One of our major themes here at The Macro Trader over the past two years has been to short Europe. We mean that in a general sense as we have been short Spain and Italy off and on for over a year and are bearish on most things EU relative to most of the world. One area that we have been looking at a lot lately is that of the Euro.

After being overvalued by 40% back in March of 2008 the Euro fell about 20% as investors went into risk aversion mode and bought the US Dollar. Since March of this year the Euro has once again climbed into wildly overvalued territory again and is currently about 35% overvalued. As you can see in the chart below when the Euro gets very far above or below the 20% bands it has a relatively sharp tendency to revert to the mean. (Click on chart twice to enlarge)

Overall, the dollar index managed to bounce from just under the 76.00 area, the lowest value touched over the last 15-months of trade, as equity and oil trade found sellers. The dollar index managed to strengthen across the board during the day, posting important gains especially against the euro and the aussie, which plunged at a very strong pace throughout the European and U.S. sessions. As long as the equity markets remain in the red, the dollar index is set to continue the current uptrend.

ETF Market Direction Summary: 11-12-2009

On Thursday, equities finally hit a legitimate wall of resistance and started showing signs of a double top pattern (i.e. peaks at October and November highs). Although market news and economic data were a combination of mixed results, positive catalysts had absolutely no impact on Thursday’s trading.

Overall, the dollar index took advantage of the negative equity markets initially took around the world in Thursday morning trade, and managed to advance a few points ahead of the U.S. open. Most of the dollar’s gains came during the European session, after relatively flat Asian currency trade. The macroeconomic calendar was light on Thursday, with the European calendar being clear of any red-flag reports, while the upcoming U.S. sessions holds the U.S. unemployment claims, and Oil Inventory report.

Forex Trader Note: Australian employment data came through on the bullish side of things, and sent Aud/Usd up to test the R2 swing point levels on the pair. The 0.9375 area will need to see a 4 hour chart close above it before long trades can now be easily considered. The long moves in aussie sent the dollar lower against the major pairs, as per the normal reaction to Australian releases in the thin Asian pre-market, with the question being, can this start a move that holds?

The chances are slim, because the pattern this week has been of a sideways grind, and unless equity markets can break long and hold, the lack of momentum may stay this way. These are ugly looking charts right now, with very little momentum or direction. Take a look below; mixed trends and momentum. This is a coin flick at the moment.

ETF Market Direction Summary: 11-11-2009

On Wednesday, the "new 52 week high club" was no longer an exclusive category for the Dow Industrials as the S&P 500 and Nasdaq 100 indices both made new 13 month highs. This expanding participation in new highs is in order if bulls are to sustain their momentum. Prior to this development, one of my concerns has been the asymmetrical character of this rally whereby a disproportionate share of technical leadership was emanating from the Dow, the most narrow of major equity indices representing the U.S. economy.

Despite some dovish talk by a couple of US Fed governors, the Bank of England's Gov. King seemed to nudge the pound to the downside. He said the decline in the pound's value was beneficial, and that they may further increase the money supply should the economy fail to grow in the fourth quarter. These comments were enough to deflate the pound's value which had been on a 1100 point run since October 13th.

Overall, the currency market saw a flat Asian session, but around the European opening bell, the dollar index started declining at a strong pace against the major pairs. However, this sell-off was somehow short-lived, since at market came to a standstill and had some attempts to turn around during the BoE Inflation Report. Looking ahead, the U.S. session will be influenced by the U.S. Veterans’ day and by the Canadian’s Remembrance Day.

click to enlarge

As reported at 4:05 p.m. (JST) in Tokyo, the single currency Euro slipped .2% to trade at 134.37 Yen, and had gone as low as 133.80 Yen at one point in the day. Another high yielder, the Australian Dollar, traded at 83.34 Yen, a .2% decline. Later this week, Australian unemployment numbers will be released, and investors are anxious to scrutinize the data for a clue as to the direction of interest rates.

ETF Market Direction Summary: 11-10-2009

The most important observation about Tuesday’s session is the fact that the market was very stingy in giving back any of its 2% plus gains from Monday. Without major economic data or many earnings announcements, there were no strong catalysts to drive the market in a decisive direction. Bulls earned a well deserved day of rest after having pushed up the S&P 500 for the last 6 out of 7 trading days.

Bubbles, like bombs, need to be dffused, or like bombs, they will make a big mess when they break. In the UK, Gordon Brown wants to enact the Tobin tax, a financial transaction tax of trading activity. He would also set up a special tax for banks and others that engage in risky behavior. We have yet to receive word that Washington is going to have a new czar to regulate and discourage bubbles.

Much has been said about the US dollar's role as a funding currency for carry trades and its well publicized rebound during the most recent episode of risk aversion (Oct 21-Nov 2). But once again, it was the Japanese yen that outperformed the US dollar as well as all major currencies. This helps explains why the emerging gains in non-USD currencies (EUR, GBP, AUD, CAD etc) remain limited against the JPY when equity markets are on the rise and are quick to lose ground vs. JPY than against USD. Both USD and JPY pay ultra low interest rates, with 3-month LIBOR at 0.27% and 0.32% respectively. But the medium term future prospects remain brighter for JPY relative to USD.

While the Federal Reserve is seen injecting emergency liquidity well into Q1, the Bank of Japan will conclude its program of purchasing of corporate debt by year-end. And with continued record bond issuance from the US treasury seen further lifting the US financial deficit to above 11% of GDP (vs. 8% for Japan), the secular case against USD shows no signs of abating. Meanwhile, as commodities respond positively to favourable dynamics for the global economy, the US dollar should once again underperform the yen.

ETF Market Direction Summary: 11-09-2009

Today I shall deviate from the usual format of the ETF Market Trends™ report and indulge in the reminiscence of the zenith of my youth some 20 years ago, which marks the fall of the Berlin Wall and a time when I was in love with a young beautiful woman from Berlin with eyes cooler than the bluest hues of any ocean and a heart warmer than the most intimate of campside fire conversations shared over a bottle of good bourbon whiskey with strangers (only a real outdoors-man will appreciate the latter comparison).

Nouriel Roubini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

One of the side effects of a weaker dollar is that the returns for foreign investors who invest in US assets are diminished. While the value of the asset may rise in dollar terms, if the dollar is losing value, the investor takes a hit when they convert their funds back into their domestic currency. For example, while the S&P 500 has risen 20.2% so far this year in US dollars, investors outside of the US have generally seen much less impressive returns.

In the table below, we looked at the YTD returns of the S&P 500 for investors in various currencies. Of the currencies we looked at, the only one that has seen a benefit from the currency translation is the Argentinean Peso. Returns have been diminished once fluctuations are taken into account for all other currencies. And of course some countries have been affected more than others. So far this year, Brazilian investors who bought the S&P 500 at the end of last year have lost nearly 12 reals for every 100 they invested on January 1st.

Japan's foreign reserves stood above $1 trillion in October for the 12th consecutive month after reserves rose a little more than $4 billion over the course of the month. This largely reflected valuation adjustments.

The euro rose roughly a cent against the dollar, and this is partially offset by the decline in asset (bond) prices. Also in terms of valuation, the price of gold appreciated from $995.75 to $1040, an increase that was worth about $1 billion to Japan's reserves. These was also a modest increase in Japan's SDR holdings.