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Is it all over or is there more to come?

Tue, Nov 25 2008, 08:27 GMT
by John Hardy

Saxo Bank

End of month rebalancing may be one driver behind sharp moves ahead of the long US Thanksgiving weekend.

HEADLINES

Japan Oct. Corporate Service Prices out at -1.4% vs. -0.5% expected

Germany Final Q3 GDP out unchanged at -0.5% as expected

Germany Dec. GfK Consumer Confidence out at 2.2 vs. 1.5 expected and 1.9 for November

THEMES TO WATCH – UPCOMING SESSION

Events Today:

• Sweden Oct. PPI (0830)

• Norway Q3 GDP (0900)

• Switzerland Oct. UBS Consumption Indicator (0900)

• UK Q3 Total Business Investment (0930)

• UK Oct. BBA Loans for House Purchase (0930)

• UK BOE's King and others to testify on Quarterly Inflation Report (0945)

• Canada Sep. Retail Sales (1330)

• US Second Estimate of Q3 GDP an related data (1330)

• US Sep. S&P CaseShiller Home Price Index (1400)

• US Nov. Consumer Confidence (1500)

• US Nov. Richmond Fed (1500)

• US Sep. House Price Index (1500)

• US Weekly ABC Consumer Confidence (2200)

Market Comment:

Currencies followed the pattern one would generally expect lately as Wall Street staged another sharp and impressive rally that saw the averages up as much as 17% from Friday's lows. EURUSD and EURJPY slammed higher and the commodity currencies were the star performers, with USDCAD swooning as much as 400 pips on the day. JPY crosses were the hardest hit as one might expect.
Now, with the first layer of resistance breached, we try to determine how long this move can extend. Countertrend rallies are difficult to gauge and difficult to trade. Our overwhelming conviction is that the world is headed for more trouble in the medium term and that we still haven't priced in the extent of economic malaise and deleveraging still in the pipeline. Paulson and company are busy trying to focus on the consumer now that it is clear that the liquidity injections are stopping at the vaults in the banks and not reaching out to consumers. Let's see what they try to cook up next.

The UK's Darling was out with the UK pre-budget report yesterday, which, as we mentioned yesterday, contains an odd mix of promises to stimulate the economy through various short term measures but also talks up plans for fiscal austerity down the road to stem the avalanche of red ink that the shortfall is tax revenues will generate. The expected plans to cut taxes on companies' foreign dividends were also a part of the report. All of this seems to be an effort to ensure foreign holders of large amounts of sterling not to liquidate their holdings as the UK fiscal situation looks precarious at best in the years to come. Looking at the EURGBP cross, it doesn't appear that investors are especially comforted so far, and we would need sub 0.8330 level to even discuss the idea of a rebound in the pound.

Our conviction is that EUR is still way over-priced in the bigger picture. When these bouts of risk willingness hit the market, it seems that EUR should be a much smaller beneficiary than it was in the kind action we saw yesterday. Yes, EUR was not as strong as the commodity currencies at times yesterday, but it should underperform more than it has and some of its strength in the big picture is simply due to premium the market places on liquidity and the fact that much of the EM trade is versus the Euro. Eventually, the EUR could face a more extended bout of weakness: if there is anything that the past rounds of banking system problems have shown us, it's that European banks were as bad as or worse than their US counterparts, but that disclosure only comes later. Many have estimated that the large European banks are even more leveraged than their US counterparts, so we can only watch and wait for the next cracks to show. Yesterday's German IFO survey was brushed aside by the market, but it was far worse than expected at 85.7, showing the worst Business Climate sentiment in 15 years and close to the record low just below 85. We also should expect that ECB rates will quickly come into line with BOE and Fed rates, meaning the meeting next week should see at least 50 bps of easing (and ought to see 125 bps, but the ECB has been dragged kicking and screaming all the way....).

On the technical side, our model of the situation suggests that this is a classic rally within a bear market. Using the US S&P500 as our global proxy for intermarket action (JPY crosses, major USD crosses, etc..) the maximum this rally can extend and still remain in the "comfort zone" for our expectations is around 900. This could correspond with EURUSD trying up toward 1.3250 or even 1.3400 on a blow-off and EURJPY perhaps toward 130.00 again. Considering our jaundiced view of the situation, though, we would prefer to wait for signs of a reversal and look for ways to short this rally in risk appetite. The first signs of a reversal come in around 1.2715 on EURUSD (that pesky 21-day moving average) with a more profound reversal evident if the pair trades below 1.2600. Those levels could change slightly if we go on to etch new highs in the short term.

Some have suggested that the moves here late in the month (later than it actually looks because the US Thanksgiving holiday means that most workers are off on Thursday and Friday, so for US markets, the month effectively ends tomorrow.) are due to portfolio rebalancing, an idea we talked about late last month, when the market rallied furiously in the last four days of the month. To repeat the idea is that you buy more of the assets that have underperformed (stocks in October and November), and sell more of the assets that have outperformed (especially bonds in November) in order to get the correct percentage allocations in your portfolio.
We would suggest that having been bitten once by rebalancing in October (anyone doing the above enhanced losses dramatically in November), the effect could be far smaller this month. This means that the situation should clear up by Monday on whether this is a sucker rally or a one that has longer legs.

Charts:

EURJPY
A sucker's rally or something we can hang our hats on? Tough call, but we suspect that while there is some chance the rally could extend, the time horizon for any such rally would be very compressed. Those looking for a reversal (us, for example), should look with interest at the 123.70 level, the recently omnipotent 21-day moving average, though a more credible reversal sets in if the pair swoons back below the 122.00 area. The first big upside resistance above the overnight high at 126.10 comes in around 131.00

EURCHF
EURCHF is in a classic ascending wedge formation. Although it appears that EURCHF is in an uptrend, this formation often results in a very sharp resolution to the downside once the lines defining it are broken. This development would fit well with our bearish view on EUR, even though we are also a bit concerned about the state of play in Swiss banks (it's all a question of which currency you hate least these days it seems)

Published on  Tue, Nov 25 2008, 08:36 GMT