During last week's trading we all saw what kind of impact the earnings reports and the moves on the S&P and Dow Jones had on the currency, commodity, and bond markets... for the week ahead I expect to see the same exact themes play out as news, data, and fundamentals remain the witch's brew of choice for the big money market movers.

Last week approximately 25% of earnings were released but over the next two weeks we get the other 75%, so do not expect any change in how those events act as the catalyst in the Forex market and Forex's correlated markets. Over-the-top earnings from the likes of Goldman Sachs, Intel, IBM, JP Morgan, and Bank of America led to a 7% gain on the S&P 500 and the Dow surging up 7.3%. The strong upside gains on the US and European equity markets sent crude oil up 6%, gold up over 2%, and Treasuries to their first decline in 6-weeks.

Market participants sent their money-flows out of Treasuries and back into equities with measured conviction as we saw the yield on the 10-year note rocket up 34bps. In this weekly outlook I'm going a little more in-depth about Treasury yield curves, specifically between 2-year and 10-year notes, because the spread and yield curve between those two key debt issuances can often times reveal quite a bit about the overall risk appetite of market participants and how they gauge the potential for future growth of the US economy.

Last Thursday world famous market bear, Nouriel Roubini, gave participants yet another incentive to buy up equities and to sell the dollar and yen as he said the worst of the financial turmoil is behind us and he expects recovery by the end of the year. Although he did say another stimulus package would be required to combat the seemingly unstoppable rise in unemployment.

So, is any of this real? Are the global financial markets really recovering and is everything really fixed? I personally do not think so, I believe another tsunami wave could hit the equity, commodity, and Forex markets later this quarter or in Q4, but it doesn't matter because in this game perception is the reality... the recovery is as real as the markets want it to be and make it out to be. The thing I have to constantly remind myself is, the markets can stay irrationally exuberant for an indeterminable amount of time.

Fundamental events moving the Forex and equity markets this week:   

This week's fundamental and economic calendar is a little lighter than usual for US data but for European data there are a number of critical fundamental events that center on inflation, the consumer, production, and manufacturing.

Bernanke testimony--

For the US dollar the bigger fundamental events take place on Tuesday and Wednesday as Fed Bernanke testifies before the House Financial Services Committee and Senate Banking Committee in DC. Bernanke's testimony will be on past, current, and future Fed monetary policy (interest rates), the state of the US economy, inflation/deflation, the housing and employment sectors, the deficit, sovereign debt monetization, future stimulus measures and the prospects of a sustainable recovery on Wall St.

All markets and all participants will be watching the Bernanke testimony and reacting accordingly. Remember, back in mid-March it was Bernanke who was one of the main catalysts that stopped the plunge in the equity markets, turned the S&P 500 higher and sent the dollar falling back off the throne it temporarily inhabited. Bernanke coined the stupid phrase, "green shoots", and the markets ran euphorically with it. Recent Fed rhetoric has been positive, upbeat, and the FOMC has upwardly revised their growth and inflation expectations. 

Not all the members on those congressional committees are buying into the idea of an instantaneous recovery, especially Ron Paul and Jim Bunning. What traders need to be watching is whether the overall sentiment of these testimonies is more on the positive side or on the negative side in terms of the future prospects of the US economy because the money-movers in the equity, commodity, and Forex markets will take their cue from Bernanke's messages to congress and how those congressional committees react.

Key EUR/USD fundamentals--

• German PPI (Monday 0200 EST)
• Fed Lockhart speech (Monday 1330 EST)
• Fed Bernanke testimony (Tuesday 1000 EST)
• Eurozone Industrial New Orders (Wednesday 0500 EST)
• Fed Bernanke testimony (Wednesday 1000 EST)
• House Price Index (Wednesday 1000 EST)
• Crude Inventories (Wednesday 1030 EST)
• Initial Claims (Thursday 0830 EST)
• Fed Tarullo speech (Thursday 0930 EST)
• Existing Home Sales (Thursday 1030 EST)
• German Manufacturing and Services PMI (Friday 0330 EST)
• Eurozone Manufacturing and Services PMI (Friday 0400 EST)
• German IFO (Friday 0400 EST)
• Michigan Sentiment (Friday 0955 EST)

Pound sterling fundamentals--

I don't usually talk about the GBP much but after looking at the UK fundamentals I see there are a few events that carry a lot of market-moving potential. If you trade the pound sterling you'll want to be aware of the following fundamental events:

• M4 (Monday 0430 EST)
• BOE/MPC Meeting Minutes (Wednesday 0430 EST)
• Retail Sales (Thursday 0430 EST)
• BBA Mortgage Approvals (Thursday 0430 EST)
• Preliminary GDP (Friday 0430 EST)   

Also, both the BOJ and RBA release their monetary policy meeting minutes on Monday. On Tuesday the BOC has an interest rate event and monetary policy statement and traders will want to watch out for any rhetoric from the BOC to cool the CAD down. It can't really be possible to slow the CAD's appreciation as long as the S&P 500 and crude oil continue gaining but the BOC probably isn't too happy with the sharp reversal of the USD/CAD, so there is always a potential the BOC could do some verbal intervention this week.

Equity earnings reports--

Unless you've been on holiday or hiding in a cave I'm sure you're well aware of how the various earnings reports on Wall St. are moving the markets. We got just a taste of that last week and the response from market participants was resoundingly positive. Of course it's possible there's no real conviction behind the strong upside gains as volumes have been lighter overall. Plus, the potential always exists that the smart money is just waiting for higher prices to grab short positions to ride the next down move, but either way, as long as earnings meet or exceed expectations, the S&P 500, Dow, crude, and gold should continue higher while the dollar and yen remain pressured.

All week long, both before and after the bell, there are a massive amount of earnings reports scheduled for release and from big household names like Texas Instruments, Caterpillar, Coca-Cola, DuPont, Apple, Morgan Stanley, Wells Fargo... too many to even list. You can check the schedule here.

What this will likely translate to is a good deal of choppy and erratic price action on the S&P 500 futures and S&P 500 cash market, the Dow/Dow futures and then of course back into the currency market. The Japanese yen has shown extreme sensitivity to the moves made on the US and Japanese equity markets and I expect that trend to continue this week. The EUR/JPY is the benchmark currency pair that's most correlated to the S&P 500 futures and S&P 500 cash market while the GBP/JPY is moving in tight correlation with the Dow, Dow futures and USD/JPY. So, if you trade the majors and yen crosses this week be mindful of what's happening on Wall St. and with crude oil.

The yield curve and interest rate spreads -- future predictors:

The business of predicting the future of any tradeable market is mostly an exercise in futility, especially under the current environment where there is zero established trend and where the vast majority of participants alter their money-flows based on news, data, and emotional impulses.

A few weeks ago the upside break of a big moving average failed equity bulls and then a downside technical pattern failed equity bears, leaving many on Wall St. scratching their heads and hopefully a few figured out that stuff has zero to do with what moves markets. Participants who are purely fundamental have done a little better but even the strictly fundamental folks like Nouriel Roubini and Marc Faber are now changing their tune and I think they are doing so based on the trend of better headline economic numbers. But that's also a very dangerous game to play...

As fundamental as I am, I don't exactly trust any data that comes from a central bank or government agency. The way the data is compiled is a joke, it's unreliable, and beside all that, who can trust a politician or a central banker?   

In my evolution as a trader and during my quest for education on how to better understand the global financial markets and what they may do in the future, I'm learning to lean more on the bond market. Specifically, on how to use the relationship between the 2-year and 10-year Treasury note... how to gauge the future of the markets by monitoring the yield curve between 2's and 10's and what's happening with the spread between interest rates.

Yield curve--

Before I go any further I want to be clear that I am no expert on this stuff, I'm still learning and trying to gain knowledge in this regard, but I'm excited enough about this market correlation that I wanted to share it so other traders who want to learn the underlying fundamentals of what really moves markets can begin learning too. I'm a simple person so this will be a very simple explanation...

The yield curve is just a basic graph with a line that represents the difference in yields and the time in which the particular debt issuance matures. The benchmark yield curve for the financial markets is between Treasury debt that matures in 2-years and 10-years. 2-year notes are considered a shorter dated maturity and the 10-year note is considered on the longer end of maturity in addition to being most closely correlated to the US housing and mortgage market. In general, the longer the date of maturity, the higher the interest rate yield should be.

When analyzing the yield curve, market participants look at the slope of the curve, whether it shows a pattern of more of an upward or downward slope. Under most markets conditions the slope or shape of the yield curve should always be up or positively sloped. A down slope or inverted slope is an extraordinary situation, but we'll get to that in a bit.

How the yield curve and spread between the interest rates of 2's and 10's can be used in a predictive manner is based purely on the actual factor that determines the yield curve -- future expectations. Interest rates are the #1 key driver of all markets and the prospect of future interest rates are the #1 key driver of money-flows in and out of the Forex, equity, commodity, and bond markets.

Yield curve and economic growth--

When it comes to interest rates, market participants always put a risk premium on the future of rates. When the yield curve positively and upwardly steepens that is a sign that a greater majority of market participants have future expectations of better and rising growth. As the sentiment of market participants becomes more euphoric, more hopeful, and more positive, the yield curve steepens to the upside. This means interest rates are expected to rise because growth and economic expansion is expected.

But, with better growth and economic expansion comes the prospect for rising price pressures and greater price-related inflation. Because longer dated maturities like the 10-year devalue under an inflationary environment, market participants will force the Treasury to pay a better yield in order to take on the risk of holding a debt instrument that may devalue due to inflation. With growth comes higher rates, higher inflation, and therefore higher yields must be returned.

Yield curve and Forex--

If you see an upwardly steepening yield curve between 2's and 10's what you can glean from this is the market telling you the prospects for better future growth are rising. And what happens when prices go higher and inflationary price pressure tick up? Simple, higher prices equate to higher equity prices, higher commodity prices, lower bond prices and higher bond yields and all that translates into a weaker US dollar and Japanese yen.

Whether Wall St. admits or not, they absolutely, positively need price inflation and higher prices, and whether or not Forex traders realize it, higher equities = higher crude and higher crude + higher equities = lower dollar. Very simple.

Just last week the interest rate spread between 2's and 10's rose by a healthy 25bps. That means the yield curve between 2's and 10's upwardly steepened and maintained a positive upward slope and look what US equities did... they all gained 7% or more and the US dollar fell. If the trend of steepening yield curve between 2's and 10's remains intact I would expect to see the S&P 500 and Dow continue making gains while the dollar and yen stay pressured lower.

Inverted yield curves--

When the yield curve inverts or starts falling sharply or makes an extended downward pattern that is a sign of fear in the markets. If market participants think the economy is going to tank or fall back into a recession, the yield curve will invert. When market participants think there will be a season of devalued interest rates, which is a sign of slow or falling growth, the yield curve will invert. Also, if participants see much more deflation than inflation the yield curve can invert of slope downwardly. There is historical evidence that shows the yield curve will downwardly slope or become inverted a year or more before a recession hits the economy.

Now, this is a very rudimentary explanation of the yield curve and interest rate spreads and I'm sure there are much more in-depth commentaries on this issue, but my point is to encourage traders who want to get away from the unreliable lagging indicators to look at more reliable leading indicators for future moves in the markets.

Nothing is perfect or foolproof, but watching the 2's and 10's is something I plan on doing more in the future. Right now the future of any market is impossible to predict as participants are mostly running on the emotions of fear and greed and speculation of all sorts. I personally think we're in a deflationary environment but if the prevailing sentiment is that we're moving towards an inflationary environment then I need to trade accordingly because if that is what the market thinks, the market is always right.

Trading:

This is going to be another wild week filled with volatile price action, erratic price swings and generally choppy conditions. There is a lack of participation and a lot of very thin liquidity volumes in the Forex market, therefore, the price action in FX will be largely dictated by what's happening in equities and commodities. I expect the market to remain a very challenging environment to trade in this week.

All the markets will be opening and starting the week at elevated levels. Last Thursday the S&P 500 futures and cash market made one solid attempt at sustaining a break above the 940 level and unless we get some downside surprises fundamentally or geo-politically, I'm expecting to see 940/950/970 levels tested. The first week of June saw the S&P 500 make an attempt at busting through 950 but then crude oil fell off a cliff leading to an equities sell-off and boost of the dollar.

If crude oil can get back over $70 and make a run at $75 we shouldn't rule out the S&P 500 making a run to 980 or even 1,000. In that scenario the dollar would be under considerable downside pressure along with the yen. But in order for that type of scenario to play out, the news and fundamentals have be strong, the earnings have to exceed expectations and Bernanke and the Fed have to keep talking up the markets.   

In my view, Wall St. will remain the center of the financial universe and where participants in all markets will take their cue. Trying to even put a fundamental basis on price valuations for the euro, dollar. pound sterling, or yen is basically a waste of time at this point because their respective price valuations will be largely be based on risk appetites and sentiments in equities and commodities.

That's all I've got for now. I should be able to get back into the chat sometime mid week or as time allows. Have a great and profitable week and happy trading.

-David

The return of euphoria:

Good earnings, hot consumer price inflation, and a textbook short-squeeze scenario skyrocketed the S&P 500, Dow, crude oil, and gold while sending the US dollar Index sliding below its support, droppingdown to the 79.50 level and closing for a 1% loss.

The good news for equities, commodities and higher-yielding currencies... CPI made its biggest jump in 7-months while the key Core CPI showed a 1.7% gain year-over-year. CPI and Core CPI showed stronger upside price pressures in contrast to the latest PPI report released yesterday.

I don't have time to cover everything, but in general the news from all sides was positive and upbeat today... everyone from Intel, to the credit card issuers, to the Fed all hitting the markets with happy and optimistic rhetoric. In the FOMC minutes the Fed said the end of the recession is in sight and they raised their forecast for inflation which the market reacted to positively.

The short-squeeze factor is fairly cut and dry... when you take the rise in points and percentages of the S&P 500 and Dow and compare them to the trade volumes, it's clear today's strong gains were made on historically low volumes which is a signal the bears were forced to cover their shorts and actual buying conviction was somewhat lacking.

I'm not crediting all of today's gains on Wall St. to a short-squeeze but consider just a few days ago the masses were screaming about a so-called "head and shoulders" pattern that was supposed to mean equities were going to nosedive but ever since then they have gone up. It's the same exact scenario from a few weeks back when the masses were going on about equities breaking above their 200-day moving average and then they tanked, causing the bulls to cover their trades.

The EUR/USD held a very strong positive correlation to equities, crude oil, and especially gold. At 0130 EST Wednesday morning both the S&P 500 futures and spot gold reached a bottom and moved up strongly and that was the point the EUR/USD turned up and never looked back. Commodity currencies like the USD/CAD and AUD/USD also benefited mightily from strong gains in crude, gold, and equities, moving a few hundred points to the upside.

From the looks of things, as long as the news stays good, the numbers beat expectations, and the fundamentals do not shock to the downside, the euphoria will continue. I'm not about to predict when it will end and I'm not exactly sold on the idea of an almost instantaneous recovery of the global economy that took five years to destroy, but no matter what, the markets are always right... tomorrow is a new day and anything can happen.

Rome is still burning:

Apparently the Fed and FDIC are still operating in the "too big to fail" realm... CIT, one of the biggest commercial and consumer lenders in the US, is about two steps away from a total collapse. Unless the government saves the sinking ship, CIT will lose its own access to credit and funding, will default on its debts and will be unable to operate. Somehow the market's attention has been mostly diverted away from this situation but when you consider how big and how important a player CIT is, the situation looks dire and could have far-reaching affects.

CIT lends and offers funding to a base of over 1-million commercial and consumer customers. They have a big retail customer base of over 300,000. Just through the Small Business Administration, CIT made almost $767 million in loans last year, and as of March CIT had $1.5 billion in available credit lines for its customers. Back in December the Fed gave CIT a $2.33 billion bailout. In the past 2-years CIT has lost well over $3 billion. So, where's all the money at and why are they on the brink of bankruptcy?

CIT has been around for about 100-years and they used to be the #1 independent commercial lender in the US and the root of the problem lies within their ability to service their own debt and creditors. In exactly one month CIT has a $1 billion debt obligation to meet and they can't do it, they will default unless the Fed and FDIC bail them out yet again.

If CIT does fail, the impact on the already battered retail, manufacturing and small business sectors could be brutal. We're talking about more job cuts and more bankruptcies in those sectors. CIT cannot get credit because their credit ratings have been slashed but they need credit to meet their debt obligations... that is the net bottomline issue for CIT.

I am expecting CIT to get another bailout and we should probably hear a resolution within the next 24 to 48-hours. Once again the US taxpayer will have to cover this one. At this it seems like the market could careless, they are too busy riding the earnings euphoria wave but should CIT's bailout fall through for some reason, it's very possible the markets react negatively to this situation.

Thursday trading:

Once again, Wall St. will remain the center of the universe tomorrow as both the Forex and commodity markets take their cues from how the S&P 500 and Dow indices are moving. There are a ton of earnings reports being released before the bell on Thursday morning, including JP Morgan. After the bell there are two monster reports from IBM and Google.

Tomorrow's big fundamentals are mostly out of the US and include Initial Claims, TIC, and the Philly Fed. If the data is bad it will likely be ignored as long as the earnings look good and there are no big downside surprises. These markets are all about confidence and fear... the news and data is giving the confidence and those that were looking for equities to roll over based on a technical pattern are trading on fear, so they have to keep covering their shorts and that will push prices higher.

For Thursday, the fate of the yen and dollar and their higher-yielding counterparts will be squarely on how the S&P 500, crude oil and gold move. Back between 2-June and 11-June the S&P 500 futures run after run at the 950 level and each time it failed to sustain above there and move higher. For what it's worth, unless the emotions of the markets suddenly change based on some bad news or fundamentals, I believe we are headed back to test that resistance zone. A sustained break of the 950-970 levels would put the S&P 500 in somewhat unchartered territories and then things would get very interesting. 

I've been doing a lot of watching and waiting so far this week, I don't like to trade or put much risk into markets that are running on pure emotion as the downside reversals can come just as quickly and violently as the upside gains. If in doubt, sit it out... there will always be another opportunity to trade in the future. 

One event I will be closely monitoring and which could impact the markets is former Treasury Paulson's testimony before congress. Paulson is a flatout liar and crook and was one of the chief architects of not only the economic meltdown but most of the major bailouts courtesy of the taxpayer. I believe his testimony is set to begin at 0900 EST or sometime there after. Paulson will stick with his lying ways and nothing will get resolved but at least it will be fun to watch him get emotional when congress grills him. 

Finally, as I've mentioned a few times in the prior updates, it's important to keep up with the bigger Chinese fundamentals as a lot of focus and attention is on China and China's ability to help end the global economic recession. At 2000 EST this evening we get Chinese GDP, Industrial Production, CPI, and PPI. Somehow the Chinese data will almost always magically meet or beat their forecasts, so if we get some hot numbers out of China we could easily see the equity futures rise, the Nikkei jump and more downside pressure get put on the dollar and yen.

Take care and happy trading.

-David

Markets make modest gains on mixed inflation and retail data:

Although the S&P 500 posted a 0.5% gain and the Dow closed up 0.3%, the price action in the equity, Forex, and commodity markets were fairly muted as each market moved in tighter ranges with overall sloppy and choppy price action. The earnings news from Goldman Sachs did little to excite the markets as it became apparent that participants bought the rumor yesterday and sold the fact today.

As I mentioned in last night's update, the markets would want to see higher inflation numbers and better retail sales in order to move up today. The PPI, Retail Sales, and Business Inventories data were quite mixed from an inflation perspective... although the headline numbers gave the appearance of price pressures and some recovery in the consumer sector, once the curtains were pulled back there were obvious signs of lingering deflation. So, because there was no clear view that inflation or the consumer was back in full force, equities, commodities, and the higher-yielding currencies were only able to make minimal gains.

Signs of lingering deflation--

The headline numbers on today's PPI and Retail Sales were inflationary enough to give the S&P 500 and Dow a boost and the dollar and yen a kick lower, but after dissecting the data, the inflation components hidden within the reports were nothing to write home about. When it comes to interpreting fundamental and economic data, the headline numbers get most of the attention but big players who move the markets with their money flows always look beyond the headlines to find the real "truth", if you can call it truth.

If there were true inflationary components within the data, Wall St. would have rallied and made bigger gains on Tuesday along with crude, gold, and higher-yielders like the EUR/USD and GBP/USD, but the gains were very muted. Lets take a look at made today's fundamentals less exciting than they looked on the surface...

PPI and Core PPI: the headline numbers on those reports printed hotter than the market was forecasting but it was all due to energy. The crude price component to PPI was up by 6.6% and that was purely based on the fact crude oil hit $72 in June. The food price component was up by 1.1%, but once you look past that, with all other price components factored in, PPI is actually down -4.6% year-over-year and that number screams deflation. 

It would be a totally different story if consumer demand was forcing producers to raise prices at the wholesale level but this is not the case at all, the slight month-over-month increase is all connected back to energy and not rising consumer demand. With PPI at -4.6%, it's hard to see any true price inflation within the data.

Retail sales: the headline numbers seemed decent but once you look under the hood it's plain as day the consumer is dead from a discretionary spending standpoint. The main reason the retail data looked not-so-bad was thanks to gasoline prices rising by 18.5%, home heating oil jumping 15.4% and propane going up by 14.6%.

Consumers were forced to pay more for non-discretionary retail products, they weren't out running up their credit cards at the shopping malls. In fact, retail sales are down a hefty -9.0% year-over-year. And once you back out what the consumer spent on energy and autos, retail sales were actually down -0.2% from just the prior month. The news gets even better... department stores reported a -1.3% drop on their retail sales.   

Business Inventories: this report probably gets neglected by the larger segment of the market, but once again, the big players who move the markets break this report down too because it offers a great view on inflation/deflation. Unfortunately, these fundamentals were more deflationary than inflationary. According to the Commerce Department, Business Inventories dropped by -1.0% month-over-month.

Why would a drop in inventories be deflationary? It's simple, less demand forces the reduction of on-hand goods and that is purely deflationary. The report also showed that business sales were lower by -0.1%, and manufacturing sales were -0.9%. Going back to the retail sector, retailers decreased their inventories by -1.6%. Manufacturing inventories fell by -0.6% and wholesaler inventories were -0.8%. And when you break it all down, the report showed business inventories have contracted for 9-months straight and are down -8.0% year-over-year while business sales are down -17.8% year-over-year.

Price inflation may be here sometime in the future but at this point I don't see it around the corner or on the horizon, not with those kinds of numbers. Wall St., crude, gold, and the higher-yielding currencies flat out need inflation to make sustainable upside moves and at this point it just doesn't exist.

Wall St. earnings data will continue moving equity and Forex markets:

As I sat down to write this update Intel released their earnings, which came in much better than expected, and within a matter of seconds the S&P 500 and Dow futures surged to their highest levels all week, pulling the EUR/USD, GBP/USD, EUR/JPY, and GBP/JPY up with them.

Whether or not traders believe news moves markets, it doesn't matter, the human reaction to the news is what moves markets and I don't see any end in sight to that trend. I'm not suggesting traders use the earnings reports as actual trade indicators for their favorite currency pair but what is important is to be consciously aware of when this data will hit the markets so you do not find yourself caught off guard or potentially on the wrong side of an extended market move.
 
The markets remain highly emotional and will continue reacting emotionally whenever the opportunity presents itself. For now, the earnings data will be one of the main catalysts which cause these emotional reactions. Earnings season will last for the next few weeks after getting their start last Wednesday. Since earnings season started the news has been surprisingly good, and in turn, the S&P 500 has posted a 3.0% gain and the Dow has moved up by 2.3%.

There is another benefit to paying attention to the earnings data... looking over the numbers can give good insight into the state of the economy. For example, JB Hunt, which is a huge trucking line in the US, underperformed on its earnings expectations. It should be easy to put 2 and 2 together on this one... JB Hunt is a major player in terms of shipping consumer and retail goods across the country in addition to having connection to the manufacturing and business sector. If JB Hunt's revenues are down, they're not hauling, and if they're not hauling, there is less demand from those various growth-related sectors.

While it might be all well and good that a pseudo hedge fund like Goldman Sachs can turn a $3 billion profit, keep in mind until just a few weeks ago they had $10 billion in taxpayer equity to work with, and they borrowed $28 billion from the FDIC at near zero interest rates, and they got $5 billion from Warren Buffet in order to make their moves in the market. Goldman was levered up by 17:1 (equity/assets) and had the full faith and confidence of the Fed, Treasury, and FDIC backing their trades. If making money in the markets were only that easy...

A company like JB Hunt doesn't have those luxuries but they are the real bellwethers of the economy, not Goldman Sachs. So as were in the midst of earnings season, do yourself a favor and look at the performance of companies who haven't been bailed out by taxpayers and who conduct business in the consumer, retail, housing, manufacturing, and transportation sectors. They will give much better insights into the state of the economy.

My favorite resource to keep up with the earnings data is here. 

Wednesday trading:
  
Don't forget the BOJ has an interest rate event early this morning (NY time). The BOJ usually holds their press conference any time after 2300 EST but typically after midnight EST. There's been a good deal of volatility with the Japanese yen the past week and any strength in the yen would obviously be unwelcomed by the BOJ, so what traders need to be on the lookout for are threats or rhetoric to weaken the yen. Should the BOJ hit the markets with anti-yen verbal rhetoric I would expect to see the yen crosses soar violently. The exporting situation in Japan is too dire to handle an appreciating yen, especially against the dollar, it's too much of a hindrance to growth.

Fundamentally, we have a big day tomorrow and once again much of the focus will be on inflation as we get Eurozone CPI and US CPI data. The euro came under pressure from weak Eurozone fundamentals on Tuesday morning and should CPI print strongly negative I would expect to see the euro sold-off. It's anybody's guess how the US consumer inflation data will print, but I'm not expecting a negative number, not with the way that food and energy prices have ticked up in June.

Beside CPI the markets will also have to contend with Capacity Utilization (price inflation connected), Industrial Production, Crude Inventories, and the FOMC Meeting Minutes. The FOMC is the real wild card tomorrow because there's no telling what kind of surprises the Fed may decide to hit the markets with. If the Fed wants to see a return of euphoria in order to push equities higher, the FOMC minutes will provide the perfect opportunity to pump up the markets.   
 
There's been a consistent price action trend for Wednesday's to be the most volatile day of the week and I think we could see another repeat performance of strong price swings and extended price moves. Unless we get some shocking downside surprises tomorrow I expect to see a continuation of more upside gains for the higher-risk, higher-yielding markets. For tonight, expect the price action to pick up after 2300 EST and watch out for the BOJ and Fed on Wednesday...

-David    

Tale of two markets:

If you started the trade day believing market participants in Asia, the world was coming to an end... if you ended the trade day believing European and North American market participants, the world has been fixed and there's nothing to worry about...

So who is right and who is wrong? We'll probably never know and it probably doesn't matter because what we saw between Sunday evening (NY time) and the close of Wall St. on Monday afternoon were participants running on pure emotion, capitalizing on thin conditions, and jumping on every piece of news or rhetoric that hit the wires the past 24-hours.

When Asia opened up last night the S&P 500 and Dow futures, EUR/USD, GBP/USD, crude oil and the yen crosses were all at vulnerable downside levels and Asian participants took advantage of the situation, sending all those markets lower as the Nikkei plunged by over 2.54%.

When Asian players left the market this morning, the S&P 500 futures was on its lows just under the 870 level but then as Frankfurt, London, and NY money-flows hit the markets, the S&P 500 futures did a 180-degree turn and never looked back, going all the way to the 897 level. The same exact moment the S&P 500 futures bottomed, the EUR/USD also bottomed and moved up over 200-points by the time Wall St. closed.

The S&P 500 cash market closed positive by 2.5% while the Dow Jones made a 2.3% gain, pressuring both the dollar and yen lower against the majors and crosses. It's not too surprising to see these kinds of moves a day before earnings season kicks into gear because there are a lot of high hopes for better than expected numbers and upside surprises.

The fear in Asia and euphoria o n Wall St. shows a clear lack of any established trend for the markets and I expect participants to remain directionless as their emotions are controlled by news and data and various rhetoric throughout the rest of the week.  

Dollar slides on news of $1.09 trillion budget deficit:

Back in June of 2008 the federal budget showed a surplus of $33.5 billion and just one year later there was a shortfall of $94.3 billion, leading to a 2009 fiscal year deficit of almost $1.09 trillion. This is the first time in 18-years that there was a deficit in the month of June and it is the second worst monthly deficit on record.

As the data hit the wires and was digested by the markets the dollar began to slide against the euro and pound sterling and in under 90-minutes both the EUR/USD and GBP/USD were breaking session highs. Wall St. seemed thrilled to see the government was spending like a drunken sailor as the S&P 500 and Dow got a boost, pressuring the dollar and yen even lower.

Since the fiscal year started, the federal government has spent $2.67 trillion but has only taken in revenues of $1.59 trillion. Year-over-year, personal income tax revenue has dropped by over 20% and corporate tax revenues are down a staggering 57%. By October 2009 the Treasury is forecasting a budget deficit of $1.84 trillion, for outlays to possibly reach $4 trillion and for income revenues to be around $2.16 trillion.

These kind of fundamentals are obviously not good news for the dollar, especially if growth stagnates because this trend of rising deficits and diminished revenues leads to a higher debt-to-GDP ratio which is really bad news for any currency. Deficits are more manageable in seasons of growth because the government's intake of revenues rises in accordance with economic growth but in season of high and rising unemployment, spending will always outpace revenue and those are negative contributing factors for the dollar. 

More irregularities with German banks:

It's no secret the European banking system remains troubled due to issues with over-leveraging and being stuck with toxic assets similar to US banks but now we are discovering that German banks may be hoarding cash. This calls the health of German banks into question for one simple reason -- the lifeblood of any bank is lending and issuing credit. But according to ECB Trichet, German Finance Minister Peer Steinbrueck, and German companies, German banks are not lending but are stockpiling cash. For what reason? That's the big question.

A bank that stops lending is the equivalent to a McDonald's that stops selling hamburgers and fries... it raises a red flag. The ECB undertook a monumental effort to encourage banks to lend when it pumped €442 billion ($619 billion) into the European money markets. The one-year tender was offered at a ridiculously low interest rate which was fixed at 1%. The main objective of the liquidity injection is to give both German and European banks strong confidence to re-inject those funds back into the economy in order to stop the rapid contraction of growth and to help free up the frozen credit markets in the Eurozone. Why would a bank not lend and how could they not make money when they are only paying a 1% premium? It doesn't quite add up...

Just last week a German business magazine, WirtschaftsWoche, released the results of a business survey which showed 57% respondents had trouble getting credit and were feeling a credit squeeze. On this issue, ECB Trichet commented:

"We remind banks of their responsibility to continue to lend to firms and households at appropriate rates and in suitable volumes; we all have to contribute to the continued functioning of our economy in these very difficult times"    

Germany's Steinbrueck had stronger rhetoric for German banks, saying:

"You will understand that these aren't just words. I will keep an eye on credit lending, request reports and will work together closely with the Bundesbank against this background."

What Steinbrueck has threatened is going to extraordinary measures to force banks to lend if he does not see improvement by 1-September. Now, what makes this story a little odd is that Steinbrueck also made comments about how Europe could still face a severe credit crisis in the near future. On one hand he's warning banks about another potential credit crunch and then on the other hand he's telling the banks to start lending or else. 

What does all this have to do with the EUR/USD? Well, although there hasn't been a massive meltdown within the European banking system I'm still convinced there is enough stress within the banking system to lead to a future devaluation of the euro. Also, if there is truly a credit squeeze in Germany, there would also be a credit squeeze in the rest of the Eurozone and the lack of credit expansion and M3 growth is highly deflationary. These deflationary factors are very negative and would also devalue the euro should they accelerate and come into play in the markets. It is the deflationary aspect to this issue which traders should most closely monitor in regards to any potential fallout in the future as this would have direct impact on the EUR/USD.

Tuesday trading:

Wall St. will be the center of the universe tomorrow for all participants in the Forex, commodity, and equity markets. What traders need to be on the lookout for is whether or not today was a classic case of "buy the rumor, sell the fact" or if participants were pre-positioning for another run up. The markets definitely bought the rumor today, now we'll need to see if they sell the fact...

I've started the week so far very untrusting of the markets, untrusting of all the moves we've seen the past 24-hours, and I'd rather not be in a trade than have to take a loss on a trade. I do think tomorrow will give a little more clarity once the markets get settled in and get some real data to work with. 

Beside all the earnings mayhem going on tomorrow, the markets will have to contend with a decent amount of key fundamental data, mostly revolving around inflation, retail sales, and the consumer. Out of Europe we get German and Eurozone ZEW which I am expecting to print at or better than expected. Eurozone Industrial Production will print the same time as ZEW and I'm expecting a better print than last month's -1.9%.

For the dollar we have two big fundamental events -- PPI and Retail Sales. It should be fairly cut and dry with those reports... equities, crude, gold, and pairs like the EUR/USD, GBP/USD, GBP/JPY, and EUR/JPY all want and need to see higher price inflation and some sort of a recovery sign from the consumer. For PPI, energy prices were fairly elevated in June so that may contribute to a positive inflation print, but with inventories still remaining high and the consumer continuing to entrench, its possible those two factors outweigh any upside price pressures from energy costs.

Equities, commodities, and the higher-yielding currencies have shown a pattern of being sensitive to consumer and retail fundamentals the past few months. I can't predict whether we get the truth or not in tomorrow's Retail Sales and Core Retail Sales but if the truth is told I would expect to see the retail data mostly flatlined. No matter what, the markets should jump on the news and the volatility will pick up when the data is released.

As great as Wall St.'s gains were today, if the news and data is lackluster they will be tested tomorrow to see if there was any real conviction behind the moves or if we saw yet another emotional response that can quickly fade. If you trade the FX market during Asia you will be well served to keep an eye on the Nikkei. Should the Nikkei recover its 236-point loss from yesterday and move into positive territory I would expect to see the yen and dollar to come under some pressure, especially after the 2200 EST or 2300 EST time frames this evening.

Lastly, don't discount the power the earnings data holds to move the markets... Goldman Sachs is the big one for tomorrow and they are scheduled to release their earnings data before the bell...

-David

For the week ahead the Forex, equity, and commodity markets will all begin trading at very key price levels and points of potential vulnerability. The S&P 500 and Dow Jones have been on a 4-week losing streak while their comrade, crude oil, dropped a staggering 10.2% in the prior five days of trading.

Granted, the lack of liquidity and thin market conditions associated with summer session trading have led to the sharp price action moves but in general we are seeing market participants come back to reality as they second guess the euphoria pumped into the markets by the central bankers back in April and May.

I am expecting a good deal of speculation to run rampant through the markets this week... speculation on whether crude will continuing falling to $55 or $52 or rise back to $65... speculation on whether the S&P 500 will go to 850 or 820 or rise back to 910... speculation on whether the US dollar Index will sustain a break above 80 and then 82 or if it will fall back to 78... speculation on how earnings will impact equities and the higher-yielding currencies... speculation on more potential stimulus measures... speculation on China's recovery and how that will affect the markets...

All the speculations will bring a continuation to the lack of any viable market trends, it will bring more daily or even hourly shifts in sentiment and risk appetites, and the general state of confusion in which all the markets have been operating the past few weeks. I have no predictions or forecasts for this week as there are a number of inflation, retail, consumer, housing, manufacturing, and central bank events which hold the power to toy with the emotions of market participants at any given moment.  

In my view the markets have shown growing concern for the state of the consumer, especially the US consumer, for the employment situation, and for the sharp slide in energy and commodity prices. Those issues will once again have to be dealt with this week and the end results will feed into where market participants send their money-flows.

From my own perspective I see that equities and commodities are more vulnerable to the downside as opposed to bouncing back to the upside. The path of least resistance has been down, not up, and the momentum has favored the downside. Of course this can all change in the blink of an eye but what I think will be required to shift sentiment and money-flows is for better than expected fundamentals or some confidence from the central banks.

It should be noted that even with the massive plunge in crude prices and the strong sell-off of gold, the dollar hasn't exactly surged against its counterparts. The US Index is above 80 but not by much, the EUR/USD hasn't even come close to testing the 1.3753 mega support zone and the GBP/USD has made a decent comeback off its recent lows after the BOE said they were not going to monetize more debt for now.

Market participants are still jumping on every little piece of news, fundamental data, and rhetoric from the central bankers and until we get bias one way or the other I expect the "trend" of no trend to be the trend.

EUR/USD fundamentals:

As I mentioned there are a number of important fundamental events this week, especially for the EUR/USD. These are the ones I'll be most focused on:

• ECB Trichet speech (Monday 0630 EST)
• Treasury Budget (Monday 1400 EST)
• German and Eurozone ZEW (Tuesday 0500 EST)
• Retail Sales (Tuesday 0830 EST)
• PPI (Tuesday 0830 EST)
• Eurozone CPI (Wednesday 0500 EST)
• US CPI (Wednesday 0830 EST)
• Industrial Production (Wednesday 0915 EST)
• Crude Inventories (Wednesday 1030 EST)
• FOMC Meeting Minutes (Wednesday 1400 EST)
• Initial Claims (Thursday 0830 EST)
• TIC Flows (Thursday 0900 EST)
• Housing Starts and Building Permits (Friday 0830 EST)

The economic calendar isn't exactly jam-packed this week but the retail sales data and especially the inflation data will come into close view by market participants. The markets are looking for any signs of life of the US consumer because it is the US consumer which is the benchmark of all consumers around the world. The saving's rate of the US consumer has clearly moved inversely to the overall retail sales figures released so far in 2009 and I do not expect to see a whole lot of change in that trend.

Inflation--  

In terms of inflation, I still firmly believe deflation is a much bigger issue at the present. Do not confuse true inflation, which is simply the printing of money, with price inflation. Some recent data suggests the Fed may actually be printing less money than what was prior assumed. Of course we will never get true and accurate numbers out of the Fed in terms of money-supply, the monetary base and the velocity of money but it could be true to a degree because we are not seeing any signs of price inflation pressures.

Consumers are still in command and are still forcing producers, manufacturers, and retailers to lower their prices. The collective buying power of the consumer base has maintained an overall trend of devaluation and lower price adjustments. In addition, the continued trend of credit destruction, debt repayments, higher savings, moderate commodity prices, falling home values, and rising unemployment are all acting as very deflationary contributing factors. Anybody screaming "hyperinflation" is living outside the realm of reality right now, it's just not there. Equities will want to see higher CPI and PPI figures. Commodity bulls will need to see rising prices as will the higher-risk, higher-yielding currencies. Should the trend of deflation show signs of a continuation it could be a rough week for those markets.

Treasury budget and the USD--

On Monday afternoon the Treasury will release the latest federal budget figures and this fundamental event could certainly impact the Forex and equity markets. Last month we got May's year-over-year budget numbers and it showed a mega spike in the deficit and spending. The Treasury is getting less tax revenue and obviously spending more money. In May 2008 the deficit stood at $165.9 billion and in May of 2009 it was $189.7 billion.

Spending has far outpaced that which the government is generating in revenue. Plus, with all the debt the Treasury is selling combined with the contraction of GDP, the ratio of debt repayments could get very uncomfortable as tax revenues continue to fall, savings continue to rise, and credit expansion stagnates. If the June figures show another surge in the deficit the market may respond by selling the dollar... keep your eye on this data.

FOMC--

The release of the meeting minutes from the last FOMC will be watched and reacted to by all markets. At this point I am not expecting any earth shattering information to be contained within the meeting minutes but you never what kind of surprises might be in there. The Fed has used the element of surprise in the past through the FOMC minutes and should there be any surprising mentions about buying more sovereign debt, raising or lowering interest rates, or on the future of the US economy the markets will move accordingly. 

Risk and price action catalyst -- USD/JPY:

Last Wednesday the Japanese yen made a massive move against the dollar, euro, and pound sterling, gaining several hundred points in a handful of hours. I felt some of the brunt of the move as I had to close net-short yen positions for a loss and while it's never fun to take a loss or to go through the process of recovery, I learned a few valuable trading lessons I want to share.

Market correlations and repeated price patterns play a big role in how I determine entry and exit points on my trades, as most of you probably know. One reason I have grown to love trading the yen crosses is because I have found them to be some of the most pattern-like pairs in the market and I like how they maintain a very close relationship with the S&P 500 and Dow Jones equity indices.

It's no secret the overall strength or weakness of the US equity markets drive currency valuations among the majors and crosses but what I came to learn and understand is that the USD/JPY holds an important place that can act as a driver of the EUR/JPY and GBP/JPY. The Forex market uses the US equity markets to gauge risk appetites and to determine price valuations, and while the EUR/JPY is the pair most correlated to the S&P 500, from my perspective what I see is that the USD/JPY can be the pair most correlated to the overall equity markets, as a whole. 

Price action impact ratios--

In the past I paid little attention to the price action and price pattern behavior of the USD/JPY but now I see that the overall strength/weakness of the USD/JPY directly impacts that of the EUR/JPY and GBP/JPY. Even more importantly, the impact ratio of an extended move on the USD/JPY is magnified anywhere from two to three times on the EUR/JPY and GBP/JPY. In other words, a 200-point extended move on the dollar-yen can translate into a 500 to 600-point extended move on a pair like the GBP/JPY and a 400-point extended move on the EUR/JPY.  

This becomes especially true if those respective yen crosses have spent a greater period of time either moving or ranging to upside or downside price levels. For example, the last time the EUR/JPY spent time at or below the 130.00 level was almost 2-months ago (18-May) and in these last 2-months the EUR/JPY has moved or ranged at elevated levels, going as high as the 138.60 level during the first week of June.

The last time the GBP/JPY spent any time below the 147.00 level was just three days after the EUR/JPY bottomed out below the 130.00 level. Back on 21-May the GBP/JPY reached a bottom just below 147.00 and over the course of the proceeding few months it moved to a high over 162.50. So in this case we see both the GBP/JPY and EUR/JPY spent an elevated period of time gaining and moving to the upside which correlates perfectly to how the S&P 500 and Dow Jones gained during that exact same time frame.        

Stop loss factors--

What helped fuel the type of moves we saw last Wednesday on the yen crosses is squarely on stop losses and stop loss triggering. The relationship between stop loss triggering, price action, and price behavior is very clear and the basis of this relationship goes back to the length of time a currency pair spends at either an appreciated or depreciated level.

Take the GBP/JPY for example... between 21-May and 12-June it moved a staggering 1,500-points+ to the upside. Although the GBP/JPY moved off it's best upside levels, it still maintained upside gains of over 1,000-points all the way until 3-July. What that means is the market was given a very reasonable amount of time to set stops on untold dozens of key psychological and technical levels at least all the way down to the price level where the market first turned up back on 21-May.

On 21-May the GBP/JPY bottomed and turned up at the 146.84 level and guess where it moved to last Wednesday? Exactly 10-points below the original upturn level... it hit 146.74, stopped and bounced back. That is no random fluke of the markets at all but shows how the extended downside move was very much fueled by stops being triggered. When stops are triggered and stop loss orders are hit, that process exacerbates a move to a large degree.

From a price pattern standpoint it also shows there is currently some fairly strong support around the 146.70-80 price zone. If you go back and look at the price action and price patterns of the EUR/JPY you would see almost a mirror image of the GBP/JPY in terms of its upside extension and then it's rapid fall back to old support price levels.

Hopefully this makes sense. At least for me it was a good exercise to go through as a refresher on the core principles of what makes these markets move, why they move, and how we can better capitalize on the markets.  

Correlation between premium, price, and risk:

For years I have been writing about the markets, about the relationship that exists between currencies, equities, commodities, and bonds and while that's all well and good, in the end, no matter how you slice it, price is king and price is all that matters. It's easy to lose sight of price sometimes but price always has the final say so in these markets. When it comes to price, price always carries a premium. There may be many factors used to determine price and valuations but when you boil it all down, it is the premium that the market puts on price which is the ultimate determining factor.

Think about it this way... when the market puts a higher premium on risk it means the market must pay more to get more. The correlation between premiums, risk, and yield (rate of return) is simple -- to get a higher yield or a better rate of return it is going to cost you more money because there is a premium placed on the price and in turn the level of risk changes.

The higher the yield, the higher the risk, and the higher the premium that must be paid to potentially profit. Conversely, when the market determines there is too much risk and the price that must be paid to take on risk has achieved its maximum potential, the premium then gets put on the markets or asset classes which cater to anti-risk, like the dollar or US Treasuries.

Many traders ask me how in the world it's possible for the euro and pound sterling to have such a close positive correlation to equities and for the dollar and yen to maintain a close inverse correlation. In my opinion the correlation is largely determined by the premiums placed on the risk and rate of return.

If the market is willingly taking on more risk and is showing a higher risk appetite the premium on risk goes up and a higher premium translates into a higher price. The euro, for example, yields more than the dollar but in times or seasons of risk aversion, no matter how long those seasons last for, the dollar is considered "safer" than the euro, so the premium and price of the dollar rises against the euro. A season of risk aversion in the equity markets will translate into a higher premium paid on mitigating risk and this higher premium is put on the dollar and yen, therefore it will cost more to own the dollar and yen because the premium has been upped by the market.   

These are very fundamental and psychological aspects of the market and have nothing to do with the technical side of things. It did not matter to the market that S&P 500 and Dow Jones broke above key technical levels, they both have sold-off ever since those technical events took place in the market. Why the S&P 500 failed at the 950 level was because the market said the premium to take on risk to gain a better rate of return at that price level was too high, plain and simple.

The premium to own the S&P 500 at the 950 price level was beyond what the market could bear so the premium got completely flipped... the premium was then placed on the best price in which to sell the S&P 500. Sell high, buy low, right? We all know that saying but what it really relates to is the premium placed on the price of ownership. At some point in the future the premium to sell the S&P 500 will reach an unsustainable level and then it will flip again causing the premium placed on the price to buy the S&P to go up.

When the market sees a higher premium to own a better yielding but riskier asset class like equities, the way the correlation works between equities and currencies will then cause a higher price premium to be placed on the EUR, GBP, AUD, CAD, NZD, etc. That's basically how it all works and how those correlations operate. I like to watch the correlations in price and premiums move in real-time, that is what suits me best, but unless we have a major correlation shift I think it is safe to expect to see those old tried and true correlations move just as they are supposed to.

Trading:

With the lack of any established market trends or clear biases, the price action will be determined by however the markets are feeling at any given point in time this week. This obviously will not make trading an easy endeavor over the next five days, so I would encourage all traders to keep up with the real-time price action of crude oil, the S&P 500 and Dow in relation to how your favorite currency pairs are moving.

And as I mentioned above, price will be king, so no matter how erratic the price action gets, the markets will always overshoot their bounds of price sustainability, they will always over extend and exhaust themselves to the upside and downside, and using those indicators is really where the safest money is to be made.

That's all I have for now. I will be in heavier trading mode this week and spending as much time and energy as possible focusing on the markets, so as time allows I will update the blog. I wish you a great and successful week of trading.

-David

Once again the the markets suffered through another bout of relentless selling and risk aversion. Today the selling began before NY opened and intensified during the Wall St. session. Crude maintained its role as the leading 'fear trade' and the market which took equities and several of the higher-risk, higher-yielding currencies to fresh weekly lows.

In the earlier European session a stronger than expected German Factory Orders report sent both crude and the EUR/USD to their day highs... the EUR/USD spiked up to the 1.4050 level while spot crude simultaneously made an attempt at the $65 level. Both moves, however, were unsustainable. After the EUR/USD took out stops on its spike up and crude came under selling pressure, both correlated markets began falling in tandem.

The S&P 500 futures and Dow futures made their daily highs the same moment spot crude and the euro were making their highs and then they all came tumbling down together, just as their correlation dictates. Basically, market participants couldn't find any real reasons to buy, so they sold. There were no US fundamentals to get euphoric over, no central bankers out talking the markets up, participants had zero to work with and nothing to switch the emotional sentiment out of the fear trade.

This afternoon's 3-year Treasury note auction wasn't spectacular, the yield was a little high and Wall St. didn't like that too much. The stories and threats of market regulation certainly didn't help matters or bring any confidence back into the markets. A few weeks ago market participants were under the impression that the UK economy was in recovery mode but this morning's UK fundamentals told a different story, both data sets printed much worse than expected and negative. It was another rough day for the bulls and probably gave the bears even more confidence to continue the markets in this direction until some news, fundamentals, central bankers or geo-politics changes the sentiment. 

Sign of the times and market psychology:

On 11-July 2008 crude oil began its fall from glory and took all the markets down with it over the course of the proceeding 8-months. Crude got the ball rolling last summer and once again we see history in the process of repeating itself, to a slightly lesser degree. Crude's latest run peaked on 30-June above the $73 level and since then has done nothing but sell-off, dragging equities and commodities with it and boosting the dollar and yen as a result. How much of last summer's history is going to repeat itself? I can't say or predict, but I can clearly see desperation in these markets and the sign of desperation can mean things may get a little ugly and nasty in the near-term. But, it will not last forever... 

Last summer as crude began to crack, the famous crude bull, T. Boone Pickens, went to great lengths to talk it up to protect his multi-billion dollar oil hedge fund. Last summer he was making claims about crude going to $300 and once again this summer he's out trying to talk crude up, saying it will return to $147. His attempts to stop the slide are purely out of desperation, it's obvious. Even the US energy department is trying to talk crude back up, saying crude will make gains toward the $100 level due to increased demand.

What can us traders take away from all this and from what we are seeing play out in the markets right now? First of all, because we know history repeats itself, prepare to see history repeat itself to one degree or another... the other thing is to look for continuing signs of desperation in the markets. Fear and desperation go hand-in-hand and as those two emotions work together to control the trading decisions of market participants, it usually means prices decline which translates into the type of selling we've seen over the past few weeks.

Now, there is a point where the fear and desperation reaches an unsustainable level, leading to reversals in price valuation and market direction. One of the best ways traders can spot that type of turning point is when everybody is saying its the end of the world, it's all over, and conditions have reached the point of no return. When it comes to markets and trading, the majority and the masses are always wrong, especially in the Forex market.

There is only one trend in the markets right now and that trend is emotion. The markets are running on pure emotion and history also tells us that when the masses are running on emotion, they ultimately make the wrong trading decisions. Their emotions act like some kind of weird mind control force that compels the masses to repeatedly pile into the last 5% of an overall market move. Just like when the S&P 500 and Dow broke the supposedly magical 200-day moving average the masses were screaming buy, buy, buy but the market went bye, bye, bye from that moment and hasn't stopped to look back.

As much as I loathe financial entertainment networks like CNBC and Bloomberg I have learned to use them as a resource to find out what the prevailing mindset is, what the emotional state of the markets are, and when the emotions of either fear or greed are reaching their climax so I know when it's most advantageous to do the opposite of the masses.

The S&P 500, Dow, and crude oil may continue in a season of selling and depreciated price valuations and obviously this would mean the US dollar and Japanese yen continue to gain ground on the majors and crosses, but I'm fairly confident in saying that when I see the majority of market participants and the masses join the bear side, I will know that the dumbest of the dumb money has piled into the last 5% of the market's move and hopefully I'll have the insight to know to run the opposite direction.

The masses totally got it wrong when they pushed the Dow Jones and S&P 500 to their all-time historical highs in the midst of the worst credit crisis and economic depression since the 1930's. The credit crisis began exactly on Sunday, August 12, 2007 and the US recession was in full bloom by December 2007, yet the equity, commodity, and Forex markets continue rising at an unprecedented pace. The US housing market was in full meltdown mode back in March of 2007 but the masses were still trying to flip homes, buying investment properties, and were taking out second and third mortgages.

It basically took a year for the masses to totally pile into the wrong side of every tradeable market on earth before the market itself ran the opposite direction and reversed on them.  Traders can absolutely profit from playing along with the emotionally-driven masses, there's nothing wrong with that but don't lose sight of the very tried and true principle of all tradeable markets -- the longer things stay the same, the more they need to change.

Wednesday trading:

The main themes for tomorrow will focus squarely on fundamentals, central banks, and geo-politics. The G8 will become the center of the universe as their 3-day meetings kick off in Italy. They should really change the name of the G-8 to the G-80 because everybody and their brother will be there but what we need to be on the lookout for is any pro or anti dollar rhetoric out of the BRIC nations and of course from the Fed, ECB, BOE, and BOJ. China, Russia, and Brazil are the three wild cards because they hold the power and potential to push the dollar around the rest of this week.

Both the dollar and yen have benefited positively from the sell-off on Wall St. and the plunge in crude prices but I still have no overall confidence in either currency due to their abysmal fundamental situation and the fact I believe the Fed will have to keep printing money to rescue the economy. We will hear growing talk of congress coming up with a new multi-billion dollar economic stimulus plan as the US fundamentals and weakness on Wall St. persists and that may turn some negative focus back onto the dollar.

Beside the G8 event, the markets will contend with Eurozone GDP and German Industrial Production data. Out of the UK there is an inflation report and then later in the NY session we get Crude Oil Inventories which should cause a nice dose of volatility with crude being under the microscope right now.

The most important job for traders the next three days is to be diligent to keep up with all the verbal rhetoric and verbal manipulation that comes out of the G8. If the central bankers and finance ministers want to talk the markets up or down, they will use the G8 event as their opportunity to do so. Don't let them catch you off guard because they love to use the element of surprise to move the markets. The trading conditions will be risky tomorrow as Wednesday's have been following a trend as the most volatile trade day of the week, so manage your risk accordingly.

-David   

Crude and global equity indices whip Forex markets around:

The markets got themselves off to a wild and volatile start this week... the price action seen in the equity, commodity, and especially the Forex markets was rather fierce. It all started during the first few moments of the Asian session and squarely with crude oil. As soon as traders in Asia and then Europe had access to the market they started selling crude which put immediate pressure on the Nikkei and then on the European bourses, all before NY traders had a chance to get to their desks.

With crude oil under continuous pressure between the Asian and European sessions, the S&P 500 and Dow futures both sold-off. The combination of crude losing 4% of its value before NY even opened along with US equity futures plunging sent the GBP/JPY and EUR/JPY in a free fall. The US dollar and Japanese yen both gained ground across the board as fear was running rampant through the markets and risk was taken off the table.

Heading into the Wall St. open the Dow and S&P 500 were looking fairly grim and certain market participants continued piling into the dollar and yen, either for protection against NY possibly continuing to sell crude and equities or for technical reasons or out of sheer panic, however, the market direction set during Asia and Europe did a complete u-turn and went back around the bend...   

Correlated markets continue to show direction and trade opportunities--

The equity, commodity, and higher-risk, higher-yielding currencies all bottomed within minutes of each other and all turned back up in tandem during the early part of the NY session this morning. The catalyst was the ISM Services report which printed much better than expected. The ISM data was released at 1000 EST and between 1000 EST and 1030 EST the S&P 500 futures, Dow futures, crude oil, gold, the EUR/USD, GBP/USD, GBP/JPY, and EUR/JPY had all stopped sliding, reached their bottom, and retraced their losses in lockstep.

Traders that follow the correlated markets to trade FX got a gift on a silver platter this morning as all the higher-risk markets bottomed at the same time and reversed at the same time. It was good to see that even in the midst of the chaos the old market correlations were still performing as they should. And as we talked about in our chat today, the pattern sequence of the 30-minute price opens of pairs like the EUR/USD, GBP/USD, GBP/JPY, and EUR/JPY all signaled extreme price exhaustion and over-extension even before Wall St. opened.

I started buying the GBP/JPY and GBP/USD at 0303 EST this morning. On the pound-yen specifically, price was so exhausted and over-extended I started buying it at the 154.40 level and continued buying it all the way down to the 153.20 level, the lower it went, the more exhausted price became to the downside and the higher my payout probabilities became to see a strong reversal retracement.

Not only did the 30-minute price opens of the GBP/JPY and GBP/USD show a repeated cyclical pattern of price overshooting too far to the downside, the fact that the move lower on the majors and yen crosses was purely emotional and not based on fundamentals or geo-politics was a dead giveaway there was no real selling conviction behind the moves and that the depreciated price valuations on those pairs were completely unsustainable.   

By the time Wall St. closed this afternoon the Dow and S&P 500 were in the green and all of the higher-risk, higher-yielding currency pairs were within spitting distance of where they started the week on Sunday evening. 

The fallacy of an established trend part II:

In yesterday's update I wrote a commentary about how it was a completely false premise to claim there are any established trends in the markets, specifically in the currency market. I know my opinions on this issue made a few eyes roll, but about 6-hours after I wrote and published that commentary I got an email from one of our community members with a link to an interesting story posted on Bloomberg last night. The title of Bloomberg's article:

'Currency Funds Crushed on Dearth of Market Trends'

Hmm... so maybe I'm not crazy after all... according to this Bloomberg article, the world's largest currency hedge fund has lost over 5% because there is no clear market trend. And what really put a smile on my face was after I did a little research on this fund, called FX Concepts, and found out that it has been traded almost on a purely technical basis using computer generated technical indicators to find momentum.

The fund's trading is based on a technical model and I think it's fairly obvious why the fund has been hammered -- lagging indicators cannot perform in a market environment where fundamentals, geo-politics, and central bank monetary policy directly affect the emotions of market participants and dictate where they send their money-flows.

From the Bloomberg article:

"I am not trying to make any excuse, but certainly it has been difficult," said John Taylor, chairman of New York-based FX Concepts, which manages about $12 billion. "Unfortunately, there's lack of consistence of what's happening. I am wondering how stupid the market can be for how long." 

There's a good lesson here for Mr. Taylor and all traders -- the market is never stupid and the market is never wrong, it is us traders who are the stupid ones when we fight against the market correlations, the fundamentals, and central bankers. What is stupid is using a system that consistently fails, needs to be tweaked out all the time, or signals trades that are in direct contrast to the underlying fundamental and geo-political factors which move markets.

Nobody likes to lose, I hate losing, but there's got to be a point where a trader takes a step back to evaluate their own trading to figure out what they are doing wrong. Blaming the market is the first sign the market is holding a trader hostage. Thinking the market is just being stupid is another good sign a trader has lost the psychological battle and is wandering aimlessly.

In the month of June my win ratio was 90.30% and guess what happened the 9.70% of the time I lost? It was my fault, not the market or my trading system. Every single loss I took in the month of June and those I've taken in the month of July were because I was either impatient, emotional, or I tried to trade against the fundamentals, geo-politics and correlated markets. It's that simple. 

Right now this is purely a traders market. There is zero trend and a lack of clear direction and nobody can predict if or when things will get back to how they were in 2006 and 2007 when all you had to do was buy the euro every time it dipped. The lack of an established trend is exactly what the central bankers want and they always get what they want because they hold all the power. It doesn't matter to me how a trader picks and chooses their entries but whatever process is used should consistently perform or else the trader ends up like Mr. Taylor who probably can't sleep at night knowing his multi-billion dollar hedge fund has been steamrolled by the market.  

Tuesday trading:

For all the AUD/USD traders don't forget the RBA has an interest rate and monetary policy event at 1230 EST this morning. There's not a single fundamental event for the US dollar tomorrow, but there are several market-moving events for the pound sterling. Manufacturing, production, consumer confidence, and retail inflation data will all be released in the early European session and I fully expect to see the market react to this data, leading to heightened volatility on the GBP/USD and GBP/JPY.

As for the euro the biggest fundamental event is the latest German Factory Order data. In my view, the markets are still looking for reasons to buy the euro against the dollar right now. Between the Fed, BOJ, BOE, and ECB, it is the ECB which currently has the highest interest rate and the tightest, most conservative monetary policy. That is why the euro losses to the dollar have not been nearly to the degree as the pound sterling's losses to the dollar. The EUR/USD has held up fairly well in light of the sell-offs in equities and commodities compared to the GBP/USD and GBP/JPY.

For tomorrow also keep in mind its the day before the G8 meetings in Italy and certain market participants may want to either square up their books or pre-position ahead of the event, and those moves could cause some more price swings like we saw today. In addition, earnings season starts the day after tomorrow plus there will be some big Treasury auctions later this week. All in all, it will be a busy day with the potential to see some surprises, especially if we get any pre-G8 rhetoric out of the Fed, ECB, China, Russia, India, or Brazil.

For me personally I'm still biased to short the dollar and yen into their strength when I get a high probability price pattern to trade. I still feel more comfortable buying pairs like the EUR/USD, GBP/JPY, and EUR/JPY on their dips when they show over extension to the downside. Crude should remain the linchpin which makes or breaks the markets.

I can't predict what the emotional state of the markets will be tomorrow, it changes almost every day, but if euphoria and greed are back on the table, equities, commodities, and the higher-yielding currencies should have a strong day. If a fundamental or geo-political event takes risk off the table and inject fears back into the markets we're likely to see a repeat of what happened in the Asian and European sessions this morning.

Be smart with your risk and money management... if you're in doubt, sit it out.

-David 

Whenever I sit down to prepare for a new week of trading and to research the market for the week ahead I always focus on those one or two big fundamental events that I know hold the power to directly influence risk appetites, money-flows, and how participants will handle their fear and greed. For this week what I am seeing as the dominate fundamental and geo-political event is clearly the G8 meetings in Italy.

Beside the G8 event, I see the major economic and fundamental themes will revolve around central bank monetary policy, inflation, and growth. Once again risk management will be imperative as the combination of geo-politics, fundamentals, ill-liquid markets, and emotionally-driven participants will lead to sharp and erratic price swings over the next five trading days -- prepare your risk and trading game plan accordingly...

G8:

I always follow the rhetoric and jaw boning that comes out G8 meetings but this go around is even more critical for two distinct reasons:

1. Market participants are showing a heightened sensitivity to verbal manipulation and rhetoric from central bankers and finance ministers
2. The timing of the G8 meetings      

In terms of the timing aspect of this week's G8 event, G8 meetings typically happen over a weekend when most of the major world markets are closed. When the Forex, equity, and commodity markets are in full swing 24 or 48 hours later, market participants have had some time to digest the event and make less emotionally-driven decisions. That will not be the case this week. 

This G8 event is totally different because it starts on a Wednesday and runs through Friday. Wednesdays can be one of the most volatile trade days of the week and is the day where extended price swings occur. The timing of this G8 means all the markets and their participants will have the opportunity to react and respond in real-time as opposed to having a 24 or 48 hour "cooling off" period to digest, think things through, and control their emotions. This is where the psychological aspect to trading comes into play...

The other timing aspect to this G8 is tied directly into the emotional fortitude of market participants which is clearly lacking since the trend of better-than-expected fundamentals has begun to reverse. The prospect of a global economic recovery taking root in the US is not nearly as clear as it appeared to be back in April and May. Or, better stated, the premise that the US and the global economic system had somehow "bottomed" in a matter of a few short weeks has been vastly overstated.

Readers of my blog have never heard me say anything about a recovery and an end to the crisis because I'm not of that mindset. Those ideas were planted into the minds of market participants by the CEO's of the big banking institutions, central bankers like Bernanke and Geithner, and investment entertainers like Jim Cramer. Recent data trends have smashed some of the hope and optimism that ran roughshod through the markets back in the Spring and led to euphoric buying in the higher-risk, higher-yielding currency, commodity, and equity markets. So, for this week the markets will have to deal with the messages that come out of the G8, good, bad, or indifferent. 

The China factor--

Earlier last week a Chinese finance minister reportedly requested the G8 bring up the idea of establishing a new reserve currency based on the IMF's system of special drawing rights. Of course this sent the dollar plunging against the euro and pound sterling but then a few days later the Chinese recanted this call.

Now the latest out of China is that they will not raise the issue of replacing the dollar as the world's reserve currency, however, they will engage in a discussion of this prospect if a G8 member brings it up at the meeting. Remember, China is not a G8 member nation but a member of the BRIC group which has been gaining influence over the markets the past few months. China and their BRIC comrades will be attending the G8 even though they are not official G8 members and this means any anti or pro dollar rhetoric will absolutely have influence over the direction of the US dollar this week.  

Chinese president Hu Jintao will be at the G8 and will likely press the group to give the Chinese more power to set policy in the global financial system. Will their requests be denied? This I cannot say but the fact the IMF has already elevated China's role in the global finance arena leads me to believe in the coming months and years the Chinese will have sway over the markets. The same should be true for India. Indian officials will also be at the G8 and although India is often overlooked it should be noted the Indian economy shows great potential in the future and they should grow in power and influence.

Be on the lookout for any rhetoric that comes out of Chinese officials this week in regards to the dollar because I can assure you the market will react to their comments, and it won't matter what you think your candle chart is telling you, the Chinese don't look at candle charts when they have a pro or anti dollar agenda to meet. It cannot be predicted what the Chinese may or may not say about the dollar but if they run their mouths the dollar will move.

Russia--

Russia's economic status is rather ugly when compared to some of their BRIC comrades but in addition to being a BRIC member they are also a G8 member. Don't say до свидания to the Russians because they too hold the power to move the US dollar, they have done it in the past and they can do it again in the future. Geo-political tensions between Russia and the US have been growing as the global financial turmoil drags on and the Russians are singing from the same page as the Chinese and Brazilians in terms of calling for an end to the dollar's dominance.       

Other G8 members beside Russia and the US include Germany, Great Britain, Japan, France, Italy, and Canada but out of that group it is the Russians who need to be closely monitored for any market-moving rhetoric this week. It should also be noted that Obama is meeting with Medvedev and there will be press conferences and various talking points hitting the markets as early as Monday. 

Stay on guard--

The last point I want to make on this G8 geo-political factor is to just reiterate how powerful of an event this can be in terms of moving the markets. I am not expecting any specific policy to be established and the G8 communiqué may be a little bland, but it's the rhetoric and comments that are said in the press conferences, back rooms, hallways, and corridors which end up hitting the new wires, causing market reactions. If there is an agenda to gradually weaken the dollar or to temporarily keep it propped up the G8 provides a perfect venue to further this process.

Fundamentals moving the markets this week:

In addition to the G8 there are several fundamental events happening over the course of the trade week that will cause the dollar to move one way or the other. For trading the EUR/USD I will most closely monitor the market's reaction to these fundamentals:

• ISM Services (Monday 1000 EST)
• German Factory Orders (Tuesday 0600 EST)
• Eurozone Final GDP (Wednesday 0500 EST)
• German Industrial Production (Wednesday 0600 EST)
• Crude Inventories (Wednesday 1030 EST)
• US Consumer Credit (Wednesday 1500 EST)
• German Final CPI (Thursday 0200 EST)
• Initial Claims (Thursday 0830 EST)
• German WPI (Friday 0200 EST)
• US Trade Balance (Friday 0830 EST)
• US Import Price Index (Friday 0830 EST)
• Michigan Sentiment (Friday 0955 EST)

The economic calendar for the US and Eurozone is a little lighter than normal but as you can see there are several inflation, growth, employment, and consumer related events happening and those fundamentals are very much in the focus of the big players.

Central banks--   

There will be plenty of Fed, ECB, and Treasury speakers this week so be on the lookout for how they decide to verbally manipulate the markets. I didn't have time last week to comment on Trichet's monetary policy press conference but overall I would not classify it as being over-the-top in favor of the euro as in times past. Trichet very clearly backed away from his recent trend of talking the euro up.

Early Sunday morning Trichet made a very interesting comment on the US dollar. He said:

"On this issue, I am very very clear. I have just one message, it is extremely important that the United States of America has been saying that a strong dollar is in the interests of the United States of America. I consider that extremely important and I welcome this declaration"

It will be interesting to see if the market decides to respond to this pro-dollar rhetoric on Sunday/Monday, I think there's a good possibility to see it. But getting back to his monetary policy press conference, Trichet was clear that interest rates had not reached their lowest levels and based on those comments we saw the euro back off from its highs against the dollar by the end of the week. In regards to deflation, Trichet gave a pro-euro message by saying deflation has not materialized in the Eurozone and that it was not an issue... yet.

BOE and RBA Interest rate events--

If you trade the GBP/USD and or AUD/USD you will want to pay attention to the their respective interest rate and monetary policy events. On Tuesday at 1230 EST the RBA will release their latest decision on the Cash Rate and more importantly, their views on future monetary policy and the economic landscape for Oz. On Thursday the BOE will hit the markets with their latest monetary policy statement and I fully expect the market to move the pound sterling based on what the BOE has to say, especially if they comment on deflation and monetizing their sovereign debt.

The pound sterling will begin trading this week near its short-term lows and it could easily end the week even lower should the BOE give a message to the markets about UK inflation dropping below target, a gloomier view on the UK economic situation, or any plans to print more money to buy Gilts. Conversely, if the BOE tells the markets their days of monetizing debt are winding down and inflation should remain at or even above target, I would expect to see the pound sterling soar. Of course the G8 could negate some of the affects of these two monetary policy events but GBP and AUD traders should pay close attention to the BOE and RBA this week. 

The fallacy of an established trend:

I often get questions from other traders about what kind of trend the dollar or euro or pound sterling is in. I trade repeated cyclical price action patterns so the "pain" that goes into finding a trend isn't something I ever really have to deal with. But, in my opinion, the idea that any of the markets like crude oil, gold, the S&P 500, or currency pairs like the EUR/USD and GBP/USD are in some kind of established trend is a joke. Those markets are moving purely based on the two emotions which control the behavior of market participants and dictate where they send their money-flows -- fear and greed.

Right now the Forex, equity, and commodity markets are moving in ranges, not trends. The reason they are moving in ranges is because that's exactly what the central bankers want. It's no coincidence that one week central bankers from the US, Europe, and Asia talk up the dollar and then the next week they talk down the dollar. This isn't bipolar verbal manipulation that's going on, this is a well coordinated, organized, and predetermined plan to keep all the majors and crosses in a specific range.

There is no such thing as a single currency and the fact they are all paired up together means the central bankers need to coordinate their efforts to prevent any one pair from falling into an established upside or downside trend move. The coordinated efforts between the banks are also designed to temporarily prevent the dollar and US dollar Index from breaking through key resistance or support zones. If you were to inject some truth serum into the central bankers they would all tell you the exact same thing I'm telling you now.    

Economic and financial agendas need to be met and this requires their respective currency to go through short-term periods of appreciation or depreciation. Take the Swiss for example... right now the Swiss are most concerned with Eastern European debtors paying their Swiss creditors so they are manipulating the value of the Swiss franc. Will it always be in the interest of the Swiss to have a depreciated currency? No, not likely, but for now that's the game plan for the Swiss.

If the pain for German exporters becomes to great, the ECB may go on a campaign to devalue the euro against the dollar and pound sterling. If the BOJ gets too uncomfortable with the range in which the USD/JPY trades, they will come out with their own brand of manipulation to depreciate the Japanese yen. This is simple stuff, economics 101.

Price is king--

When the SNB and BIS decide to perform an open-market operation to manipulate the price of the EUR/CHF do you think they are looking at a candle chart and worrying about whether or not the EUR/CHF is above/below a moving average or near a Fibonacci line? Of course not, they are looking purely at price and valuation and they are making a determination based on a fundamental and economic basis to re-value and re-price the market.

If Trichet sees the price and valuation of the EUR/USD at the 1.4200 level and knows the price differential between the euro and dollar is not favorable for the Eurozone, he and his ECB comrades can and will talk it down. Or, if Trichet sees a deflationary situation in Europe he will absolutely talk the euro up against the dollar. That's how these markets work, that's how they move and what makes them move.

Another case... a few weeks ago the Dow and S&P 500 broke above the so-called "magical" 200-day moving average and all the tech traders got excited because this was supposed to mean that equities were going to fly up. Wrong. Ever since that supposed technical breakout occurred, what has happened to the S&P 500 and Dow? They have plunged decisively off their highs.

My point here is to encourage traders to spend a little more time staying on top of the real underlying factors which determine price and valuation in the currency market and to spend less time looking for some kind of a holy grail indicator that cannot produce consistent results and causes undo stress. Concerning yourself over trends or whether a currency pair is above/below a moving average can distract you from staying on the right side of the market, that's why all the Forex brokers give that crap away because its extremely distracting and causes confusion and chaos in the retail FX market.

Trading outlook: 

I'm very much looking forward to trading this week. Last week I personally put in a poor performance, took some unneeded losses due to lack of patience for certain price patterns to play out but with all the geo-political, fundamental, and central bank events going down I'm excited about the potential to see some profitable price swings in the markets.

Crude oil, S&P 500, and EUR/USD--

I'll repeat my mantra -- crude oil is one of the linchpins that make or break the markets. The correlation between crude oil and the dollar has remained clear. As crude has fallen from its yearly highs above the $73 level, the US dollar Index has risen from its lows below the 78 level. On 30-June spot crude oil hit its peak so far this year and has since moved decisively below the $66 level. Less than 24-hours after crude hit its peak the S&P 500 futures topped out around the 927 level and have moved down in tandem with crude, hitting a low around the 889 level as equities and commodities sold-off based on the latest NFP data.

The very same day the S&P 500 futures topped at the 927 level guess what the EUR/USD did? Surprise, surprise, it topped at 1.4200 and has done nothing but fall from there. Not a coincidence... equities, commodities, and currencies are all obviously moving just as their correlations dictate them to.

On Friday the EUR/USD flirted with its key support zone around the 1.3982 level after the market ran stops below there on Thursday. If the 1.3982 level breaks decisively to the downside the next price zones you will want to keep an eye on are: 1.3923 / 1.3853 / 1.3818 / 1.3784 / 1.3752. On the upside keep a watch at these levels: 1.4025 / 1.4088 / 1.4128 / 1.4172 / 1.4224. 

As I've already mentioned, the G8, the monetary policy, the central banks, and the fundamentals will dominate these markets this week and will dictate whether or not risk is taken off the table or put back on the table. Market participants who were on holiday may decide to react to NFP early this week, a delayed response could very well happen. Also, there will be more US debt auctions and the markets will also begin focusing on the upcoming earnings season on Wall St.

There's a whole lot going on right now and the lack of liquidity and market participation is going to make things even more volatile. If you're in doubt sit it out... be smart with your risk and money management and don't let these central bankers catch you off guard, they love to use the element of surprise... I wish you a great and profitable week of trading.

-David

When I woke up this morning to trade the NY session and started catching up on the price action of the Forex, equities, and commodities markets I got that gut feeling that said, "don't take a trade, you'll lose". It's been awhile since I sat through an entire NY session without taking a single trade but I'm glad I listened because I probably would have lost on trades today as the markets were very disjointed, choppy, and erratic to kick off the third quarter. My hat's off to all those traders who did make a profit today...

I can't put my finger on one exact thing that caused the markets to become disjointed but it was more a combo of central bank, fundamental, and geo-political factors. The erratic price action really started last evening in the Asian session with Fed Yellen's strong anti-dollar rhetoric. On the prospect of the Fed leaving their interest rate near zero for the next several years, Yellen said:

"It is not outside the realm of possibility; we have a very serious recession, we have a 9.4% unemployment rate, and inflation possibly falling further below the Fed's preferred level; we should want to do more. If we were not at zero, we would be lowering the funds rate"    

That kind of central bank rhetoric is about as anti-dollar as it gets and the almost immediate response from the market was to drive the euro higher against the dollar. The reason why market participants sent their money-flows into the euro is because the euro is still yielding a minimum of 75bps higher than the dollar and when compared to the pound sterling, the euro yields a better rate against the dollar, so the euro was one of the main beneficiaries of Yellen's anti-dollar comments.

From a fundamental standpoint, it was mostly a mixed bag of somewhat-bad and not-so-bad data... the data that the S&P 500 and Dow Jones enjoyed most was the ISM report and specifically the ISM Price Index. ISM Manufacturing is still well below the 50 level but as I looked at the various components it's easy to see what the markets got excited about. The production and employment components were both up by over 6% and best of all, the prices component was up by 6.5%.

Remember, higher prices are good for higher-risk, higher-yielding markets, it's what these markets need... any price related components in this type of data that are not deflationary is just another reason to buy. Whenever a piece of fundamental data that is connected to price inflation prints hot or better than expected I've seen a clear pattern for equities to rise and the dollar to fall and this pattern played out again today.

And finally from a geo-political standpoint, the dollar was hammered by more comments from China. At 1158 EST, just as London was closing, these comments from a Chinese finance minister hit the news wires:

"China has asked the G8 Italy summit to discuss issue of new global reserve currency; China requests reserve currency debate at G8"

Within seconds of these anti-dollar comments hitting the wires the EUR/USD jumped up over 60-pips, took out stops at the 1.4200 level and then fell right back down to the point of lift-off after NY closed this afternoon. I'm not exactly sure why the Chinese are talking the dollar down but all I can think of is that they are strategizing way in the future and not so much in the past or present.

The argument that the Chinese shouldn't talk the dollar down no longer holds any water because they have shown a pattern of using verbal rhetoric to depreciate the dollar in recent months. I believe the Chinese are thinking ahead by about 10-years and whatever their ulterior economic and social agendas dictate for the future probably includes the dollar being dethroned as the world's reserve currency.

All in all, it was a weird start to Q3 and it will probably stay weird as the markets deal with a tag-team NFP/ECB event tomorrow morning and Friday's US bank holiday...

NFP and unemployment rate event:

I'm going to get this out of the way now -- do not trade NFP tomorrow. You saw how wild last month's NFP event was and I expect no different tomorrow. The best way to properly manage your risk is to sit on the sidelines, let the market do its thing, and either trade after the dust settles or wait until next week.

Last month's NFP printed way better than expected but I believe that number will be revised lower tomorrow. Last month's unemployment rate will not likely be revised lower but possibly revised higher. As far as the actual market forecasts are currently running, this is what the bank traders are forecasting:

Non-farm payrolls consensus range: -435K to -225K
Unemployment rate consensus range: 9.7% to 9.5%

My NFP forecast: -378K to -414K
My unemployment rate forecast: 9.7%

The ADP NFP report came in much worse than expected at -473K but I do not think tomorrow's government report will breach that level. What Wall St. and the higher-risk, higher-yielders want to see is an NFP print that comes in as it did last month because they are still looking for any news-driven reason to keep buying and to keep prices supported.

The thing to remember is, this employment data from the BLS is hardly reliable and purely manipulated. If the markets are looking for a reason to go up, they will find it within the data... if the profit-takers want a reason to square their books ahead of the holiday weekend, they will find a reason within the data... if big money movers want to push the dollar and USD Index lower, they will find a reason in the data...      

ECB interest rate event:

As important as tomorrow's NFP even is, the ECB interest rate policy and Trichet press conference is even more important and should likely have greater affect over the value of the EUR/USD. Monetary policy always trumps a single fundamental event and you can be sure all eyes will be on Trichet at 0830 EST tomorrow morning and looking for any sign or signal to either sell or buy the euro against the dollar.

That's what tomorrow's event is really all about... what to do with the euro... the Eurozone's dismal fundamentals have kept the euro's gains somewhat capped against the dollar and it's been the ECB's verbal rhetoric along with the euro's correlation to equities and commodities which has kept it from breaking below the 1.3750 level. If Trichet and his ECB comrades decide they want to continue their pro-euro stance this should be made clear at the press conference. Conversely, if Trichet wants to help support a Eurozone recovery by depreciating the euro, like the Swiss are doing with the franc, he will talk it down tomorrow.

As far as the ECB interest rate is concerned I see no change and for rates to be held at 1.00%. Trichet said he's not dropping rates this month and I'm going on his word. Obviously if Trichet was playing games with the markets and does decide to drop rates this would be a shock and unexpected move and the euro would sell-off against the dollar.

Central bankers like Trichet and Bernanke have been fairly trustworthy trade indicators in recent weeks, they've been telling the markets exactly what they want their respective currencies to do. So, as you're watching Trichet's press conference tomorrow and you're looking for signs he wants the euro to stay supported, he will say things like:

• ECB interest rates have reached their lowest levels 
• ECB interest rates may rise in the near-term
• The ECB is more concerned with inflation and price stability compared to deflation
• Deflation is not at all an issue in the Eurozone
• ECB forecasts show an end to the growth contraction in Europe and signs of a growth recovery are present
• European credit markets are stabilizing and money and credit is expanding
• The European banking system is sound
• The ECB will not monetize any sovereign or commercial debt beyond their already existing program
• The ECB expects German exports to rebound in the near-term
• The employment situation in Europe is improving
• The worst of the financial crisis is over and recovery is right around the corner  

If Trichet wants the euro to depreciate he will make comments like this:

• ECB interest rates have not reached their lowest threshold and may come lower in the near-term
• The ECB is open and ready to use more non-standard measures
• The ECB will monetize more sovereign or commercial debt
• The ECB is concerned with deflation/disinflation
• Consumer and producer inflation rates are expected to remain negative in the near-term
• The European banking system remains at risk
• Eurozone growth will contract beyond what the ECB has estimated
• Unemployment will continue rising
• The consumer will remain weak for a longer period of time than anticipated 

The points on those two lists are the main things Trichet would say to either appreciate or depreciate the euro tomorrow. I can't predict which Trichet we'll get but I'm leaning towards him making more comments that are supportive of the euro compared to negative comments. The biggest risks for the euro obviously would be an announcement of interest rates being lowered and or more debt being monetized.

Even if you do not trade the EUR/USD you will be well served to watch Trichet's press conference because it's a great learning lesson for how central bank monetary policy and geo-politics drive price action of currencies and how these guys use verbal rhetoric to manipulate the Forex market. You can watch the press conference here. 

Manage your risk:

On a scale of 1-10 tomorrow's trading risk is an 11. I really encourage all retail FX traders to practice some patience and good money management by sitting on the sidelines. I usually trade every NFP and ECB event but at this point I'm leaning towards sitting on the sidelines as well. The other risk factor beside these fundamental events is the fact the markets are severely ill-liquid right now. That means it takes far less money to move the market as opposed to what it may take under normal trading conditions when the level of market participation is higher.

The price swings could be very sharp tomorrow and not something you want to find yourself on the wrong side of... you could be on the right side of a market move and 30-seconds later find yourself on the wrong side of a price swing... that's the potential risk for tomorrow. If you can't help yourself from trading I suggest using at least half of your normal entry size. I always recommend for traders to use just half of one percent used margin entries so you may want to cut that in half for tomorrow and Friday.

Finally, a great Jesse Livermore quote to consider:

"After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting"

 -David

Markets show continued vulnerabilities to weak fundamentals:

Besides a healthy round of Q2 profit-taking which occurred across the board today, crude, gold, the S&P 500, Dow, EUR/USD and GBP/USD all came under pressure after astring of poorer than expected fundamentals caused market participants to scale back their risk appetites, sending their money-flows out of the higher-risk, higher-yielding markets and back into the safe havens of the USD, JPY, and Treasuries.

Higher-yielders like the euro and pound sterling made their highs, topped out and began reversing lower after the markets were hit with several downside surprises on both UK and Eurozone data. The pound sterling was especially hit hard and sold-off strongly after the latest UK Final GDP data was released and digested.

Once Wall St. got rolling equities were actually in the green but within seconds of the Consumer Confidence data hitting the news wires, the Dow, S&P 500, crude, and gold did a complete reversal, dragging the EUR/USD and GBP/USD with it. I think what was most interesting about today was how the markets showed their sensitivities to fundamental data and how fundamentals connected to growth and the consumer continue to drive overall market sentiment, risk appetites and money-flows... before all the big data came out this morning the markets ran up all the higher-yielders only to bring them all back down as the bad data erased the euphoria and brought back a sense of fear.

In recent weeks the trend with the fundamentals have been for better than expected numbers and this has been very supportive of prices but now we are starting to see signs that the markets haven't fully embraced risk because on days like today when the data surprises to the downside the markets sell-off.

Q2 market review -- how the EUR/USD and its correlated markets performed:

Overall, the second quarter was good for the S&P 500, good for crude, good for the EUR, GBP, and AUD and bad for the USD and JPY. During Q2 crude oil, equities and the higher-yielders like the EUR/USD and GBP/USD made their year-to-date highs while the USD, US dollar Index, and Treasuries hit their lows. Obviously this isn't a coincidence based on how those markets correlate with each other but what should be noted is that the strong upside momentum seen during the height of the euphoria on Wall St. has clearly subsided as we now enter Q3 and full on summer trading conditions.

We'll get to Q3 in a moment but lets first take a look at how the correlated markets performed during Q2...

S&P 500 vs. US dollar Index--

The two "gods of war" did battle all quarter long and the S&P 500 clearly emerged as the winner here as the S&P 500 gained 15% in Q2. At the start of the quarter the S&P 500 was trading around the 780 level running all the way up to the 950 level on 11-June. The US dollar Index started the second quarter right near its highs at the 86 level, made it a few ticks above 87 and then fell dramatically to the 78 level by 2-June. Just based on the numbers we see some pretty clear evidence the S&P 500 and USD Index maintained a fairly tight inverse correlation just as they should.

Crude oil--

In my opinion crude oil was the leader of the Q2 rally and the center of the financial universe. Spot crude started the month a few pennies above the $47 level and was only $15 above its year-to-date low back in Q1. After failing to sustain a break below the $43 level, on 21-April spot crude took off and never looked back the entire second quarter. On the very same day spot crude made its quarterly low, the S&P 500 made its quarterly low, rising from the 823 level and never returning that low the rest of the quarter. The very day and exact hour that spot crude hit its high above the $73 level the S&P 500 futures also hit its high above the 952 level. Coincidence? Of course not.

EUR/USD--

Any traders using the equities and commodities correlation to trade the EUR/USD, GBP/USD, GBP/JPY, and EUR/JPY should have had a relatively profitable second quarter because the correlations worked about as beautifully as it gets. Add in the fact the Fed told the markets to sell the dollar on two separate occasions made trading even easier. The first time the Fed told the markets to sell the dollar was just a few days before Q2 began... on 18-March the Fed gave their first "please sell the dollar" message to the markets and the markets did exactly as they were told. A few weeks later, in Q2, the Fed renewed its anti-dollar message in their FOMC meeting minutes.  

So as Q2 began the markets were comfortably in an anti-dollar and pro-euro, pro-crude, pro-equities frame of mind based purely on Fed monetary policy. On 18-March when the Fed told the markets to devalue the dollar, the euro gained about 500-points on the dollar, a month later the euro made a test on the downside from where it took off on that day, it failed to break lower and then never looked back the rest of the quarter. The EUR/USD's bottom to top move during Q2 was from the 1.2880 level all the way up to the 1.4330 level.

Crude oil, the S&P 500, the Dow Jones, the EUR/USD, GBP/USD, GBP/JPY, and EUR/JPY all made their year-to-date highs during Q2 while the US dollar and US Treasuries hit their year-to-date lows but out of all those correlated markets, only crude oil has shown any ability to sustain its gains and make repeated upside attempts to break its yearly highs.

Q3:

Looking ahead at Q3 I see some potential trouble for the higher-risk, higher-yielders especially if they continue to show this recent pattern of being vulnerable to poor fundamentals. Remember, for the equity markets it takes sustained buying conviction to keep prices supported and moving up. That sustained buying conviction has obviously dried up in recent weeks and I think the only thing keeping Wall St. alive right now is crude's continued support above the $65 level.

As I say in many of my updates, I still think crude oil is the linchpin that makes or breaks the markets. The euro had a great quarter against the dollar but this is not because the euro is strong, or because its bullish, or because the Eurozone is in better shape than the US. All the evidence for why the euro made a strong Q2 run against the dollar is clear and if crude oil gives way to the downside it will bring the S&P 500 and the euro down with it.

Bear in mind what kind of efforts the ECB went to during Q2 to talk up the euro. Last week the ECB had six of their own central bankers talk the euro up about 300-points against the dollar and that was the pattern they followed all quarter long. Will the trend of the ECB talking the euro up continue in Q3? I have no idea but the euro's first Q3 test will happen on Thursday at Trichet's monetary policy press conference.

As a whole, the markets will get their first Q3 test with Thursday's NFP and Unemployment Rate event. Trying to predict or forecast what Q3 is going to be like isn't worth burning brain cells over but unless the correlated markets become completely disjointed I plan on trading the same exact way I've been. If China puts out some hot fundamentals during Q3 and crude oil can sustain a move over $75 this would obviously be supportive of the S&P 500 and the higher-yielders in the Forex market.

China was a pretty important fundamental factor in Q2 and as long as market participants rest their hope in a Chinese recovery, good or bad, the Chinese data should continue to drive money-flows. Also, the Fed and ECB played the see-saw game quite well during the last part of Q2 in order to keep the EUR/USD in a fairly tight range. It's not been in the interest of the Fed and ECB and their respective economies to see large daily fluctuations in the price of the EUR/USD and US dollar Index. So for Q3 I will closely monitoring every piece of rhetoric and monetary policy action by the Fed and ECB in order to see which currency they want stronger and which one they want weaker.

Q3 monetary policy--

I see no change in the Fed Funds Rate during Q3, it won't go up and it won't go down. The ECB on the other hand does have room to cut rates in Q3. A few days ago Trichet said he's not cutting interest rates on Thursday but this doesn't mean he won't cut them in August or September. Fundamentally, the Eurozone is entering the third quarter in a deep recession. The European banking sector remains fractured, growth has strongly contracted, German exports are at multi-decade lows, some European sovereign debt has been downgraded and worst of all is the imminent threat of deflation.

Here again I can't predict how Trichet will handle ECB monetary policy this quarter but he's got his hands full because the fundamentals are not improving for Europe and the inflation/deflation situation is ugly. A persistently strong euro isn't doing the Eurozone any favors right now and I think if a strong euro becomes too painful and the ECB comes under pressure they could easily use monetary policy or verbal rhetoric to bring the euro lower, I'm not ruling this possibility out at all during Q3.

The other risk for the euro is that the ECB could embark on a loose monetary policy path of monetizing debt. The Maastricht Treaty prevents the ECB from doing exactly as the Fed and BOE are doing with their sovereign debt but these central bankers are creative enough to get around rules and regulations, when they have an agenda they can make it happen. Of course this is also a risk for the dollar should the Fed decide to buy more than $300 billion worth of Treasuries in Q3.

At some point during this quarter more talk of hyperinflation will emerge and that could make things interesting but I'm not forecasting any hyperinflation happening in Q3. Consumers are still punishing economies right now and they are causing more of a deflationary environment. When consumers embrace the old ways of relying on credit and debt, the price inflation will return but for now all this talk of hyperinflation is absurd. Last summer it cost me $3.25 for a gallon of milk and $4.10 for a gallon of gas. This weekend I paid $1.58 for that same gallon of milk and $2.35 for a gallon of gas. All the money the Fed is printing is purely inflationary but there is no hyperinflation, there is disinflation right now.

So for Q3 I believe we continue seeing mostly loose and sloppy monetary policy in order to reinflate the markets and keep prices supported.

Wednesday trading:

Trading tomorrow could get very interesting... its the first day of the new quarter and that usually means some market participants attempt to pre-position themselves for the next three months. In addition, we have another full load of fundamental data which I expect the markets to react to. The bulk of the key data comes out of the US with ADP NFP, ISM, Pending Home Sales, Construction Spending and Crude Oil Inventories. Your guess is as good as mine for how this data will print and even though ADP is about as worthless as it gets the markets may take a strong reaction to any upside/downside surprises on that data.

You remember what kind of intense volatility last month's NFP report brought to the markets... we could easily see a repeat performance on Thursday, so if ADP prints much better or worse than expected we could see the markets move strongly in anticipation of Thursday's employment event. The markets may also see more rounds of profit-taking ahead of the ECB, so be on the lookout for that.

Basically it's looking like we could have some heavier price swings tomorrow as the liquidity and market participation will be low and there will be plenty of numbers and data sets for market participants to jump on all day long. As far as trading goes, I still favor selling the dollar and yen against the majors and crosses into their strength (i.e. buying the dips). The EUR/USD went 1-pip below my last downside key level today and bounced nicely, so as long as the markets keep buying crude and the S&P 500 on the dips, I'll keep buying the EUR/USD when it dips. When I do see crude oil finally show viable signs its cracking and breaking down I'll feel more comfortable buying the dollar and yen against the majors and crosses but not until then.

All the currencies are crap but from a trading standpoint I'm not going to fight against the market correlations or what the central banks want... when they want the dollar higher and the euro lower I trust they will say the word, they've been reliable market-movers. As always, be very smart with your risk and money management. EUR/USD key levels will be posted before Wall St. opens tomorrow. 

-David