Friday July 10, 2009

Overall, the major currencies moved lower compared to the dollar during the Asian session, retracing some of the gains seen recently. Additional downside momentum probably came from the S&P futures market, were the index lost 3 points and re-tested the low made on Thursday, and from the crude oil market, as the raw material is once again moving lower. Ahead, the economic calendar is loaded with important data from Europe and the U.S., which may help the market sustain strong momentum during the day.

The Euro (Eur/Usd) is trading once again above the 20-day moving average, as the pair retraced almost half of the gains posted in the previous day of trading. On Thursday, the euro advanced as much as 200 pips, but closed the day only 150 pips higher. During the Asian session, the euro lost another 50 pips.

The Pound (Gbp/Usd) advanced at a strong pace in the prior day, on Thursday, but during the late U.S. session, the pound topped and started retracing some of its recent gains. Since then, the pound fell approximately 100 pips, from which half came during tonight’s Asian session

Overall, the currency market has entered again into a risk-aversion mode, having the major currencies shed every pip gained on Thursday. The market may have been sent lower, as rumors surfaced that IMF is in talks with 10 Eastern European countries, which added a lot of downside pressure to the euro. Going towards the U.S. session, the market is likely to become volatile around the open of the Chicago futures market, but then the momentum will slowly fade away as the Friday close approaches.

The Euro (Eur/Usd) declined 150 pips during the overnight session, shedding every pip it gained in the previous day of trading. For now, the euro is slightly above the 50-day moving average, which provided a strong support area over the last few days of trading.

The main factors:

Government Spending and Consumer Confidence:

The previous recession of 2001 was caused by a bursting of the dot com bubble. Due to this, people in the United States lost a large amount of wealth in stock markets that was created during the boom period of 1990s.

Yesterday I was unpacking my books from China, a chore that took a few hours. I came upon a wonderfully illustrated, hardbound edition of Henry Wadsworth Longfellow's "The Wreck of the Hesperus." Unable to resist, I sat down and cracked it open – the copy is about 70 years old. (photo1 photo2)

For a little background, Longfellow was a New Englander who lived seaside for much of his life from 1807-1882. Many of his poems have a rhythmic cadence, and he is also very well known for the poem "Paul Revere's Ride."

Although risk aversion dominated trading in the European hours, the better than expected U.S. trade figures has helped to ease the safe haven flows into the U.S. dollar. In our Daily Report Thursday, we talked about how the rally on Thursday was nothing more than a relief rally as the signs of recovery recede, but the sharp rise in exports in May were encouraging.

In the month of May, the U.S. trade balance fell from -28.8 billion to -26 billion to the smallest level in close to 10 years. In a healthy market environment, this would be overwhelming positive for the dollar because it would suggests that exports are growing at a rapid rate. However in the current market environment when global trade has contracted significantly and oil prices were increasing, traders are skeptical about how much real demand contributed to the sharp increase in exports compared to oil prices. Nonetheless, the U.S. trade numbers reflect the positive impact of the weaker dollar. Exports rose 1.6 percent, the strongest gain since July 2008. Imports decreased by 0.6 percent and even though crude oil imports fell, the average price per barrel increased $4.61 that month. Import prices in May rose 3.2 percent, the strongest increase in nearly 2 decades.

The long term outlook for the USD continues to look dire. As the story broke that the G8 failed to reach a consensus on policy, but believed that the world economy is too weak to withdraw stimulus, and the developing economies rose to challenge the G8, the BoE surprised by halting the expansion of its quantitative easing program.

As I have written before, Britain is the canary in the coal mine for the US. The UK, unlike the US, has a very similar range of problems as the US but does not have the luxury of being the issuer of a major reserve currency.

I really don't want to beat a dead horse here and although I already gave it a kick in the context of the release of the May consumer price data, I do think that this is a pretty significant [quote from Bloomberg with my emphasis].

Japan’s producer prices fell at a record pace in June as oil costs declined and companies required fewer materials amid a global recession. The costs companies pay for commodities and unfinished goods tumbled 6.6 percent from a year earlier after sliding a revised 5.5 percent in May, the Bank of Japan said today in Tokyo. The median estimate of 22 economists surveyed by Bloomberg News was for a 6.4 percent drop.

A study called “The international role of the euro” published by the ECB just came out. The study showed that the currency preferences of the markets are quite stable and only in a limited way influenced by changes in overall financial activity, caused by the global crisis. This is in line with earlier conclusions that the international role of currencies tends to be relatively stable over time. It is however clear that the role of the euro is increasing. In markets that were tracked, like international debt markets, foreign exchange trading and global foreign exchange reserve holdings, the share of the euro increased from one to several percentage points.

Overall trading volume in the foreign exchange market declined quite significantly in 2008. Data from EBS showed that daily average trading volumes declined from USD 226 billion in the first three quarters to 179 billion in the last quarter, a drop of 21%. The report suggests that the drop may have been caused by the lack of trust among dealers in the interbank spot foreign exchange market. Additionally, market participants like hedge funds may have exited the market due to growing risk aversion and increasing costs.

click to enlarge

Overall, the major currencies posted important gains compared to the dollar on Thursday, which has caused the dollar to lose a little more than 1%. However, unlike in the past few weeks when the FX market moved together with the global market, yesterday, the major currencies had their own way of trading. The dollar sold off strongly, even when the equity markets (which are usually a gauge for risk-aversion) posted small gains, while crude oil moved flat most of the time. It will be interesting to see if the FX market can maintain this momentum over the next few trading sessions, since it usually requires a fundamental driver behind it in order to maintain such momentum.

The Euro (Eur/Usd) is currently trading above TheLFB R3, as the pair advanced 170 pips on Thursday. The euro moved higher most of the time, something that helped the pair break above the 20-day moving average throughout the European session.

For the first half of this week, foreign exchange traders were very pessimistic and Wednesday they expressed their pessimism by driving all of the major currency pairs sharply lower. After such a depressing move, a relief rally is normal and expected. Therefore we are not surprised at all to see the dollar trade lower against all of the higher yielding currencies and for it to recover against the Japanese Yen. Yet the degree of Thursday’s rally in the EUR/USD and GBP/USD leads many traders to wonder whether this is not just a relief rally. The EUR/USD traded back above 1.40 while the GBP/USD rose close to 2 percent or approximately 300 pips. Only time will tell if today’s move will continue but we can get a better sense of what will happen by taking a look at the performance of the other markets and currency pairs.

More than Just a Relief Rally?

The dollar has been hit again. Losses are broad based, with most emerging market currencies participating, though the Mexican peso is a clear laggard as concerns about the budget (and therefore rating) implications of last week's elections. The main driver appears to be players being stopped out of short foreign currency positions, which had been the trend since the start of the month. Some momentum players are getting long the foreign currencies. While the gains in the foreign currencies look impressive, they are still mired in the ranges that have plagued players since late May.

The combination of market positions and momentum warn not to fade this move yet as there will likely be follow through today. Also today, France, Italy, Greece and Netherlands report industrial production data and this data will likely be seen as consistent with the "green shoots" story. The US reports trade figures, which given the rise in oil prices may deteriorate, and Univ of Michigan preliminary measure of consumer confidence for July. Risk is a bit of slippage from the 70.8 reading in June. These reports should not stand in the way of additional dollar selling--near-term. Despite the dollar's firmer tone since the start of the month, sentiment remains largely negative.

Could the sell-off in the dollar and the ensuing rally in commodities today be attributed to the G-8? The dollar and yen were lower as all other currencies rallied, perhaps the fear trade? So many questions; let's try to get some answers.

Treasuries were lower, you know the deal by now…short Euro-dollars.

The G8 meeting is wrapping up and there have been no surprises to speak of. The global economies and financial systems appear too fragile to begin reversing the emergency measures. There were the usual platitudes about completing the Doha trade round and promises to avoid protectionism. Of note, especially in light of the various comments in recent weeks from assorted officials warning that currency appreciation would jeopardize their economic recoveries or in other ways underscored the benefits of soft currencies,the G8 encouraged countries to refrain from competitive currency devaluations.

After rejecting initiatives by the Chinese and Russians (according to news reports) to formally discuss reform of the international monetary order to reduce the role of the dollar, the G8 draft indicates support for a "stable" and "well-functioning" international monetary system.

A 48% rise in Chinese passenger car sales in June gave a shot in the arm to global stock markets and commodity prices. Growing fears earlier in the week focused on a stall in global recovery, which had driven down energy prices. As those fears mutated the dollar rose and helped undermine further the prices of other commodities along the way. But the stimulus-inspired jump in car sales to the highest level since February 2006 has instilled confidence that the recovery process is still there if you know where to look.

In our last post we discussed our views on deflation and how it will be around longer then most investors think. Most people are stuck on the idea that hyper inflation is just around the corner and that you must be buying gold, most other commodities, and Asian stocks and at the same time short the US Dollar, Japanese Yen, US Treasuries, and US stocks. Eventually this may be the right stance, but for now we think, along with the market, that it is the wrong view for the short and medium term.

The main issue stems from the idea that because the government has printed a gazillion dollars that we MUST have hyper inflation tomorrow. The reality is that until that money is actually in circulation it will not cause inflation. If you look at the financial situation of most banks it is obvious that not only are they not lending, but they are still so weak that they can’t lend. Until they have rebuilt their balance sheets they will remain weak and unable to do any large scale lending on anything but bad terms.

Overall, the dollar index saw a day of strong declines on Thursday, in which it lost approximately 60 ticks, or 0.70%. The dollar was sent lower from the first few minutes of trading, around the Asian open. During the European session, the major currencies retained the positive momentum, and continued to advance compared to the greenback.

Ahead, traders will focus on the BoE interest rate decision, which might prove to be crucial, having the power to send the currency market back into a risk-aversion mode, or not. Most likely, the BoE interest rate decision and the S&P futures will be the main hubs during the U.S. session, since the economic calendar is relatively light.

Overall, the major currencies traded side-ways during the Asian and the European sessions, but posted strong declines compared to the dollar during the U.S. trading hours. Most of the declines came ahead of the earnings season, as some investors expect the quarterly numbers to be grim rather than rosy, which is what the financial market has already priced in over the last few months. The Japanese yen was the most affected currency in this direction, as it posted very strong gains on Wednesday.

The Euro (Eur/Usd) is trading slightly above the 50-day moving average, after it declined as much as 80 pips during the intra-day session. Moreover, the euro also tested the 1.3840 support area on Wednesday, which has acted as a major swing point for almost 6 weeks now.