Gain Capital

Financial market turmoil continues unabated with the major development this week being the evaporation of lending in the inter-bank market, necessitating liquidity injections from the world’s leading central banks. The proximate catalyst for that was the announcement on Thursday by BNP that it was freezing redemptions because it could not accurately value the assets held in three asset-backed securities (ABS) funds. Liquidity injections were needed again on Friday as banks demanded interest rates well in excess of central bank benchmark overnight interest rates for a second day in a row. For example, Fed funds opened on Friday at 6%, 0.75% higher than the Fed funds target rate. The Fed added liquidity, in three separate operations, to bring the rate back to the target level of 5.25%, while also opening the discount window, the Fed’s last-resort lending facility. I don’t know yet whether any banks had to go to the discount window (probably not given the Fed’s repeated repo operations), but if any have it’ll lead to another ratcheting up of credit concerns.

Looking ahead, about the only observation I can make with any degree of certainty is that volatile trading conditions will persist for the foreseeable future. Risk aversion remains at extremely high levels and positions continue to be liquidated. Economic data reports will have little overall impact while this environment persists, but data pointing to the downside will likely have a more pronounced effect than any positive data. Markets remain both nervous and relatively illiquid, a recipe for continued volatility.

Which way will volatility push the major markets? Given overall uncertainty and the sporadic nature of news items, it’s nearly impossible to predict fundamental events that may transpire. In times such as these, I rely more extensively on the charts and the picture I’m seeing is not a pretty one.

Looking at the US equity markets first, I would point out that the S&P 500 index fell through the Ichimoku cloud with the sell-off of July 26. (Ichimoku analysis is a long-term trend identification system. When prices are above the cloud, roughly a series of moving averages, the trend is higher; when prices are below the cloud, the trend is lower.) Subsequent price action saw the S&P make new lows only to rally sharply earlier this week. That rally tested (you got it) the cloud above and was rejected in extreme fashion. The DJIA, lagging the S&P, finally broke below the cloud yesterday and today’s high was exactly on the cloud resistance and we look set to close below the cloud. Looking at the S&P on the candlesticks, I’m struck by the last two weekly candles showing very long tails on the upside. Those long tails are symptomatic of a market that is trying to rally, but keeps getting knocked back down. Overall the patterns are very bearish and suggest further weakness is ahead. Daily candles are a little more optimistic, with Friday’s S&P generating a ‘hammer’, potentially signaling a few days of strength early next week. How might those conflicting signals play out? The lack of any bad news over the weekend may be sufficient to embolden buyers again early next week, leading to a few days of gains, until fresh bad news materializes later next week, fulfilling the bearish weekly candle view.

Turning to the currencies, all the action has been focused on the JPY-crosses, the mainstay of the carry trade. I would briefly note, however, that the USD index tested briefly below the pivotal 80.00 level only to rally sharply subsequently, leaving a double bottom in its wake. That price response continues to support my overall view that the USD has bottomed against European currencies (EUR, GBP, CHF) as well as the high yielders (AUD and NZD).

Re-focusing on the JPY-crosses, the volatility has been overwhelming to say the least. Taking a step back and looking at weekly candlestick charts, the last two weeks have posted two successive spinning tops, with some pairs showing a ‘double-doji’ (where the weekly close is the same as the weekly open), with very long tails on both sides reflecting intense volatility. Spinning tops and doji pattern are neutral and symptomatic of indecision in the market about which way to proceed. A pair of spinning tops or a double doji indicate heightened uncertainty and suggests that the eventual resolution of the period of indecision will be especially explosive. But explosive in which direction? Given the overall negative trading conditions in the market at the moment and the risks they pose to the carry trades, I have to conclude that the risks are for a pronounced downside breakout in the JPY-crosses. Keep in mind that Friday’s price action also generated ‘hammers’ in most of the JPY-cross pairs, suggesting we may see some initial strength in the early part of next week, similar to what I described above for the equity markets. But the overall expectation is for further weakness in the JPY crosses and I think they remain a sell on rallies.

The sub-prime meltdown has cascaded from financial market to financial market, first roiling the mortgage-backed debt market, then broader corporate debt markets, followed by stocks. This week, the commercial paper market got hit. While the forex market has been more volatile recently, I would suggest we have not seen the ultimate shake-out in the JPY-crosses yet, and that could very easily be the focus of the market next week. Keep in mind that Japanese retail traders have been a source of resilience in the carry-trade, allowing it to remain viable far longer than circumstances have warranted. The exceptional volatility of the last few weeks has likely wreaked havoc on Japanese margin traders, making them less likely to be a force to contain the downside going forward. A final capitulation by the so-called Japanese housewives remains the most likely catalyst for a downside wipe out in USD/JPY and JPY crosses, and currencies may start to lead other markets in the next phase of the volatility cascade.
Looking at the data and event calendar next week, US data begins on Monday with July advance retail sales and June business inventories. Tuesday sees the June trade balance, July PPI and August IBD/TIPP economic optimism. Wednesday sees July CPI, August Empire manufacturing, June TIC data, July industrial production and the August NAHB housing market index. Thursday sees July housing starts and building permits, along with initial weekly jobless claims and the Philadelphia Fed index at noon. Friday has only the preliminary Univ. of Michigan consumer confidence index. The only Fed speaker is St. Louis Fed’s Poole on Friday speaking on US exports.