Currency Updates by Finexo

Wednesday, November 26, 2008

Currencies followed the pattern one would generally expect lately as Wall Street staged another sharp and impressive rally which saw the major averages up as much as 17% from Friday's lows. EUR/USD and EUR/JPY were higher and the commodity currencies were the star performers, with USD/CAD swooning as much as 400 pips on the day. JPY crosses were the hardest hit as one might expect. Now, with the first layer of resistance breached, we try to determine how long this move can extend. Counter-trend rallies are difficult to gauge and very difficult to trade. Our overwhelming conviction is that the world is headed for more trouble in the medium term and that we still haven't priced in the extent of economic malaise and the deleveraging that is still in the pipeline. US Treasury Secretary, Henry Paulson and his team are busy trying to focus more on the consumer right now. This is because it is clear that the liquidity injections are stopping at the vaults in the banks and not reaching out to consumers, an unanticipated consequence of their prior efforts. We have to wait and see what they come up with next.

The UK's Darling was out with the UK pre-budget report yesterday, which, as we mentioned yesterday, contains an odd mix of promises to stimulate the economy through various short term measures but also talks up plans for fiscal austerity down the road to stem the avalanche of red ink that the shortfall is tax revenues will generate. The expected plans to cut taxes on companies' foreign dividends were also a part of the report. All of this seems to be an effort to ensure foreign holders of large amounts of sterling not to liquidate their holdings as the UK fiscal situation looks precarious at best in the years to come. Looking at the EUR/GBP cross, it doesn't appear that investors are especially comforted so far, and we would need sub 0.8330 level to even discuss the idea of a rebound in the pound.

Our conviction is that EUR is still way over-priced in the bigger picture. When these bouts of risk willingness hit the market, it seems that EUR should be a much smaller beneficiary than it was in the kind action we saw yesterday. Yes, EUR was not as strong as the commodity currencies at times yesterday, but it should under perform more than it has and some of its strength in the big picture is simply due to premium the market places on liquidity and the fact that much of the Emerging Market trade is versus the Euro. Eventually, the EUR could face a more extended bout of weakness: if there is anything that the past rounds of banking system problems have shown us, it's that European banks were as bad as or worse than their US counterparts, but that disclosure only comes later. Many have estimated that the large European banks are even more leveraged than their US counterparts, so we can only watch and wait for the next cracks to show. Yesterday's German IFO business survey was brushed aside by the market, but it was far worse than expected at 85.7, showing the worst Business Climate sentiment in 15 years and close to the record low just below 85. We also should expect that European Central Bank rates will quickly come into line with BOE and Fed rates, meaning the meeting next week should see at least 50 bps of easing (and ought to see 125 bps, but the European Central Bank has been dragged - kicking and screaming all the way....).

On the technical side, our model of the situation suggests that this is a classic rally within a bear market. Using the US S&P500 as our global proxy for inter market action (JPY crosses, major USD crosses, etc) the maximum this rally can extend and still remain in the "comfort zone" for our expectations is around 900. This could correspond with EUR/USD trying up toward 1.3250 or even 1.3400 on a blow-off and EUR/JPY perhaps toward 130.00 again. Considering our jaundiced view of the situation, though, we would prefer to wait for signs of a reversal and look for ways to short this rally in risk appetite. The first signs of a reversal come in around 1.2715 on EUR/USD (that pesky 21-day moving average) with a more profound reversal evident if the pair trades below 1.2600. Those levels could change slightly if we go on to etch new highs in the short term.

Some have suggested that the moves here late in the month (later than it actually looks because the US Thanksgiving holiday means that most workers are off on Thursday and Friday, so for US markets, the month effectively ends tomorrow.) are due to portfolio rebalancing, an idea we talked about late last month, when the market rallied furiously in the last four days of the month. To repeat the idea is that you buy more of the assets that have underperformed (stocks in October and November), and sell more of the assets that have outperformed (especially bonds in November) in order to get the correct percentage allocations in your portfolio. We would suggest that having been bitten once by rebalancing in October (anyone doing the above enhanced losses dramatically in November), the effect could be far smaller this month. This means that the situation should clear up by Monday on whether this is a sucker rally or a one that has longer legs.


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