Currencies

• Dollar Rallies after Fed Talks QE3 Exit, Will EUR/USD Break 1.2800?
• Japanese Yen Traders See the Limits, Ill Side Effects of BoJ Stimulus
• British Pound: A Round of Data and Nothing Went the Sterling’s Way
• Euro Optimism to be Tested by Recession Warning in PMI Data
• Australian Dollar Slides Further on Stimulus Concerns, Chinese Data
• Canadian Dollar Breaks from Multi-Year Range with Help of Retail Stats
• Gold: Steady Fed and BoJ Stimulus Programs Dollar Bullish, Gold Bearish

Dollar Rallies after Fed Talks QE3 Exit, Will EUR/USD Break 1.2800?

The markets have sought out guidance on the future of the Federal Reserve’s QE3 plans to shape their speculation, and that is exactly what Fed Chairman Ben Bernanke and the FOMC minutes offered. Tentative but tangible commentary about the eventual reduction in the current $85 billion-per-month program spurred the traditional ‘risk aversion’ move from the capital markets. For the S&P 500, an intraday reversal tore the index from fresh record highs to a dangerous shift in momentum that threatens a deeper rollover. Leading the safe havens – and a direct victim of the supply-and-demand elements of the US money supply – the Dow Jones FXCM Dollar (ticker = USDollar) surged above 10,850 to its highest level since July 2010. These are both meaningful developments, but they don’t exactly confirm conviction just yet. Just like a technical breakout does not necessarily guarantee a lasting trend, a fundamental volatility swell does not ensure a systemic shift in capital.

To determine whether the market will finally pitch into a fear-driven deleveraging and risk aversion spiral, we need to see the proper fundamental catalyst to unite investors’ fears about their exposure. The Fed’s commentary does a little more than sow the seeds of doubt. The action began in the New York morning session when central bank head Bernanke testified before Congress’ Joint Economic Committee. Much of what he offered were words of caution. He clearly warned that premature tightening could undermine the US economy’s recovery. Yet, tightening and tempering are two different concepts. For speculators that have accessed record levels of leverage through the NYSE and have driven carry-favored yen crosses far off track of their yield differentials, what really stuck out was his suggestion that “in the next few meetings…(they) could take a step down in (their) pace of purchases.” How much in the way of capital gains can investors hope to squeeze out in just a few more months – because interest / yields / dividends aren’t up to par.

The hand wringing intensified a few hours later when the transcript of the Federal Open Market Committee’s (FOMC) last meeting was released. While the group noted that ‘many’ members thought that further progress was necessary to slow the policy cadence, shift away from certainty was unmistakable. Furthermore, ‘some’ on the Committee believed QE3 could be slowed as early as the June meeting. In the end, it is not confidence of growth, but fear of disastrous side effects (a market bubble) that would ultimately encourage the shift – and such fears were also noted. This is far from confirmation of a change in bearing for the world’s most prolific stimulator, but it offers a clear reason for doubt. And, at record price and exposure (leverage) levels, that may be enough to start the contagion.

Japanese Yen Traders See the Limits, Ill Side Effects of BoJ Stimulus

As expected, the Bank of Japan decided to keep its monetary policy bearing unchanged from the already remarkable objective of increasing the country’s money base by ¥60-70 trillion yen a year. This serious policy move was made little over a month ago, so a period of ‘wait and measure’ is to be expected. Yet, that may be little comfort for FX traders who have driving the yen down between approximately 25 percent in the span of six months – an extreme move for the liquid currency market. While pairs like AUDJPY, EURJPY and USDJPY probe multi-year highs, the carry (yield differential) that they offer are at historical lows. Capital gains through expectations of a constant bid are the only hope of real return. Meanwhile, the BoJ is facing a serious problem. With an aim to end deflation, interest rates will inevitable rise in Japan. However, the 10-year JGB yield surged a fourth day by 4 percent. It is now double its low in April. This is dangerous for a country with so much debt…

British Pound: A Round of Data and Nothing Went the Sterling’s Way

There was plenty of fundamental fodder on the UK docket this past session, and none of it was good for the sterling. Retail sales figures dropped the most in two years (1.4 percent) while the CBI manufacturing activity trends report posted a deeper contraction than expected. What is really troublesome in these times of stimulus, the disappointing figures are unlikely to encourage more BoE support. The BoE minutes showed the same 3 MPC members were outvoted to keep policy unchanged. Coming up, watch the second read of UK 1Q GDP to see critical details.

Euro Optimism to be Tested by Recession Warning in PMI Data

As blatant as the updates on monetary policy for the UK, Japan and UK were this past session; there seems a lack of appreciation for the subtlety of Europe’s policy regime (if few people are speculating on a change, such a move will have greater impact down the line). Worth noting though, ECB member Praet remarked on the group’s exploration of SME (small and medium-size business) loans and quality reviews of asset backed securities. In the upcoming session, we will be reminded of Europe’s biggest problem – recession – with the monthly PMI figures.

Australian Dollar Slides Further on Stimulus Concerns, Chinese Data

If there is a fear of risk, the Australian dollar will certainly take a brunt of the hit. This currency was already suffering while other benchmarks for sentiment – like equities – were still holding steady. A new addition to the currency’s troubles was added this morning when the HSBC Chinese Manufacturing PMI report for May reported a dip back into contractionary territory (49.6). A near-term rebound only works in a risk stable market.

Canadian Dollar Breaks from Multi-Year Range with Help of Retail Stats

Since October 2009, USDCAD has been guided lower by a consistent descending trendline. This past session, the pair finally closed above the high-profile technical level. The unique strength of the US dollar and general risk aversion support the break above 1.0300; and if sentiment really starts moving, that will be the catalyst for a trend. Meanwhile, the Canadian retail sales miss may hint at trouble in economic paradise.

Gold: Steady Fed and BoJ Stimulus Programs Dollar Bullish, Gold Bearish

Gold is first and foremost an alternative store of wealth for traditional fiats nowadays. That being the case, the metal found little support in the developments of the past 24 hours. Fed talk of tapering their balance sheet expansion curbs the unnatural depreciation of the world’s reserve currency. Furthermore, the BoJ has said it would stick to the course for now and the BoE is no closer to watering down their own currency. Selling was met with the highest volume in months, an uptick in the Gold Volatility Index and ETF holdings hit a fresh multi-year low.

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--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

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THE TAKEAWAY: The US Dollar and the S&P 500 may struggle to find meaningful upward follow-through having set year-to-date highs over the past 24 hours.

US DOLLAR TECHNICAL ANALYSIS– Prices invalidated a bearish Dark Cloud Cover candlestick pattern to break above resistance at 10822, the 50% Fibonacci expansion. Buyers now target the 61.8% level at 10922, with a break above that exposing the 76.4% Fib at 11045. Negative RSI divergence warns of ebbing upward momentum however and hints the move higher may be short-lived. The 10822 mark has been recast as near-term support, with a reversal back beneath that initially eyeing the 38.2% expansion at 10722.

Daily Chart - Created Using FXCM Marketscope 2.0

S&P 500 TECHNICAL ANALYSIS – Prices are hovering below resistance at 1676.50, the 123.6% Fibonacci expansion, with early signs of negative RSI divergence warning a pullback may be ahead. Initial support is at 1649.60, the 100% level. A drop beneath that aims for the 76.4% expansion at 1622.70. Alternatively, a break above resistance targets the 138.2% Fib at 1693.10.

Daily Chart - Created Using FXCM Marketscope 2.0

GOLD TECHNICAL ANALYSIS – Prices completed a Bullish Engulfing candlestick pattern above support at 1348.97, the 38.2% Fibonacci retracement level, hinting at gains ahead. Initial resistance is at 1402.11, the 23.6% level, with a break above that targeting the 14.6% Fib at 1434.86 and the May 3 high at 1488.00. Alternatively, a move below support eyes the 50% expansion at 1306.02.

Daily Chart - Created Using FXCM Marketscope 2.0

CRUDE OIL TECHNICAL ANALYSIS– Prices moved lower as expected after putting in a bearish Dark Cloud Cover candlestick pattern. Near-term support is at 92.73, the 38.2% Fibonacci expansion, with a break below that eyeing the 50% level at 91.31. Critical resistance is at 96.93, marked by a falling trend line set from late January.

Daily Chart - Created Using FXCM Marketscope 2.0

--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

To contact Ilya, e-mail ispivak@dailyfx.com. Follow Ilya on Twitter at @IlyaSpivak

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Summary: The Australian Dollar (ticker: FXA) has tumbled despite record-highs in the S&P 500 (ticker: SPY). Is the Aussie currency the canary in the coal mine, and does it point to a big S&P pullback?

Strong bull markets in stocks have historically coincided with Australian Dollar(ticker: FXA)strength, and indeed the 2009 lows in the S&P 500 (ticker: SPY) occurred almost exactly as the AUDUSD established a lasting bottom. Yet a critical divergence suggests a key S&P top may be near.

Last week we highlighted the fact that the sharp divergence between AUDUSD and S&P 500 could partly be explained by a sharp drop in Australian yields (ticker: AUD). But nothing moves in a vacuum—we can’t ignore the same factors that move yields should be the factors that move equity markets. Indeed, we argue that a bigger correction in bond markets (ticker: TLH) could be a major catalyst to spark a much larger US Dollar rally.

The question becomes simple: is the Australian Dollar the so-called “canary in the coal mine”? Or in simpler terms, does the Australian Dollar sell-off point to an imminent correction in stocks?

Australian Dollar Plotted Against Relative Moves in S&P 500, Gold (ticker: GLD)

Data source: Bloomberg, Chart source: R

We’re big fans of Dow Theory here at DailyFX, a set of six basic rules derived by Charles Dow that date back nearly 120 years. One of the most important rules is “Stock market averages must confirm each other.” And though we’re talking about currencies and stocks, we feel it’s still relevant here. In fact, our Senior Technical Strategist pointed out a critical divergence between EURUSD (ticker: FXE) and USDCHF (ticker: FXF) that preceded the substantial EURUSD sell-off and USDCHF surge.

The fact that the S&P 500 (and broader global equity indices) are hitting record-peaks as the Australian Dollar and commodity markets sell off sharply is a major warning sign. But it’s likewise clear that the only factor that really matters in trading is time.

We’re probably right in calling for a potentially significant S&P 500 pullback, but the critical question is “When?” If it happens after the S&P rallies another 100 big points, we won’t be in a great position to take advantage. Let’s see if trader sentiment can give us some clues. We’ll start with the Australian Dollar:

Retail Sentiment Favors Continued Australian Dollar Weakness

Data source: FXCM Execution Desk, Weekly Sentiment Table

It’s rare that we use such hyperbole in our research, but we recently wrote “Australian Dollar Direction Couldn’t Be Any More Clear” as the number of retail traders long AUDUSD recently hit record-highs. We use our proprietary Speculative Sentiment Index data as a contrarian signal to price action: if everyone’s long, we like to sell and vice versa. Such incredibly one-sided sentiment leaves us plainly in favor of continued Aussie Dollar declines. What about the S&P?

Retail CFD Speculators Are Extremely Short SPX500

This one requires a bit of a leap of faith: retail CFD speculators are essentially their most short the SPX500 contract on record. But—and this is an important caveat—we’ve recently seen a noteworthy build in crowd buying. According to our sample of retail traders, the number of long orders has surged by nearly 60 percent in the past 30 days.

In the interests of full disclosure, we made the same observation in Thursday’s weekly SSI report and yet the SPX500 has moved to fresh highs. Yet we’ll once again defer to Dow Theory—there are three phases in market trends: accumulation, public participation, and distribution.

In plain English, a trend begins as traders “in the know” accumulate (buy) shares/currencies/whatever and push price higher. The second phase is when the public sees the trend and rushes to buy so as not to miss the “obvious” profit opportunity—Elliott Wave fans might call this a “Wave 5”. The third phase is simple enough: the market trend comes to a potentially violent end as everyone rushes for the exits.

Our proprietary retail speculative sentiment data warns that we might be in Phase 2 of this S&P 500 move as the public finally shows itself willing to buy into record peaks. We’re speaking in terms of Dow Theory, but it could just as easily be explained in any terms you like—once the crowd gets involved we’re almost certainly closer to the top than the bottom.

Another few factoids worth considering: the S&P 500 rally has been its most consistent since important March, 2012 peaks and other key market tops. All the while, a key break higher in Australian Dollar volatility prices suggests the AUDUSD may have considerably more room to fall.

Is the Australian Dollar the canary in the coal mine? Certainly S&P 500 bulls might want to reconsider their portofolio weights given that typically-correlated markets such as the AUD or even Gold/Crude Oil/other commodities fail to hit similar peaks.

Forex Correlations SummaryView forex correlations to the S&P 500, S&P Volatility Index (ticker: VXX), Crude Oil (ticker: USO) Futures prices, US 2-Year Treasury Yields (ticker: SHY), and Spot Gold prices in the past 30 days:

Data source: Bloomberg. Chart source: R

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--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

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David specializes in automated trading strategies. Find out more about our automated sentiment-based strategies on DailyFX PLUS.Contact and follow David via Twitter: https://twitter.com/DRodriguezFX

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