Gain Capital

The USD sank to new lows in its current downtrend against most major currencies, but by the end of the week, it was on the rebound against all but the EUR and JPY. Notably, however, it was not a US dollar-centric rebound, but rather a messy unwinding of risky asset trades, fueled by further write-downs (and rumors of still more losses and write-downs) of MBS (mortgage-backed securities) debt held by banks. The exodus from risky trades saw stocks plummet, JPY-crosses plunge, gold rejected from just below $850/oz, and commodities retreat from new highs.

The fear and uncertainty surrounding the credit meltdown shows signs of only increasing and the key element remains the suspicion that financial firms are still not revealing the full extent of losses from toxic debt. Concerns spread to other global financial centers leading to sharp equity market losses around the world. Continued market turmoil is also raising the perceived risks of a recession in the US and undermining global growth scenarios. The doubt, suspicion and uncertainty emanating from the financial sector looks set to continue for the time being and this will keep markets volatile and risk averse. Such an environment is likely to keep the JPY supported and to benefit the USD in general, as widespread uncertainty gives the buck a safe-haven bid.

In the context of the overall USD downtrend, expectations have been that the Fed would be forced to lower rates further, while the potential for rate hikes remained elsewhere, most notably in the Eurozone. Fed Chair Bernanke indicated that he expects the US economy to slow noticeably in coming months, but he also cautioned that rising inflationary concerns may not permit the Fed to ease. Markets went with his first indication and priced in a 98% likelihood of a ¼% rate cut at the Dec. 11 FOMC meeting. ECB Pres. Trichet, also noted rising inflationary pressures and increased downside risks to growth. While he could not say it, it appears increasingly likely that the ECB will be forced by circumstances to forego further rate hikes. Ongoing premiums in money market rates represent a de facto tightening as it is, and EUR strength has become a sensitive political issue, both suggesting a pause in tightening. As time passes, the likelihood of lower growth will further obviate the need to tighten rates, leaving the ECB looking at a potential rate cut in Q1 if growth slows more rapidly than forecast. The ECB will again revise its 2008 growth outlook next week, and expectations are that GDP estimates will be cut by a ½% to 2.0%.

In terms of price action this week, I observed several key reversal signals in a variety of currency pairs and other markets. (Please recall that a reversal signal does not necessarily indicate that prices will turn around and move in the opposite direction, only that the prior trend has stopped. Prices could move sideways in a consolidation or reverse course, or some combination of the two.) In gold, a double-top was made at 845.60/80 on two successive days. In candlesticks, the gold prices generated a tweezer top pattern. This pattern was also evident in the US dollar index, which posted a tweezer bottom pattern at about 75.00, suggesting the decline is set to pause and possibly recover higher. The CRB commodity index posted a series of spinning tops, a signal of uncertainty with regard to the existing trend, and a potential harbinger of a price reversal. In commodity currencies, AUD/USD posted a shooting star top, a reversal signal after an uptrend, and USD/CAD posted a hammer pattern, a reversal indicator after a downtrend. In GBP/USD, a bearish engulfing line on daily’s, with a long upper shadow indicating sharp rejection, and a doji on the weekly, suggesting a top has been made. Only EUR/USD and USD/CHF have failed to show such strong indications of an end to their trends, but I am watching closely as the other currency pairs tend to act as leading indicators.

The Eurozone group of finance ministers is set to gather in Brussels on Monday evening for a regularly scheduled meeting on Tuesday. The strength of the EUR will undoubtedly be a topic of discussion, and a subject of impromptu remarks from arriving ministers. But so long as Germany continues to resist criticizing the currency’s strength, concrete actions to stem the EUR’s rise do not appear imminent. From the US side of the equation, US Treasury Sec. Paulson continues to demur on the weak USD, leaving it to twist in the wind. Finally, the Forex market was given a red herring this week in the form a Chinese politician suggesting China would more actively diversify its foreign reserve assets away from the USD. The official is a political functionary with no role in currency allocation policy and he has made misguided statements in the past. Subsequent statements sought to downplay the remarks, but the damage was done, having boosted the EUR and GBP by about 200 pips a piece. A more formal statement by the Chinese government that reserve diversification policy remains unchanged could quickly see that extra premium evaporate.