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Forex Trading Strategies

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Equities sliding and long end of government bond curve rallying

Tue, Nov 18 2008, 07:30 GMT
by John Hardy

Saxo Bank

Market mood sours after Citi announces huge job cuts and markets can't find positive spin. Should AUDUSD trade lower?

MAJOR HEADLINES – PREVIOUS SESSION

• Japan Q3 Housing Loans rose 4.2% YoY

• Japan Oct. Department Sales fell -6.8% YoY vs. -4.7% in Sep.

THEMES TO WATCH – UPCOMING SESSION

Events Today:

• Switzerland Sep. Retail Sales (0815)

• UK Oct. CPI/RPI (0930)

• US Oct. Producer Price Index (1330)

• US Sep. Net Long-term TIC Flows (1400)

• US Treasury Secretary Paulson, Fed's Bernanke to Speak (1430)

• UK BoE's Beasley to Speak (1545)

• US Nov. NAHB Housing Market Index (1800)

• New Zealand Q3 Producer Prices (2145)

• US Weekly ABC Consumer Confidence (2200)

• Australia Sep. Westpac Leading Index (2330)

• Japan Sep. All Industry Index (2350)

• Australia RBA's Edey to Speak (0350)

Market Comment:

It's looking like crunch time for equities again after the US had a second session in a row when the action simply collapsed into the close with no apparent trigger. Bears are understandably very nervous after last Thursday's whiplash 11%+ rally after the S&P notched new lows below 825 (there were even rumors that the so-called Plunge Protection Team was on the loose to prop up the markets artificially, but our guess is that traders were more likely seeing their own shadows). It is clear, in any case, that for the next, more sustainable move in risk aversion to take place, we will need the indices to close at new lows after two failed breaks in recent weeks.

A key confirming indicator that the market's view of the future is souring more and more is the long end of the major government bond market, where prices seem to keep marching higher and higher (yields falling lower and lower). We eye the 4.00% level on the US 30-year T-bond as being the medium term game-changer for the long end as an asset class. Three attempts below this level have all been driven back earlier this year, but the yields also always fail to rise back above 4.50%, so something has to give soon one way or another. Everyone has been bearish on the long end of the curve as the market nervously eyes the magnitude of the various bailout packages in circulation and wonders how the governments will ever repay. The most popular macro trade has been curve steepening trades (buying bonds on the short end of the curve and selling bonds on the long end). Could there be a huge unwind out there in short duration trades? If so, this would continue to support JPY, USD and even CHF, which has looked a bit too weak lately, especially vs. the EUR.

Looking at the action in AUDUSD, we wonder if the market is being artificially held up by the fear of RBA intervention. These fears may be overrated, as the RBA is no BoJ in terms of its potential firepower, and as we have stated in the past, the RBA is likely more interested in defending the AUD when the action gets too volatile on any given day rather than picking specific levels (as if stealing a page from our notes, the RBA even explicitly state overnight that "FX intervention not designed to defend any particular level in AUDUSD", so there is nothing significant at all about the 0.6350 level were the bank was rumored to have intervened recently. Any further bout of risk aversion is likely to see AUDUSD testing toward 0.6000 again. Still, traders may want to be quick to take profits intraday as volatility increases.

The pound finally gained a more secure footing yesterday after recent precipitous declines, but the move was probably mostly driven by over-positioning after the post G20 action failed to provide a further meltdown. 1.5060-80 looks like a key resistance area, though if it doesn't hold, the pair may have a go at the old low at 1.5270. We can only see position unwinding as the driver for GBPUSD upside and prefer selling strength at all turns as long as risk aversion is the theme.

We remain nervous about our view that risk aversion will continue, as momentum has come out of the market in places and we do admit the possibility that the market could lurch into some kind of volatile range-trading environment in the short to medium term.
But there is simply nothing out there that one can put a positive spin on and we fear that another round of liquidation is the greater risk. We also feel that the persistent rally in the long end in government bonds is a strong wind at our back in this view. If that were to reverse, then we would be happy to re-evaluate the short term setup. We prefer to use short EUR positions to express this view.

Chart: EURJPY

This is one of the more potent trades in an environment of easing interest rates and falling equities (in other words, broad risk aversion). The pair seems to have become stuck in range lately, but it feels like we are nearing a decision point in which we either see a strong rally through the 21-day moving average that further neutralizes the chart in the short term and extends the expectations for further range trading, or a sharp sell-off through the rising line of consolidation that could set up new lows for the pair. We prefer the latter scenario, but would like to see a drop through the 120.00 area and the line first.

Published on  Tue, Nov 18 2008, 07:33 GMT