FX - US Treasury Releases Semi-Annual FX Report; Italian Auction Ahead

• Italian bond auction key focus for Wednesday and Thursday trade
• Yen has been finding some bids, perhaps influenced by US Treasury
• Oil stands out as relative outperformer aided by geopolitics
• Economic calendar extremely light today

For any of you trading the markets this week, things have picked up a tad into Wednesday, with volume getting to as about as high as it will get until after the New Year in this very light holiday trade. The key focus for today will undoubtedly be the Italian bond auction results, with the economic calendar basically empty. The Italian bond auction due today and Thursday will total up to Eur20B and should be the first big test of the European Central Bank’s latest three year LTRO liquidity program. To this point however, it seems as though the newly modified central bank policy tool has not done anything major to bolster sentiment. But the Italian bond auction does take on added meaning given the country’s use as a barometer for the broader European debt crisis. Today’s auction is the less important of the two, with the longer term debt due on Thursday.

Moving on, from an FX standpoint, we have been seeing some mild risk off price action, with currencies tracking lower against the safe havens. More interesting is the price action in the Yen, with USD/JPY slowly moving lower and away from the 78.00 area. Also of note has been the price action in oil, with the commodity very well bid over the past week and standing out as a relative outperformer as the price rallies back over $100. Iran's threat to block oil shipments from moving through the Strait of Hormuz if foreign sanctions are imposed have certainly factored into the supported oil market.

Elsewhere, the US Treasury has released its semi-annual FX report, and while there was no specific mention of China as a currency manipulator, this did not dissuade the Treasury from coming down hard on Japan’s recent intervention actions. The report said that it “did not support” Japan’s FX market interventions in August and October given the fact that FX movements during that period were orderly. The report contrasted the interventions from August and October to the earlier post earthquake intervention from March where the official Japanese action was more justified. However, a Japanese government official has since been on the wires saying that the US criticism will do nothing to change the country’s stance on FX.

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.

TECHNICAL OUTLOOK

EUR/USD: The market has finally taken out the key October lows at 1.3145 to confirm a lower top by 1.3550 and open the next downside extension towards the 2011 lows from January at 1.2870. Daily studies are however looking a little stretched and at this point we could see some corrective action before the market resumes its downward trajectory. Look for any rallies to be well capped in the 1.3300 area from where the next lower top will be sought out.

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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