For the week ahead the Forex, equity, and commodity markets will all begin trading at very key price levels and points of potential vulnerability. The S&P 500 and Dow Jones have been on a 4-week losing streak while their comrade, crude oil, dropped a staggering 10.2% in the prior five days of trading.
Granted, the lack of liquidity and thin market conditions associated with summer session trading have led to the sharp price action moves but in general we are seeing market participants come back to reality as they second guess the euphoria pumped into the markets by the central bankers back in April and May.
I am expecting a good deal of speculation to run rampant through the markets this week... speculation on whether crude will continuing falling to $55 or $52 or rise back to $65... speculation on whether the S&P 500 will go to 850 or 820 or rise back to 910... speculation on whether the US dollar Index will sustain a break above 80 and then 82 or if it will fall back to 78... speculation on how earnings will impact equities and the higher-yielding currencies... speculation on more potential stimulus measures... speculation on China's recovery and how that will affect the markets...
All the speculations will bring a continuation to the lack of any viable market trends, it will bring more daily or even hourly shifts in sentiment and risk appetites, and the general state of confusion in which all the markets have been operating the past few weeks. I have no predictions or forecasts for this week as there are a number of inflation, retail, consumer, housing, manufacturing, and central bank events which hold the power to toy with the emotions of market participants at any given moment.
In my view the markets have shown growing concern for the state of the consumer, especially the US consumer, for the employment situation, and for the sharp slide in energy and commodity prices. Those issues will once again have to be dealt with this week and the end results will feed into where market participants send their money-flows.
From my own perspective I see that equities and commodities are more vulnerable to the downside as opposed to bouncing back to the upside. The path of least resistance has been down, not up, and the momentum has favored the downside. Of course this can all change in the blink of an eye but what I think will be required to shift sentiment and money-flows is for better than expected fundamentals or some confidence from the central banks.
It should be noted that even with the massive plunge in crude prices and the strong sell-off of gold, the dollar hasn't exactly surged against its counterparts. The US Index is above 80 but not by much, the EUR/USD hasn't even come close to testing the 1.3753 mega support zone and the GBP/USD has made a decent comeback off its recent lows after the BOE said they were not going to monetize more debt for now.
Market participants are still jumping on every little piece of news, fundamental data, and rhetoric from the central bankers and until we get bias one way or the other I expect the "trend" of no trend to be the trend.
EUR/USD fundamentals:
As I mentioned there are a number of important fundamental events this week, especially for the EUR/USD. These are the ones I'll be most focused on:
Inflation--
In terms of inflation, I still firmly believe deflation is a much bigger issue at the present. Do not confuse true inflation, which is simply the printing of money, with price inflation. Some recent data suggests the Fed may actually be printing less money than what was prior assumed. Of course we will never get true and accurate numbers out of the Fed in terms of money-supply, the monetary base and the velocity of money but it could be true to a degree because we are not seeing any signs of price inflation pressures.
Consumers are still in command and are still forcing producers, manufacturers, and retailers to lower their prices. The collective buying power of the consumer base has maintained an overall trend of devaluation and lower price adjustments. In addition, the continued trend of credit destruction, debt repayments, higher savings, moderate commodity prices, falling home values, and rising unemployment are all acting as very deflationary contributing factors. Anybody screaming "hyperinflation" is living outside the realm of reality right now, it's just not there. Equities will want to see higher CPI and PPI figures. Commodity bulls will need to see rising prices as will the higher-risk, higher-yielding currencies. Should the trend of deflation show signs of a continuation it could be a rough week for those markets.
Treasury budget and the USD--
On Monday afternoon the Treasury will release the latest federal budget figures and this fundamental event could certainly impact the Forex and equity markets. Last month we got May's year-over-year budget numbers and it showed a mega spike in the deficit and spending. The Treasury is getting less tax revenue and obviously spending more money. In May 2008 the deficit stood at $165.9 billion and in May of 2009 it was $189.7 billion.
Spending has far outpaced that which the government is generating in revenue. Plus, with all the debt the Treasury is selling combined with the contraction of GDP, the ratio of debt repayments could get very uncomfortable as tax revenues continue to fall, savings continue to rise, and credit expansion stagnates. If the June figures show another surge in the deficit the market may respond by selling the dollar... keep your eye on this data.
FOMC--
The release of the meeting minutes from the last FOMC will be watched and reacted to by all markets. At this point I am not expecting any earth shattering information to be contained within the meeting minutes but you never what kind of surprises might be in there. The Fed has used the element of surprise in the past through the FOMC minutes and should there be any surprising mentions about buying more sovereign debt, raising or lowering interest rates, or on the future of the US economy the markets will move accordingly.
Risk and price action catalyst -- USD/JPY:
Last Wednesday the Japanese yen made a massive move against the dollar, euro, and pound sterling, gaining several hundred points in a handful of hours. I felt some of the brunt of the move as I had to close net-short yen positions for a loss and while it's never fun to take a loss or to go through the process of recovery, I learned a few valuable trading lessons I want to share.
Market correlations and repeated price patterns play a big role in how I determine entry and exit points on my trades, as most of you probably know. One reason I have grown to love trading the yen crosses is because I have found them to be some of the most pattern-like pairs in the market and I like how they maintain a very close relationship with the S&P 500 and Dow Jones equity indices.
It's no secret the overall strength or weakness of the US equity markets drive currency valuations among the majors and crosses but what I came to learn and understand is that the USD/JPY holds an important place that can act as a driver of the EUR/JPY and GBP/JPY. The Forex market uses the US equity markets to gauge risk appetites and to determine price valuations, and while the EUR/JPY is the pair most correlated to the S&P 500, from my perspective what I see is that the USD/JPY can be the pair most correlated to the overall equity markets, as a whole.
Price action impact ratios--
In the past I paid little attention to the price action and price pattern behavior of the USD/JPY but now I see that the overall strength/weakness of the USD/JPY directly impacts that of the EUR/JPY and GBP/JPY. Even more importantly, the impact ratio of an extended move on the USD/JPY is magnified anywhere from two to three times on the EUR/JPY and GBP/JPY. In other words, a 200-point extended move on the dollar-yen can translate into a 500 to 600-point extended move on a pair like the GBP/JPY and a 400-point extended move on the EUR/JPY.
This becomes especially true if those respective yen crosses have spent a greater period of time either moving or ranging to upside or downside price levels. For example, the last time the EUR/JPY spent time at or below the 130.00 level was almost 2-months ago (18-May) and in these last 2-months the EUR/JPY has moved or ranged at elevated levels, going as high as the 138.60 level during the first week of June.
The last time the GBP/JPY spent any time below the 147.00 level was just three days after the EUR/JPY bottomed out below the 130.00 level. Back on 21-May the GBP/JPY reached a bottom just below 147.00 and over the course of the proceeding few months it moved to a high over 162.50. So in this case we see both the GBP/JPY and EUR/JPY spent an elevated period of time gaining and moving to the upside which correlates perfectly to how the S&P 500 and Dow Jones gained during that exact same time frame.
Stop loss factors--
What helped fuel the type of moves we saw last Wednesday on the yen crosses is squarely on stop losses and stop loss triggering. The relationship between stop loss triggering, price action, and price behavior is very clear and the basis of this relationship goes back to the length of time a currency pair spends at either an appreciated or depreciated level.
Take the GBP/JPY for example... between 21-May and 12-June it moved a staggering 1,500-points+ to the upside. Although the GBP/JPY moved off it's best upside levels, it still maintained upside gains of over 1,000-points all the way until 3-July. What that means is the market was given a very reasonable amount of time to set stops on untold dozens of key psychological and technical levels at least all the way down to the price level where the market first turned up back on 21-May.
On 21-May the GBP/JPY bottomed and turned up at the 146.84 level and guess where it moved to last Wednesday? Exactly 10-points below the original upturn level... it hit 146.74, stopped and bounced back. That is no random fluke of the markets at all but shows how the extended downside move was very much fueled by stops being triggered. When stops are triggered and stop loss orders are hit, that process exacerbates a move to a large degree.
From a price pattern standpoint it also shows there is currently some fairly strong support around the 146.70-80 price zone. If you go back and look at the price action and price patterns of the EUR/JPY you would see almost a mirror image of the GBP/JPY in terms of its upside extension and then it's rapid fall back to old support price levels.
Hopefully this makes sense. At least for me it was a good exercise to go through as a refresher on the core principles of what makes these markets move, why they move, and how we can better capitalize on the markets.
Correlation between premium, price, and risk:
For years I have been writing about the markets, about the relationship that exists between currencies, equities, commodities, and bonds and while that's all well and good, in the end, no matter how you slice it, price is king and price is all that matters. It's easy to lose sight of price sometimes but price always has the final say so in these markets. When it comes to price, price always carries a premium. There may be many factors used to determine price and valuations but when you boil it all down, it is the premium that the market puts on price which is the ultimate determining factor.
Think about it this way... when the market puts a higher premium on risk it means the market must pay more to get more. The correlation between premiums, risk, and yield (rate of return) is simple -- to get a higher yield or a better rate of return it is going to cost you more money because there is a premium placed on the price and in turn the level of risk changes.
The higher the yield, the higher the risk, and the higher the premium that must be paid to potentially profit. Conversely, when the market determines there is too much risk and the price that must be paid to take on risk has achieved its maximum potential, the premium then gets put on the markets or asset classes which cater to anti-risk, like the dollar or US Treasuries.
Many traders ask me how in the world it's possible for the euro and pound sterling to have such a close positive correlation to equities and for the dollar and yen to maintain a close inverse correlation. In my opinion the correlation is largely determined by the premiums placed on the risk and rate of return.
If the market is willingly taking on more risk and is showing a higher risk appetite the premium on risk goes up and a higher premium translates into a higher price. The euro, for example, yields more than the dollar but in times or seasons of risk aversion, no matter how long those seasons last for, the dollar is considered "safer" than the euro, so the premium and price of the dollar rises against the euro. A season of risk aversion in the equity markets will translate into a higher premium paid on mitigating risk and this higher premium is put on the dollar and yen, therefore it will cost more to own the dollar and yen because the premium has been upped by the market.
These are very fundamental and psychological aspects of the market and have nothing to do with the technical side of things. It did not matter to the market that S&P 500 and Dow Jones broke above key technical levels, they both have sold-off ever since those technical events took place in the market. Why the S&P 500 failed at the 950 level was because the market said the premium to take on risk to gain a better rate of return at that price level was too high, plain and simple.
The premium to own the S&P 500 at the 950 price level was beyond what the market could bear so the premium got completely flipped... the premium was then placed on the best price in which to sell the S&P 500. Sell high, buy low, right? We all know that saying but what it really relates to is the premium placed on the price of ownership. At some point in the future the premium to sell the S&P 500 will reach an unsustainable level and then it will flip again causing the premium placed on the price to buy the S&P to go up.
When the market sees a higher premium to own a better yielding but riskier asset class like equities, the way the correlation works between equities and currencies will then cause a higher price premium to be placed on the EUR, GBP, AUD, CAD, NZD, etc. That's basically how it all works and how those correlations operate. I like to watch the correlations in price and premiums move in real-time, that is what suits me best, but unless we have a major correlation shift I think it is safe to expect to see those old tried and true correlations move just as they are supposed to.
Trading:
With the lack of any established market trends or clear biases, the price action will be determined by however the markets are feeling at any given point in time this week. This obviously will not make trading an easy endeavor over the next five days, so I would encourage all traders to keep up with the real-time price action of crude oil, the S&P 500 and Dow in relation to how your favorite currency pairs are moving.
And as I mentioned above, price will be king, so no matter how erratic the price action gets, the markets will always overshoot their bounds of price sustainability, they will always over extend and exhaust themselves to the upside and downside, and using those indicators is really where the safest money is to be made.
That's all I have for now. I will be in heavier trading mode this week and spending as much time and energy as possible focusing on the markets, so as time allows I will update the blog. I wish you a great and successful week of trading.
-David
Granted, the lack of liquidity and thin market conditions associated with summer session trading have led to the sharp price action moves but in general we are seeing market participants come back to reality as they second guess the euphoria pumped into the markets by the central bankers back in April and May.
I am expecting a good deal of speculation to run rampant through the markets this week... speculation on whether crude will continuing falling to $55 or $52 or rise back to $65... speculation on whether the S&P 500 will go to 850 or 820 or rise back to 910... speculation on whether the US dollar Index will sustain a break above 80 and then 82 or if it will fall back to 78... speculation on how earnings will impact equities and the higher-yielding currencies... speculation on more potential stimulus measures... speculation on China's recovery and how that will affect the markets...
All the speculations will bring a continuation to the lack of any viable market trends, it will bring more daily or even hourly shifts in sentiment and risk appetites, and the general state of confusion in which all the markets have been operating the past few weeks. I have no predictions or forecasts for this week as there are a number of inflation, retail, consumer, housing, manufacturing, and central bank events which hold the power to toy with the emotions of market participants at any given moment.
In my view the markets have shown growing concern for the state of the consumer, especially the US consumer, for the employment situation, and for the sharp slide in energy and commodity prices. Those issues will once again have to be dealt with this week and the end results will feed into where market participants send their money-flows.
From my own perspective I see that equities and commodities are more vulnerable to the downside as opposed to bouncing back to the upside. The path of least resistance has been down, not up, and the momentum has favored the downside. Of course this can all change in the blink of an eye but what I think will be required to shift sentiment and money-flows is for better than expected fundamentals or some confidence from the central banks.
It should be noted that even with the massive plunge in crude prices and the strong sell-off of gold, the dollar hasn't exactly surged against its counterparts. The US Index is above 80 but not by much, the EUR/USD hasn't even come close to testing the 1.3753 mega support zone and the GBP/USD has made a decent comeback off its recent lows after the BOE said they were not going to monetize more debt for now.
Market participants are still jumping on every little piece of news, fundamental data, and rhetoric from the central bankers and until we get bias one way or the other I expect the "trend" of no trend to be the trend.
EUR/USD fundamentals:
As I mentioned there are a number of important fundamental events this week, especially for the EUR/USD. These are the ones I'll be most focused on:
- ECB Trichet speech (Monday 0630 EST)
- Treasury Budget (Monday 1400 EST)
- German and Eurozone ZEW (Tuesday 0500 EST)
- Retail Sales (Tuesday 0830 EST)
- PPI (Tuesday 0830 EST)
- Eurozone CPI (Wednesday 0500 EST)
- US CPI (Wednesday 0830 EST)
- Industrial Production (Wednesday 0915 EST)
- Crude Inventories (Wednesday 1030 EST)
- FOMC Meeting Minutes (Wednesday 1400 EST)
- Initial Claims (Thursday 0830 EST)
- TIC Flows (Thursday 0900 EST)
- Housing Starts and Building Permits (Friday 0830 EST)
Inflation--
In terms of inflation, I still firmly believe deflation is a much bigger issue at the present. Do not confuse true inflation, which is simply the printing of money, with price inflation. Some recent data suggests the Fed may actually be printing less money than what was prior assumed. Of course we will never get true and accurate numbers out of the Fed in terms of money-supply, the monetary base and the velocity of money but it could be true to a degree because we are not seeing any signs of price inflation pressures.
Consumers are still in command and are still forcing producers, manufacturers, and retailers to lower their prices. The collective buying power of the consumer base has maintained an overall trend of devaluation and lower price adjustments. In addition, the continued trend of credit destruction, debt repayments, higher savings, moderate commodity prices, falling home values, and rising unemployment are all acting as very deflationary contributing factors. Anybody screaming "hyperinflation" is living outside the realm of reality right now, it's just not there. Equities will want to see higher CPI and PPI figures. Commodity bulls will need to see rising prices as will the higher-risk, higher-yielding currencies. Should the trend of deflation show signs of a continuation it could be a rough week for those markets.
Treasury budget and the USD--
On Monday afternoon the Treasury will release the latest federal budget figures and this fundamental event could certainly impact the Forex and equity markets. Last month we got May's year-over-year budget numbers and it showed a mega spike in the deficit and spending. The Treasury is getting less tax revenue and obviously spending more money. In May 2008 the deficit stood at $165.9 billion and in May of 2009 it was $189.7 billion.
Spending has far outpaced that which the government is generating in revenue. Plus, with all the debt the Treasury is selling combined with the contraction of GDP, the ratio of debt repayments could get very uncomfortable as tax revenues continue to fall, savings continue to rise, and credit expansion stagnates. If the June figures show another surge in the deficit the market may respond by selling the dollar... keep your eye on this data.
FOMC--
The release of the meeting minutes from the last FOMC will be watched and reacted to by all markets. At this point I am not expecting any earth shattering information to be contained within the meeting minutes but you never what kind of surprises might be in there. The Fed has used the element of surprise in the past through the FOMC minutes and should there be any surprising mentions about buying more sovereign debt, raising or lowering interest rates, or on the future of the US economy the markets will move accordingly.
Risk and price action catalyst -- USD/JPY:
Last Wednesday the Japanese yen made a massive move against the dollar, euro, and pound sterling, gaining several hundred points in a handful of hours. I felt some of the brunt of the move as I had to close net-short yen positions for a loss and while it's never fun to take a loss or to go through the process of recovery, I learned a few valuable trading lessons I want to share.
Market correlations and repeated price patterns play a big role in how I determine entry and exit points on my trades, as most of you probably know. One reason I have grown to love trading the yen crosses is because I have found them to be some of the most pattern-like pairs in the market and I like how they maintain a very close relationship with the S&P 500 and Dow Jones equity indices.
It's no secret the overall strength or weakness of the US equity markets drive currency valuations among the majors and crosses but what I came to learn and understand is that the USD/JPY holds an important place that can act as a driver of the EUR/JPY and GBP/JPY. The Forex market uses the US equity markets to gauge risk appetites and to determine price valuations, and while the EUR/JPY is the pair most correlated to the S&P 500, from my perspective what I see is that the USD/JPY can be the pair most correlated to the overall equity markets, as a whole.
Price action impact ratios--
In the past I paid little attention to the price action and price pattern behavior of the USD/JPY but now I see that the overall strength/weakness of the USD/JPY directly impacts that of the EUR/JPY and GBP/JPY. Even more importantly, the impact ratio of an extended move on the USD/JPY is magnified anywhere from two to three times on the EUR/JPY and GBP/JPY. In other words, a 200-point extended move on the dollar-yen can translate into a 500 to 600-point extended move on a pair like the GBP/JPY and a 400-point extended move on the EUR/JPY.
This becomes especially true if those respective yen crosses have spent a greater period of time either moving or ranging to upside or downside price levels. For example, the last time the EUR/JPY spent time at or below the 130.00 level was almost 2-months ago (18-May) and in these last 2-months the EUR/JPY has moved or ranged at elevated levels, going as high as the 138.60 level during the first week of June.
The last time the GBP/JPY spent any time below the 147.00 level was just three days after the EUR/JPY bottomed out below the 130.00 level. Back on 21-May the GBP/JPY reached a bottom just below 147.00 and over the course of the proceeding few months it moved to a high over 162.50. So in this case we see both the GBP/JPY and EUR/JPY spent an elevated period of time gaining and moving to the upside which correlates perfectly to how the S&P 500 and Dow Jones gained during that exact same time frame.
Stop loss factors--
What helped fuel the type of moves we saw last Wednesday on the yen crosses is squarely on stop losses and stop loss triggering. The relationship between stop loss triggering, price action, and price behavior is very clear and the basis of this relationship goes back to the length of time a currency pair spends at either an appreciated or depreciated level.
Take the GBP/JPY for example... between 21-May and 12-June it moved a staggering 1,500-points+ to the upside. Although the GBP/JPY moved off it's best upside levels, it still maintained upside gains of over 1,000-points all the way until 3-July. What that means is the market was given a very reasonable amount of time to set stops on untold dozens of key psychological and technical levels at least all the way down to the price level where the market first turned up back on 21-May.
On 21-May the GBP/JPY bottomed and turned up at the 146.84 level and guess where it moved to last Wednesday? Exactly 10-points below the original upturn level... it hit 146.74, stopped and bounced back. That is no random fluke of the markets at all but shows how the extended downside move was very much fueled by stops being triggered. When stops are triggered and stop loss orders are hit, that process exacerbates a move to a large degree.
From a price pattern standpoint it also shows there is currently some fairly strong support around the 146.70-80 price zone. If you go back and look at the price action and price patterns of the EUR/JPY you would see almost a mirror image of the GBP/JPY in terms of its upside extension and then it's rapid fall back to old support price levels.
Hopefully this makes sense. At least for me it was a good exercise to go through as a refresher on the core principles of what makes these markets move, why they move, and how we can better capitalize on the markets.
Correlation between premium, price, and risk:
For years I have been writing about the markets, about the relationship that exists between currencies, equities, commodities, and bonds and while that's all well and good, in the end, no matter how you slice it, price is king and price is all that matters. It's easy to lose sight of price sometimes but price always has the final say so in these markets. When it comes to price, price always carries a premium. There may be many factors used to determine price and valuations but when you boil it all down, it is the premium that the market puts on price which is the ultimate determining factor.
Think about it this way... when the market puts a higher premium on risk it means the market must pay more to get more. The correlation between premiums, risk, and yield (rate of return) is simple -- to get a higher yield or a better rate of return it is going to cost you more money because there is a premium placed on the price and in turn the level of risk changes.
The higher the yield, the higher the risk, and the higher the premium that must be paid to potentially profit. Conversely, when the market determines there is too much risk and the price that must be paid to take on risk has achieved its maximum potential, the premium then gets put on the markets or asset classes which cater to anti-risk, like the dollar or US Treasuries.
Many traders ask me how in the world it's possible for the euro and pound sterling to have such a close positive correlation to equities and for the dollar and yen to maintain a close inverse correlation. In my opinion the correlation is largely determined by the premiums placed on the risk and rate of return.
If the market is willingly taking on more risk and is showing a higher risk appetite the premium on risk goes up and a higher premium translates into a higher price. The euro, for example, yields more than the dollar but in times or seasons of risk aversion, no matter how long those seasons last for, the dollar is considered "safer" than the euro, so the premium and price of the dollar rises against the euro. A season of risk aversion in the equity markets will translate into a higher premium paid on mitigating risk and this higher premium is put on the dollar and yen, therefore it will cost more to own the dollar and yen because the premium has been upped by the market.
These are very fundamental and psychological aspects of the market and have nothing to do with the technical side of things. It did not matter to the market that S&P 500 and Dow Jones broke above key technical levels, they both have sold-off ever since those technical events took place in the market. Why the S&P 500 failed at the 950 level was because the market said the premium to take on risk to gain a better rate of return at that price level was too high, plain and simple.
The premium to own the S&P 500 at the 950 price level was beyond what the market could bear so the premium got completely flipped... the premium was then placed on the best price in which to sell the S&P 500. Sell high, buy low, right? We all know that saying but what it really relates to is the premium placed on the price of ownership. At some point in the future the premium to sell the S&P 500 will reach an unsustainable level and then it will flip again causing the premium placed on the price to buy the S&P to go up.
When the market sees a higher premium to own a better yielding but riskier asset class like equities, the way the correlation works between equities and currencies will then cause a higher price premium to be placed on the EUR, GBP, AUD, CAD, NZD, etc. That's basically how it all works and how those correlations operate. I like to watch the correlations in price and premiums move in real-time, that is what suits me best, but unless we have a major correlation shift I think it is safe to expect to see those old tried and true correlations move just as they are supposed to.
Trading:
With the lack of any established market trends or clear biases, the price action will be determined by however the markets are feeling at any given point in time this week. This obviously will not make trading an easy endeavor over the next five days, so I would encourage all traders to keep up with the real-time price action of crude oil, the S&P 500 and Dow in relation to how your favorite currency pairs are moving.
And as I mentioned above, price will be king, so no matter how erratic the price action gets, the markets will always overshoot their bounds of price sustainability, they will always over extend and exhaust themselves to the upside and downside, and using those indicators is really where the safest money is to be made.
That's all I have for now. I will be in heavier trading mode this week and spending as much time and energy as possible focusing on the markets, so as time allows I will update the blog. I wish you a great and successful week of trading.
-David
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