FX - Quiet Holiday Consolidation But S&P and WSJ Could Influence

• Holiday trade brings with it some quiet holiday price action
• Euro 2011 lows from January could hold as the yearly low
• Rating agency comments and warnings could weigh on sentiment
• WSJ says Fed may extend commitment to ultra low rates into 2014

It is not always the case, but the lightened holiday trade has brought with it some equally quiet trade, with the currency markets so far content on some consolidation and avoiding violent intraday price swings on the razor thin conditions. The Euro has stalled out just shy of the 2011 lows from January by 1.2870 and at this point, it looks as though those lows will remain intact for the remainder of the year. However, come January, we would expect to see the 1.2870 level taken out as the broader underlying trend is still very much in the US Dollar’s favor and could open a Euro drop into the 1.2000’s in the first half of 2012.

All major markets will be closed today and any remaining market participants will likely focus on some of he developments from the previous week, particularly out from the rating agencies. S&P was out with some risk negative comments after saying that the ECB LTRO will not do anything to remove the threat of bank downgrades in Europe, and talk is now circulating that the only reason S&P delayed its report of 15 EMU member countries, was to avoid having to issue downgrades around Christmas.

Moving on, there was also an interesting article in the WSJ from the previous week which could influence markets into 2012. The article which is titled “Fed May Signal Low Rates Into 2014” could obviously inspire a bearish USD reaction if it in fact proves to be true, although we doubt any USD selling would be substantial as this would not come as a complete surprise. Currently, the Fed has committed to low rates into mid-2013, and it seems as though Fed officials have become increasingly uncomfortable with this time constraint and our now considering an extension at the next meeting. In any event, this is something that should be watched closely over the coming weeks.

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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