Euro Retakes 1.5600 as Bargain Hunters Come in

Talking Points• Japanese Yen: remains near 102.00 as equities supportive• Euro: Back above 1.5600 as bargain hunters come in PPI hot • Pound: PMI Construction misses badly• Swiss Franc: still weak off UBS news• US Dollar: ADP on tap
A relatively quite night of trade in the FX markets as the dollar consolidated its gains of the past several days. The EURUSD bounced back above the 1.5600 level as the sharp sell off of the past several days brought out some bargain hunting euro longs. The only economic event of note – EZ PPI - printed at a bit hotter than expected 0.6% and stoked the move higher.Meanwhile, news out of the UK continues to confirm the fact that the housing sector is rapidly contracting. The steep fall off in construction PMI which came in at 47.2 versus 52.0 forecasts indicates that housing activity will decelerate sharply as the year progresses, likely causing the BoE to begin lowering rates in earnest. The one possible offset could come from the manufacturing sector which continues to perform well due to favorable EURGBP exchange rates. Still, housing is a bigger portion of the UK economy than manufacturing and further slowdown in that arena is likely to turn UK monetary policy more dovish. In contrast to last week, when the decoupling thesis was driving trade in the FX market especially after the better than forecast IFO, this week market players are casting a more skeptical eye towards the EZ. Last night’s horrid Retail Sales numbers along with the massive write-offs from European banks suggest that spillover effects are reaching the 17 member region. Whereas in the past EURUSD rallied off positive European data, this week the pair will only find strength if US data proves far worse than expected. In short, instead of being a test of relative strength, the trade in the EURUSD is quickly becoming a race to the bottomToday, the ADP data, though hardly accurate in the past, could roil the markets if the number prints materially worse than expected. As we noted before only a print of –100K or worse in the NFP is likely to re-ignite the euro rally. On the other hand a mild contraction in US labor demand has already been priced in and the greenback may actually rally back to the 1.5500 level.

Using Currencies To Time Equity Moves

Many traders and analysts have taken advantage of the growing correlation between asset classes to forecast movements in one market by analyzing the changes in another. However, while using the changes in equities to forecast price action in risk-sensitive currency pairs has grown in popularity, the reverse (using FX moves to anticipate changes in the equities market) has not. And, considering the currency market’s deep liquidity and 24-hour session, overlooking such an advantage would be missing out on one of the best strategies in current market conditions.

Yen Crosses: Opportunities to Sell on Big Rallies

We still view the drop from 167.64 as a series of 1st and 2nd waves (following a major truncated 5th wave). However, the EURJPY has yet to accelerate lower in a 3rd of a 3rd wave as expected. As long as price is below 159.20, this very bearish (3rd of a 3rd decline) remains a possibility. A breach of 159.20 would suggest that wave ii (within the 5 wave drop from 166.65) is still underway and will complete after a spike through 161.40.
Regardless of the larger trend, the GBPJPY is due for a rally. There are 5 waves down from the November high at 241.35. Expect a test of the center of the triangle near 210 in the coming weeks. The 38.2% of 241.35-192.60 is at 211.22. Near term, a small b wave is either unfolding now or is complete at 195.09.
The decline from 101.85 to 92.15 is only in 3 waves but could be wave A of a flat correction. The 3 wave advance is a classic B wave. Risk is tight on shorts at 101.85 and targets for a few months out are the 100% and 161.8% extensions of 101.85-92.15/100.72 at 91.02 and 85.02. For a more in depth look at the CHFJPY, see CHFJPY Plunge.
We maintain that the CADJPY is headed lower longer term (the series of lower lows and lower highs inspires confidence in the bearish assessment). However, a countertrend rally is underway now that likely reaches 101 (38.2% of 109.62-95.68) or even 104.30 (61.8% of 109.62-95.68). The decline from 109.62 is in 5 waves and the rally from 95.68 serves to correct that rally. The aforementioned 101 and 104.30 are potential reversal points.
A major top is in place (likely a multi-year top at 107.84). We view the drop from 107.84 to 92.99 as wave 1 in a 5 wave bear cycle. Wave 2 takes the form of an expanded flat and is likely complete at 100.49. Near term, a small correction is underway (as in the other Yen crosses) and should end near the 61.8% of 100.49-88.14 at 95.77.
To be honest, the NZDJPY pattern is unclear at the moment. Specifically, the price action since mid October is a mess. This is usually a sign that the pattern in question is a B wave. In this case, the up-down sequence from the August 2007 low at 74.25 could be waves A and B in a correction of the 97.74-74.25 decline. If this is correct, then the NZDJPY is in for a large rally. Another count is bearish as long as price is below 88.11.

Is the US Dollar Recovery Here to Stay?

The US dollar made a solid recovery after manufacturing activity unexpectedly picked up, and strengthened against most of the major currencies as investors increased their risk appetite. Consequently, the US dollar picked up the biggest gains against the Swiss Franc and Yen as investors pulled out of the lower yielding currencies. Against the European currencies, the US dollar recouped previous losses against the euro and British pound as the pairs fell toward the 1.56 and 1.975 levels, respectively. The recovering dollar also soaked in gains against the Australian and New Zealand dollar as commodity prices declined. The Canadian dollar was the sole currency to rise against the US dollar - with market participants turning bullish as Canada’s biggest trading partner begins to show signs of recovery.
On the economic front, fresh manufacturing data improved the economic outlook for the US as the ISM Manufacturing index unexpectedly rose to 48.6 from 48.3. Amid the mild increase, the index remains in a state of contraction but helped market sentiment to pick up as many speculated manufacturing activity to decline. However, the ISM Prices Paid index raised inflationary concerns as it rose to 83.5 from 75.5 – reflecting the highest level of inflation since Hurricane Katrina. The outlook for the housing sector remains unclear as Construction Spending fell for the fifth consecutive month, but declined at a slower pace of minus 0.3 percent from minus 1.7 percent.

The securities market continued yesterday’s advance as liquidity fears eased with Lehman Brothers netting a total of $4B from stock sales while Blackstone raised a record $10.9B for its property fund. As a result, the DJIA picked up a whopping 391.47 points to bring the average to 12,654.36, with all of the big 30 advancing. The broader S&P500 rose 47.48 points to 1,370.18 points, with the amount of advancing issues more than tripling the amount of declining issues. However, repercussion effects from the credit crunch are showing signs overseas as financial giant UBS projected a first quarter loss of $11.9B, with Chairman Marcel Ospel announcing his resignation.

Investors left the safe haven of US Treasuries as improved data stoked an increase in risk appetite, and pushed bond prices lower. As a result, the benchmark 10-Year yield jumped to 3.56 percent from 3.41 percent, while the 2-Year yield surged to 1.80 percent from 1.59 percent.

Looking ahead, all eyes will be on Fed Chairman Bernanke tomorrow as he testifies before the joint economic committee at 13:30 GMT, and will be followed by the Factory Order index at 14:00 GMT. Prior to Bernanke’s testimony, the ADP Employment Change is expected to add downward pressures for the US dollar as we expected the index to fall to minus 30K from minus 23K.

Dollar Decline: Not a Sure Thing

Since 2002, the Dollar has lost 70% of its value, relative to the Euro. Meanwhile, the same factors that signaled bearishness in 2002 persist in 2008, or even worsened in some aspects. The twin deficits are still growing, though the current account deficit may be leveling off. The US economy is headed towards recession. Inflation is set to rise due to soaring commodity prices and a loosening of monetary policy. As a result, many investors are betting that the Dollar's slide will continue well into the near future.
However, prudent investors would be wise to "handle with care." While not entirely applicable to forex markets, efficient markets theory dictates that inherent in a security's current valuation is all relevant, publicly available information. Thus, all of the bad news listed above has already been priced into the Dollar, to some degree at least. The rule of diversification is in full effect when betting on forex. Thus, rather then putting all of one's chips directly behind one currency, an investors could buy foreign securities (stocks and bonds) instead, which also capture any currency appreciation (and depreciation). Investors can also purchase Treasury Inflation Protected Securities (TIPS), whose yield is linked to inflation and, thus, acts as a hedge against a declining Dollar. The Wall Street Journal reports:
While some market watchers believe the six-year dollar bear market isn't over yet, investors should recognize that trends in the currency markets are typically marked by volatile ups and downs along the way.

Fundamentals Harm Emerging Market Currencies

Since the inception of the credit crunch, one of the themes in forex markets has been the surprising strength of the Dollar. Despite growing economic uncertainty, the US is still viewed as a relatively safe place to invest. On the other hand, emerging markets, especially those with current account deficits, have witnessed capital flight and subsequent currency depreciation. The currencies of South Africa and Iceland, for example, have both experienced declines 20% since the start of this year. Risk premiums had fallen to historic lows prior to the credit crunch, and neither country experienced great difficulty financing its respecive deficits. However, investors are growing increasingly nervous and are shifting capital to countries with stable current account balances. The Financial Times reports:
Goldman Sachs says: "We have long argued that in times of global turmoil suppliers of capital are poised to outperform countries in need of capital. However, it is only since January 2008 that we have seen the current account theme really gain momentum in the FX market."

Risk Control

Controlling risk is one of the most important ingredients of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he is willing to lose on each trade before cutting losses, and how much he is willing to lose in his account before ceasing trading and re-evaluating. Risk will essentially be controlled in two ways: 1) by exiting losing trades before losses exceed your pre-determined maximum tolerance (or "cutting losses"), and 2) by limiting the "leverage" or position size you trade for a given account size. Cutting LossesToo often, the beginning trader will be overly concerned about incurring losing trades. He therefore lets losses mount, with the "hope" that the market will turn around and the loss will turn into a gain. Almost all successful trading strategies include a disciplined procedure for cutting losses. When a trader is down on a positions, many emotions often come into play, making it difficult to cut losses at the right level. The best practice is to decide where losses will be cut before a trade is even initiated. This will assure the trader of the maximum amount he can expect to lose on the trade.The other key element of risk control is overall account risk. In other words, a trader should know before he begins his trading endeavor how much of his account he is willing to lose before ceasing trading and re-evaluating his strategy. If you open an account with $2,000, are you willing to lose all $2,000? $1,000? As with risk control on individual trades, the most important discipline is to decide on a level and stick with it.Determining Position SizeBefore beginning any trading program, an assessment should be made of the maximum account loss that is likely to occur over time, per lot . For example, assume you have determined that your worse case loss on any trade is 30 pips. That translates into approximately $300 per $100,000 position size. Further assume that the $100,000 position size is equal to one lot. Five consecutive losing trades would result in a loss of $1,500 (5 x $300); a difficult period but not to be unexpected over the long run. For a $10,000 account trading one lot, this translates into a 15% loss. Therefore, even though it may be possible to trade 5 lots or more with a $10,000 account, this analysis suggests that the resulting "drawdown" would be too great (75% or more of the account value would be wiped out). Any trader should have a sense of this maximum loss per lot, and then determine the amount he wishes to trade for a given account size that will yield tolerable drawdowns.