Nearly 3 weeks after we highlighted the global risk parameters at $82 oil and 1,100 S$P500 (both 100-week MAs), global risk aversion has deepened across the board, triggering a 6% drop in G7 equity indices, a 7% decline in oil and broad gains in the safer haven currencies of USD and JPY. The more aggressive equity indices of Brazil's Bovespa & India's Sensex gave us an invaluable sell signal on equities and a more constructive position in the greenback.

Breaking 1047-1.47

On Oct 24th, we alerted readers of the equity-FX interplay between the S&P500 and EURUSD. The fact that the S&P500 ended Nov 2nd below the crucial support of 1,047 (55-day MA and 8-month trend line) despite a positive data trifecta from the US (ISM 55.7, pending home sales +6.1%, construction spending +0.8%) underlines markets' broadening defensiveness ahead of the FOMC/BoE and US jobs data. The 1047-1.47 twin support levels (S&P500 and EURUSD) were prominently broken last Friday, translating into a weekly and monthly close. EURUSD still struggling at the $1.4830 resistance as it joins the risk currencies lower against USD and JPY, eyeing the next target at $1.4550, followed by $1.4480. Any hawkish signs from FOMC statement signalling earlier accommodation withdrawal (such as removing for an extended period in 3^rd paragraph of statement) would prove positive for USD, JPY at the expense of equities, bonds and oil.

Last week's oil price break above $75 was an essential catalyst in accelerating the pace of USD selling beyond $1.50 in EURUSD, 0.93 in AUDUSD, and 1.03 in USDCAD. Technically, the next oil barrier emerges at $82.00 (100-week MA), a break of which would extend the rally towards $89.90. Coincidently, US equity indices also face their next resistance at the 100-week MA (1,100 for S&P and 10,209 for the Dow). But a more important landmark for the S&P500 stands at 1,121, which marks the 50% retracement of the decline from the October 2007 high to the March 2009 low.

Recall how oil prices repetitively failed to break its 200-week MA of $75.70s in August and September until recurring dollar weakness (hawkish central bank outside US) empowered oil traders to breach the key level. The simultaneous technical resistance in both of these high profile instruments (US crude and S&P500) may well dissuade the accumulation of fresh risk appetite. And Wednesdays downgrade of Wells Fargo may have been instrumental in stepping up trading volumes in a down day. But the only viable means for dollar bulls to see hope again is the implementation of the exit strategy. Short of such implementation, earnings disappointments and/or negative guidance, FX traders will see little resistance to selling the dollar.

The story from the Independent about Arab Gulf States and China looking for alternatives to the US dollar could be dismissed for now due to the lack of immediacy about its implementation. Neither such a story nor the immediate denial from Saudi Arabian officials is new. But the Arab Gulf State element certainly adds to the Chinese diversification element in highlighting the structural impediments of the US currency (zero interest rates at least into Q2 2010, budget deficit at 10% of GDP, tepid prospects of consumer-led recovery).

Only when China has attained the building blocks for currency convertibility (widening the band of the peg, become an invoice currency, reduce FX controls) would the notion of a reserve currency basket gain more credence. Thus, the next concrete step (that the USD should fear) is an outright revaluation of the yuan by the PBOC, as was done in July 2005.

While FX trading seems to become increasingly bifurcated (broad USD weakness & broad JPY strength or vice versa), the unfolding trend remains a concerted move away from the QE currencies (USD, GBP) and into the commodity/high yielders as well as the EUR. Emerging talk on whether the US dollar has become the new low-yielding vehicle for carry trades financing equities, commodities and currencies vehicle highlights the difference between the USD and JPY carry trades. The latter was driven by structurally low Japanese rates (sub 1.0% since for past 10 years), which were a reflection of Japan's anti-deflation policy, its current account surplus and the resulting proclivity to save.

But with the US budget deficit outpacing the level of twice the total of the twin deficits (trade and budget) prevailing in 2004 (now at nearly 10% of GDP), there emerges the risk of renewed steepening in the US yield curve (widening spread between long and short term rates) as short term rates are dragged down by falling US LIBOR rates and long term yields chase escalating gov't debt (which remains on the rise despite slowing private sector and household debt).

Current price action in currencies may be sending some interesting signals. Broad dollar damage is being accompanied by broad yen strength, which is an unusual pattern when risk appetite is on the rise. This suggests that dollar weakness is not necessarily a reflection of improved risk appetite but of secular weakness in the greenback (as a result of Chinese gold purchases and most importantly hedge funds testing key dollar support levels vs. EUR (1.4620) GBP (1.67) and AUD (0.8640-50s).

If the explanation that the greenback has become the sole candidate for financing carry trades into equities may be plausible, then this promises for emerging bounce at the next bout of equity selling. But with the higher lows displayed by the euro and high yielders (AUD, NZD) remaining a major part of the FX trading landscape, dollar bulls scan still find solace vs. GBP, CAD and CHF.

Just when we started highlighting the case for peaking risk appetite in last week's article, oil prices picked up the mantle for the bulls and triggered the sell USD, buy risk trade, partly caused by a plunge in weekly crude oil inventories. The previously unimaginable break above $74 per barrel has taken place this week, courtesy of growth optimism from better than expected Eurozone PMI figures and the 4th straight monthly increase in US existing home sales. But with currencies such as GBP and CAD solely rallying on the USD-side of the equation, their secular lack of fundamental strength has led to rapid reversals off their highs. FX markets are reluctant to retain any gains in risk currencies (currencies with high positive correlation with equities such as GBP, CAD, AUD and EUR).

Market participants are increasingly aware that intermittent bouts of risk appetite remain largely driven by inventory-related price jumps in oil rather than signs of improved demand or upside economic surprises. Consequentially, energy-related members of major equity indices have dominated the advancers.

Oil's Resistance & VIX Support

The Faces of Dissipating Appetite

The 4 charts below display the emerging challenges for overall risk appetite as manifested through EURUSD, GBPUSD, S&P500 and US crude oil. The latter is increasingly considered as the lifeblood of overall risk appetite, showing recurring failure to break above the $73 level and the negative momentum divergence, as seen by falling stochastics and a flattening price. A similar negative divergence is seen in the S&P500 (as is the case in most equity indices), facing key resistance at 1,015-- the 38% retracement of the decline from all time high of October 2007 to the low of March 2009.

Sterling Contracts as BoE Expands QE

Sterling dropped across the board Thursday after the Bank of England expanded its quantitative easing program by adding an extra 50 billion of asset purchases into the next 3 months. Yields on 10 year guilts dropped 35 bps to 3.57%, GBPUSD shed 200 pts, while EURGBP shot up 100 pts to 0.8555, further proving the 0.84 support to be a key foundation in the cross pairs cyclical ascent. The above equation surely must have been examined by the Bank of England. With oil prices doubling year to date, sterling rising 25% vs USD and 11% vs EUR respectively and unemployment still on the rise, the Bank of England could run the risk of prolonging the tightening mechanism via excessive GBP gains in the event of closing the door on QE. For the ECB, the euro is up 16% from the year's lows, unemployment is back above 9% and oil prices are still more costly (despite a strong EUR), all at a time when annual inflation has turned negative.

Dollar weakness has been excessive...at least for now.

The overnight wave of dollar selling was mostly led by a fresh wave of buying in commodity currencies (rather than only rising equities) courtesy of +$70 in crude prices and hawkish comments from the Reserve Bank of Australia raising the possibility of rate hikes before a peak in the unemployment rate. Markets were already expecting the RBA to raise rates by 25 bps by year-end. Tuesday's comments further boost the long term viability of the currency. But current US dollar weakness shows to have grown unsustainable considering the related expansion in risk appetite and the lack of unjustifiable data developments in the Eurozone, UK, Canada and New Zealand--and not to mention recent rhetoric from central bankers and finance Ministry officials to jawbone the latest strength in their currencies. Accordingly, we cannot ignore the flattening momentum in G-5 equities over the last 3 sessions, which is beginning to appear similar to the period prevailing in the first week of June.

The explosive surge in risk appetite following the earnings blowout from Goldman (GS) and Intel (INTC) is posing serious threat to the validity of the Head-&-Shoulder formations in the S&P500 and the Dow30 at the 8.600 and 930 levels, supporting the case for protracted rebound in equities and overall risk appetite.

But Thursday's bigger than expected decline (first sub-500K reading in 4-week moving average in 5 months) failed to prolong the rise in stocks and bond yields. Unexpected deterioration in the July Philly Fed index to -7.5 from June's -2.2 and news of an imminent CIT bankruptcy are preventing the positive impact from Jobless claims and JP Morgan (JPM) earnings.

Sterling leads the list of currencies losing against the dollar and yen amid widespread expectations the Bank of England will exercise its quantitative easing expansion option by purchasing an additional 25 bln in assets without seeking government approval. Concerted selling in emerging market bourses further elevates the risk-aversion lustre of USD and JPY. Oil's $10 decline from last week's $73.30 highs is partly provoked by the discovery of inappropriate trades being behind the buying. Reduced risk appetite and the latest forecasts reports of falling global oil demand are further enforcing the positive correlation between equities and oil, thereby weighing on commodity currencies. Chief among them is the CAD and NOK, with USDCAD firmly in its 4-week up-trend, targeting 1.1770, followed by 1.1810. USDNOK faces more substantial obstacles at 6.7.

But any dollar advances could intensify in the event that a deleveraging ensues on the commodities front as well as in commodity currencies (via renewed cenbank dovishness and currency jawboning). We cautioned 4-weeks ago that eroding risk aversion was key for any recovery in the greenback.

There are more substantive fundamental and technical grounds that the recent pullback in equities and global bond yields will extend throughout Q3 to the benefit of the US dollar, which will likely stabilize, rather than wage a rally such as in H2 2008. Current explanations for a stronger dollar in H2 based on US recovery preceding rest-of-world are off the mark. The past 7 years have proven that each time US data emerged on the stronger side, global bourses pushed higher-at the expense of the greenback. While we back the notion for a stronger USD in Q3, our rationale is based on the following:

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Neither the Fed, the Bank of England or the Bank of Canada can or plan to exit their quantitative easing policies any time soon.

Thursday's recovery in European & US bond yields is a stark reminder of the continued undoing of the 29-year bull market in bonds and the ensuing recovery in long term rates, whose dampening effect on equities is proving increasingly evident. The pullback in equities has helped cap down bond yields earlier in the week, especially as the US bond-issuing schedule took a break this week. But as the US Treasury sets to finance this year's 300% increase in the deficit (from last year) and the inflationary tide of the Fed's injection reaches ashore, the upward run in yields could complete the retracement process of its 20-year downtrend.

The intermarket relationship underpinning the US currency and global equities remains largely unhinged, with falling equities persisting as the lone saviour for the corroding US dollar. And so once again, the falling US dollar got a fresh respite from a falling stock market. Earlier on Wednesday, the dollar seemed to succumb to one of those typical selling waves after better than expected UK housing numbers, improving confidence figures in Australia and higher than expected Norwegian inflation -- all of which bolstered the rally of these currencies against the greenback. Such figures reduce the need for quantitative easing in these economies, which only add to a widening in their yield differential ahead of the US currency.

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Talk of Fed Exit Strategy is Premature. Yesterday's 23-basis point jump in 10-year yields to 3.74% may have been helped by mortgage backed securities traders hedging, but the upward trend remains clearly intact. With Fed increasingly behind the curve in catching up with US Treasurys relentless bond issues, 10 year yields have now retraced over 50% of their decline from their 5.32% high of June 2007 to their record low of 2.03% in December. The path is now paved towards the 4.1% market, last attained in October 2008. We cannot imagine the Fed sticking with its current plan to purchase $300 bln in treasuries when their yields are exasperating the fragile jobless recovery and further endangering the value of their foreign holders. The only solution so far is for the FOMC to step up purchases towards the $500-700 billion target, the implications of which will flash the green-light for dollar selling.

"Green Shoots" optimists, credit rating pessimists and bonds-to-stocks rotation realists have all provided arguments for the jump in bond yields. The acceleration could be extended by reduced portfolio weightings in government bonds and onto metals and agriculture. Portfolio re-allocations from fixed income to commodities may be uncommon, but central banks reflationary policies leave little choice for investors to pursue seek capital preservation strategies.

Today's serious case of dollar damage was once again made courtesy of the nation's central bank. The Fed's purchase of $7.7 bln in 7 and 10-year treasuries in the morning, followed by purchases of $3.08 bln in Agency securities in the afternoon accelerated the dollar decline and the resulting rally in commodities --as was the case on March 18 when the Fed first announced purchases of long term treasuries. Today's dollar sell-off stood out from previous declines by the fact that EURUSD knifed through the key resistance of $1.3740 (failed 4 times this year) to $1.3830, and even sterling finally managed to break above its 200-day moving average vs USD--something that all majors currencies had achieved in previous weeks surging to a 7-month high of $1.5794.

Contrary to what some media concerns have stated, the dollar selling emerged well before the release of the FOMC minutes, which did accelerate the selling.

While both oil and equity indices reveal preliminary signs of a consolidation, downward momentum is particularly expected to weigh on oil. This is especially supported by my expectation for oil prices to underperform metals, which is signaled by a looming rebound in the Gold/Oil ratio. The chart below cogently illustrates how the turning points in the Gold/Oil ratio are driven by commodity markets' optimism with the economy. Thus, a rising G/O ratio occurs during deteriorating sentiment (expressed primarily by oil weakness) while a falling G/O ratio emerges in tandem with improved market sentiment. And despite the decline in the G/O ratio from its 14-year highs attained in February, it continued to hold above its 200-day MA, which hasn't been broken since last fall.

You must have read by now that about 70% of the activity in currency markets over the last 2 years has been largely driven by risk appetite, with equity indices being the primary independent variable steering FX flows. But there are times when currencies peak or bottom 2-3 days before equities begin to turnaround. The more resounding and recent example was the March 4^th bottom in the EURUSD (peak in the US dollar), which occurred 2 days before the low in the major stocks indices. That low in the EURUSD coincided with the peak in the US dollar index at 89.62, which happened to fall right below the 38% retracement of the major decline from the 2002 high (top of dollar bull market) to the all time low of March 2008. On March 10th, we warned that the dollar index would reach today's level of 84, 10 year yields would exceed 3% and the S&P500 would regain the 800 level, with each level prominently displayed.

So does Thursday's euro test of its 200-day MA for the first time in 9 months forewarn a looming top in equities? Various measures of sentiment suggest the current 35% rally in the S&P500 from its March lows has the configurations of a typical bear market rally, where sentiment is 3x as much as that of bull market rallies. What may have been an attractive proposition to buy stocks 8 weeks ago when indices were at 17-year lows has turned into a momentum trade fuelled by the helium of second derivative, postulating that slowing pace of contraction warrants the fastest (magnitude over time) bear market rally in history. Will stocks be right to rally another 3% on Friday in the event that US jobs turned out to lose only half a million instead of the forecasted 600K?

Cant' fight the Fed? Bond vigilantes are fighting the Fed and winning at bidding up bond yields. Short of another shock-&-awe policy announcement this Wednesday, the FOMC decision is likely to generate fresh dollar strength against risk currencies (non-JPY).

Wednesday's FOMC announcement is not expected to generate the fireworks from the March meeting of buying long term Treasuries. Yet, considering the combination of rising US bond yields testing 5-month highs with $101 billion in new issuance this week, the need for the Fed to rein in long yields could re-emerge. In the event that the FOMC statement makes a discreet reference to improved market economic/dynamics (such as slowing pace of decline, tentative signs of stability), bond yields could easily snap back up. To prevent that, the Fed will have to clearly reiterate that the economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Global risk aversion gradually returns as equity indices struggle in passing the earnings test. Our oft-mentioned 860-865 target in the S&P500 denoting the +30% rally mark from the March low was tested without success, further highlighting the significance of the implications for the latest equity rally. Although the S&P500 breached above the 50 and 100-day moving averages, these moving averages stand halfway between the 200-day MA (989) and the March low (666). The wide disparity between the 100 and 200 day MAs in US indices highlights the speed of the recent advances as they managed to breach above medium term trend measures (50 and 100-day MAs) but still remain far below the longer trend measure (200-day MA) which remains dwarfed by the longer-term trend.

While the relationship between equities and currencies evolved since the ongoing retreat in volatility 4 weeks ago, the principal rule of behind risk and lower yielding currencies continues to hold. The upper chart shows the relationship between the S&P500 and selected currency pairs with notably positive correlation. AUDUSD and USDCAD (expressed in inverted terms on chart as CADUSD) have shown the highest correlation with the S&P500 since March (recovery in stocks) at 0.78 and -0.77 respectively--but for different reasons. Aussie's correlation with equities had been more robust during a rising market, while the loonie's correlation with equities had been slightly higher during a falling market. NZD continues to attract strong selling interest against USD and JPY during falling equities due to lingering negativism and expectations of at least 50-bps in RBNZ rate cuts. The Canadian dollar has largely benefited from a rebound in oil prices and steady oil prices, but the looming threat of quantitative easing from the Bank of Canada as well as the lagging effect of US macro-deterioration on Canada raises doubts about the credibility of the loonie's advances.