that level.

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78 has become a key battleground for USD/JPY

Canadian dollar
The Canadian dollar (NYSEARCA:FXC) is one of the more "boring" trades against the U.S. dollar. I expect it to continue to lingering around parity as Canada cannot afford a currency that gets "too strong" against the U.S. dollar. I only look to trade the Canadian dollar for specific event-driven reasons. I recently went short USD/CAD as a play on an end to the U.S. dollar's post-QE rally. I closed that out after a quick gain in order to establish a fresh start for the fourth quarter.

Summary
I start the fourth quarter with an empty plate looking for trades. I am waiting for the next RBA monetary policy statement to confirm my expectations for Aussie interest rates. I am bullish on the British pound but waiting for a fresh breakout against the U.S. and Australian dollars. I am looking to see whether the euro will hold support against the U.S. dollar. Finally, I am keeping an eye on opportunities to short the Japanese yen.

Be careful out there!

Source: The Best Currency Setups To Start Q4

Additional disclosure: In forex, I may initiate trades as indicated in this piece at any time.