FX - Risk Off Trade Inensifies in Holiday Thin Conditions

• First round of Italian bond auction well received
• Markets fail to respond positively to results
• Ongoing Eurozone debt concerns open fresh wave of risk off trade
• EUR/JPY threatening break of critical psychological barrier

We finally saw some holiday volatility on Wednesday as we had warned, with the Euro leading the way and eventually dropping below 1.2900 to stall just shy of the critical 2011 lows from January at 1.2870. There have been no specific fundamental catalysts to speak of for the risk off price action, but it seems as though it is going to take much more than a better Italian auction result to inspire confidence in the Eurozone recovery. At this point, the message seems to be that the Eurozone debt crisis will continue to shake up the broader markets into 2012 unless EU officials can come up with a more effective strategy.

One source aptly notes that the massive deposit by the EU banks to the ECB over the holidays only reflects that these banks prefer the safety of the central bank over lending to other banks or countries that are riddled with debt. In light of this latest bout of risk liquidation, it will be worth watching the Yen crosses over the coming sessions, with a particular interest in a EUR/JPY cross which trades by multi-year lows and threatens a drop below critical psychological barriers at 100.00.

Looking Ahead to 2012 - Foreign Investment in US Equities

While on the surface, the recommendation appears to be non-currency specific, we view this as an extremely attractive opportunity for a portfolio hedge in 2012 and potential arbitrage strategy. Currencies have been broadly outperforming against the US Dollar in recent years and it finally appears as though this trend could be on the verge of some form of a reversal back in favor of the buck. However, long USD positions have also been quite risky and exposure to the Greenback might bring with it some unwelcome stress. As such, our recommendation is foreign investment in US equities. What does this mean?

Here is how we see this playing out. Should current correlations stand, if US equities are to head higher, then the investor will benefit from the US equity return, but at the same time, likely have his/her investment offset by the sell-off in the US Dollar and appreciation in his/her local currency on the resurgence in risk appetite and outflow from the safe-haven US Dollar. If on the other hand US equities head lower, then the risk off market environment will allow the investor to offset his/her loss in US stocks through the appreciation in the US Dollar on its safe-haven flows (remember – the investor in invested in US equities and thereby has USD exposure).

So if this is the case, then where is the benefit in this trade, and why even do it? Well, what if we see a break down in familiar correlations where the US equity market rallies and the US Dollar also rallies at the same time? What if we see a situation where US equities and the US Dollar become positively correlated? In this scenario, the investor stands to benefit a great deal and will not only make money from his investment in US equities, but will also enhance his/her returns on the appreciation in the US Dollar.

The global recession appears to be moving in phases, and with the markets now dealing with phase two of the crisis in Europe, we can start to anticipate the transition to phase three, where we believe that China, the commodity bloc economies and emerging markets will all be exposed. At the same time, we see a first in and first out type of situation, with the US economy the first to emerge from the global recession which should translate into a more upbeat outlook on low valuation US equities and the US Dollar as well, on a narrowing of yield differentials back in favor of the Greenback as the Fed begins to signal a reversal of ultra accommodative monetary policy.

ECONOMIC CALENDAR

TECHNICAL OUTLOOK

EUR/USD: The market is now looking to establish below the critical 2011 lows from January 2011 at 1.2870 and a weekly close below this level will open the door for the next major downside extension towards the 1.2500 area. Overall, we retain a strong bearish outlook for this market and look for setbacks to extend towards the 1.2000 handle over the coming months. While we would not rule out the potential for corrective rallies, any rallies should be very well capped above 1.3500.

USD/JPY:The market has managed to successfully hold above the bottom of the daily Ichimoku cloud to further strengthen our constructive outlook and we look for the formation of a inter-day higher low by 76.55 ahead of the next major upside extension back towards and eventually through the recent multi-day highs by 79.55. Ultimately, only a close back below the bottom of the Ichimoku cloud would negate outlook and give reason for pause, while a daily close back above 78.30 accelerates.

GBP/USD: Rallies have been very well capped ahead of 1.5800 and it looks as though a lower top has now been carved out by 1.5780 ahead of the next major downside extension back towards the October lows at 1.5270. Key support comes in by 1.5400 and a daily close below this level will be required to confirm bias and accelerate declines. Ultimately, only back above 1.5780 would negate bearish outlook and give reason for pause.

USD/CHF: The recent break above the critical October highs at 0.9315 is significant and now opens the door for the next major upside extension over the coming weeks back towards parity. A confirmed higher low is now in place by 0.9065 following the recent break over 0.9330, and next key resistance comes in by 0.9785. Ultimately, only back under 0.9065 would delay constructive outlook.

--- Written by Joel Kruger, Technical Currency Strategist

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