By Michael Trinkle, ForexTraders

Two of the most powerful people in the world will speak Thursday morning concerning the global economic outlook.  The EUR/USD has moved up slightly during the London session on the heels of positive bond auctions in Spain and France; however, the market was unable to bid prices up beyond yesterday’s HI’s at 1.2855 as investors wait for European Central Bank President Jean-Claude Trichet to speak at 8:30 am and Fed Chairman Ben Bernanke at 9:00 am.

Although today is heavy with key risk events, the market may not break out of its trading range until the Non-Farm Payroll release tomorrow morning.  NFP tends to be one of the most revered key leading indicators of economic health, and the market may be hesitant to commit to large directional positions before the NFP confirms economic direction.

Trichet

As stated, the euro found strong support this morning as a result of strong bond auctions in France and Spain.  Strong bond auctions are expected in France, but the market is still watching Spain, Portugal, Greece, Italy, and Ireland very closely.  For several months now, we have been writing about the possibility of the EuroZone Debt Crisis re-emerging this fall.  One of the leading indicators that will show the EuroZone is again in serious trouble will be when and if these struggling countries face difficult bond auctions.  As of yet, there is still plenty of investor demand for these bonds, but if the fiscal concerns do become serious enough that investors are unwilling to buy Greece, Portugal, Spain, Ireland, or Italy’s bonds, then there will most likely be a huge bout of risk aversion that sweeps the market once again.

European equity markets remained subdued even in light of the positive bond auctions as investors were unwilling to bid prices up before Trichet speaks this morning.  The market will be watching and listening closely to see whether Trichet formally commits to extending liquidity to help the European banking system.  GDP blew past market expectations in the 2nd quarter.  The expected figure was 0.7%, and the actual figure came out at 1.0%, which was quite surprising considering the systemic problems the EuroZone faced during the Q2 with its Debt Crisis.  However, Germany was able to benefit enormously from a cheap euro as its exports were much more attractive to foreign buyers, and that increased exporting activity in Germany helped overall EuroZone GDP tremendously.  Now, many economists are concerned that economic growth will slow significantly in Q3 as the euro has strengthened during the last 3 months.

Trichet is also expected to cast a cautious tone concerning economic outlook, but traders will be listening closely for any new verbiage or departure from his normal mood of cautious optimism.  Trichet has also been championing fiscal austerity in developed nations, saying that countries such as the U.S. should turn to decreasing government spending.  Interestingly enough, Fed Chairman Ben Bernanke is actually about to the do the exact opposite as he and the rest of his Board Members at the Fed are currently preparing to inject another round of fiscal stimulus into the U.S. economy.

Bernanke

Today, Fed Chairman Ben Bernanke will be testifying before the Financial Crisis Enquiry Commission in Washington DC.  Bernanke’s testimony comes in 2 parts:  a written, prepared statement and an open Q&A session with the Congressional board.  The prepared statement does not generally move the market as most of his verbiage will most likely be as expected, but during the Q&A, his answers to tough questions oftentimes offer a clearer picture to investors concerning the Federal Reserve’s next steps.

The most likely scenario in the United States is that the economy will enter into a prolonged period of very sluggish growth.  Mr. Bernanke has been communicating this view consistently, but he is concerned that the very sluggish growth could pull the U.S. into a deflationary period, which can be disastrous for an economy and can lead to a decade or more of virtually no economic growth.  This fear is why Mr. Bernanke and the Federal Reserve are seriously considering yet another round of quantitative easing.  They are willing to do anything to stimulate the economy back into robust growth.

Market Price Action

Yesterday, we mentioned the euro was beginning to put pressure on resistance to the upside.  We currently have some very fascinating price action beginning to develop between the euro, pound, and dollar.  Generally, the EUR/USD and GBP/USD move in very tight correlation.  However, we have been seeing that correlation break down over the last few days.  This morning, U.K. Nationwide HPI came out below the market expectation of -0.3% at -0.9%.  This surprise to the downside led the pound to move lower in the immediate aftermath of the release and then to drift sideways and lower throughout the London session.
 
On the other hand, the euro has again moved to the upside during the London session today.  The economic outlook and Central Bank leaders in the U.S, U.K. and EuroZone are diverging.  In the EuroZone, Trichet is by far the most hawkish concerning interest rates and monetary conditions, and the EuroZone is also posting pretty good economic data relative to these other countries.  Therefore, the euro is beginning to move higher, and if economic data continues to back up Trichet’s decisions, we could see the euro move up quite a bit versus both the dollar and pound in the coming weeks.

Of course, the elephant in the room concerning the EuroZone is the possibility that any day the EuroZone Debt Crisis could begin to erupt again, but currently those fears seem to be on the backburner.  If the sovereign default concerns in the EuroZone can remain contained, then the euro could move up quite nicely in the next few months.

We have been calling for a huge drop in the euro at some point in the latter part of 2010, but the reality is that will most likely not happen as long as the Debt Crisis remains under control.  As a trader, be on the lookout for the first signs of major fiscal trouble in struggling EuroZone countries.

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By Michael Trinkle, ForexTraders

After nearly 2 weeks of trading within a tight 150 pip range, the euro broke upside resistance at 1.2780 during the London session early Wednesday morning.  The euro actually broke through 2 key swing HI’s on the hourly chart as it broke to the upside, so we could see further euro gains in the coming days.  
 
In this chart, you can see the two clear swing HI’s in the green-shaded boxes that the euro broke above in order to post new HI’s this morning.  Then, the euro continued to push higher in early New York trading as buyers bid EUR/USD up to the 1.2850 area.  The euro will face heavy resistance in the 1.2900 area and should see sellers protect the area initially.  If the euro moves higher during the NY trading session and pressures the 2900 level, there may be very strong selling interest today.  The euro has already moved beyond its daily range at the start of the NY session, and when a currency pair is overbought as the euro is today, it oftentimes has strong difficulty breaking through key areas of support and resistance.

The push from 1.2800 to 1.2850 during early NY trading was due to the ADP Employment figure that came out at 8:15 est.  The number was a big disappointment as it posted at -10k versus the expected figure of +15k.  This means there was a loss of 10,000 jobs instead of the expected gain of 15,000.  The focus in the United States is heavily on employment figures.  The very poor labor market conditions are weighing on economic recovery and this number today is yet another confirmation that the U.S. economy is really struggling.  Economists and investors know this, but each disappointing figure just makes it worse.

The ADP Employment number can also be a leading indicator for Friday’s Non-Farm Payroll, and if it is in this case, we could see a very strong bout of risk aversion enter the market.  The question is which direction will the Dollar go?

Case for Dollar Weakness

Generally, when U.S. data comes out very poor, the Dollar tends to get strong as investors rush into the safety of the U.S. Dollar.  Then, as U.S. data comes out good, investors tend to sell the Dollar as they rush out of the low-yielding Dollar and into higher-yielding currencies.  However, during the last 3 months we have seen this correlation break down.  During the months of June and July, market participants aggressively sold the U.S. Dollar as key economic data came out negative.  Let’s break down why this has been happening.

The current global recovery is facing a major wall of resistance as the U.K., U.S., China, and the EuroZone are all facing uncertain financial conditions.  The U.S., however, seems to be facing the most difficulty at the moment.  China is still moving forward in very strong fashion, they are simply going through a period of slower than usual growth.  The same seems to be true in the U.K. and the EuroZone.  The U.S. is in a different place, though.  In the U.S., the threat is not only an economic slow-down, but an actual economic contraction.  Key economic indicators seem to be pointing to a possible double-dip recession in the United States, and some economists are beginning to predict that the Q3 GDP may read negative in the U.S.  Two consecutive quarters of negative GDP constitutes a recession.  Since the U.S. is really facing this potential threat alone, investors are beginning to raise the possibility of selling the U.S. Dollar as U.S. news continues to come out negative.

If this phenomenon continues, it could serve disastrous for the U.S. Dollar.  Investors have long been not interested in holding the Dollar during good times because of the incredibly low yield offered.  However, the market has tended to hold the Dollar during bad times since investors want the safety of their capital above everything else.  What will happen if the U.S. heads into economic contraction and other developed nations do not?  How will this affect the U.S. Dollar?

Most likely the U.S. Dollar will weaken significantly because there will be no reason for investors to hold it.  This could be the beginning of the great U.S. Dollar bear run that many economists and experts have been predicting for some time.  We have seen hints of this phenomenon unfold during June and July and we have seen it again today.

Case for Dollar Strength

Unfortunately, it seems that the only case for real U.S. Dollar strength during the 2nd half of 2010 and into 2011 is if the global economy slows significantly.  Currently, investors are unsure of the economic outlook.  There are many mixed signals in the market, and the economic outlook is probably more uncertain right now than in recent history.  At the beginning of The Great Recession, at least investors knew we were in trouble.  Now, no one is sure.  Are we going to rebound and move up from here, or is there still significant downside risk?  Of course, there is downside risk, but no one knows how far we will fall, if we will fall, or when we will fall if we do.  The outlook is very uncertain.

As long as the global outlook remains uncertain, the U.S. Dollar should find strength as investors are unwilling to completely depart from the safety of U.S. Treasuries.  However, if the global economy does deteriorate during the next month to several months, and it becomes clear that other countries are in the same degree of trouble as the U.S., then the Dollar should remain in bullish mode.

Lately, we have seen poor U.S. news come out, the market sells the Dollar aggressively, and then after 15-30 minutes of Dollar selling, the market reverses course and begins buying the Dollar only to retrace all the Dollar weakness and actually move into further Dollar strength within several hours.  This is what is playing out during the NY trading session at the moment, as investors remain very uncertain of the economic outlook.

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This morning the Bank of International Settlements released its Triennial FX survey which is basically the market’s benchmark for forex volume and turnover. To no one’s surprise, volume has surged over the past 3 years. Between April 2007 and April 2010, global foreign exchange market increased by 20 percent from $3.3 trillion to $4.0 trillion, which is now the golden number for forex volume.

Reading between the lines, we can tell that a large part of the increase in volume is due to the trading activities of RETAIL traders! (Yes, we are making a BIG difference) According to the BIS report, 48% of the growth was in spot transactions which represents 37% of the total turnover (or total FX flow). Although swaps became more popular to trade, all other related foreign exchange instruments saw only a 7 percent increase in volume. The report also says that “the higher global foreign exchange market turnover is associated with the increased trading activity of “other financial institutions” (think retail forex brokers). Turnover in this category rose 42% and for the first time ever, reporting dealers (banks) did more transactions with “other financial institutions” than with other banks.

Having just come back from Singapore where shelves and shelves were filled with forex trading books, I am in no way surprised that the BIS has confirmed the popularity of forex trading.

The foreign exchange market also became more global with cross-border transactions representing 65% of trading activity in April 2010, while local transactions account for 35%.

U.S. Dollar Becoming Less Important

Back in 2001, the U.S. dollar was involved in 90% of all currency transactions and as of April 2010, this fell to 84.9%. The decline in trading of dollars has benefited the euro, which gained 2 percentage points in market share since the last survey and accounts for 39% of all transactions. “The Japanese yen also increased its market share by 2 percentage points to 19%, a recovery relative to the 2007 survey but still below its peak of 23.5% reached in 2001. The pound sterling gave up most of its post-euro gains, with its share returning to the immediate post-euro level of around 13%. Trading in the Swiss franc also declined marginally to 6.4% from 6.8% in April 2007. The Australian and Canadian dollars both increased their share by around 1 percentage point, to 7.6% and 5.3%, respectively.”

“The percentage share of the US dollar has continued its slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained relative to April 2007. Among the 10 most actively traded currencies, the Australian and Canadian dollars both increased market share, while the pound sterling and the Swiss franc lost ground. The market share of emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won.”

Of the major currency pairs, trading of EUR/USD and USD/JPY have increased while trading of the GBP/USD has decreased.

The U.K. is still the largest trading center for forex but the relative ranking of foreign exchange trading centres has changed slightly from the previous survey. The United Kingdom continued to be the most active location with a share of 46% of worldwide trading, followed by the United States with a share of 24%, slightly down from 2007. Outside these two centres, trading took place primarily in France (7%) and Japan (3%), both slightly down from 2007, Singapore (3%) and Switzerland (3%), both slightly up. Turnover in Germany almost halved to less than 2% in April 2010 compared with 2007. Banks located in the United Kingdom accounted for 36.7%, against 34.6% in 2007, of all foreign exchange market turnover, followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%).

Lower Forex Margin Should Temper Volume Increases in the Future

However the pace of growth will most likely be moderated by the reduction in leverage announced in the U.S. and Japan. Last month, Japan reduced leverage to 50:1 and plans to bring this down even further to 25:1 next year. U.S. regulators announced earlier this week that leverage will be capped at to 50:1 for major currencies and 20:1 for all other currencies. This will go into effect on October 18. Lower leverage will make forex trading less attractive to some participants but 50:1 is still very generous leverage by all counts and so it will not be catastrophic for the retail forex industry. We should still see retail trading contribute positively to forex volume, but probably not by the double digit levels seen in past years.

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