FX Closing Note: Back to the brink - how deep is the abyss?

John J. Hardy, FX Consultant, Saxo Bank

FX Closing Note: Back to the brink - how deep is the abyss?

The storm of risk aversion that began in Asia overnight swept around the world and completed its destruction of all major markets with a miserable session on Wall Street, as the major US equity indices fell back below Dow 10,000 and the US S&P500 looks to notch its lowest close on the year - around 1040 and right on the neckline of a rather scary head and shoulders formation. Cursory projections suggest a high risk of a fall toward the 900 area or below if the cold winds of risk aversion continue to blow.

So how would such a continuation of this move in risk aversion affect FX? After some degree of surprising resilience in especially the AUD of late despite generally negative risk tendencies elsewhere, the commodity currencies fell like a trio of lead zeppelins today vs. especially the USD, JPY and CHF. (In EURCHF, we suspect that the time horizon for declines like we have seen in the last three days may only stretch another day from here, as similar markets in the past show that four large days of declines is often the most you get in parabolic kinds of market action. The tricky aspect here is more the price than the time, since acceleration is sometimes at the highest as the trend comes to an end before someone finally steps into the breach.

Apparently it took negative implications from China and a commodity sell-off to get things rolling for the bears on these currencies as the market had perhaps been distracted enough by the weak US economic data to avoid buying greenbacks for a time (perhaps some tired old EM decoupling thinking going on out there?). But today showed the folly of that tack, as an absolutely horrific US Jun. Consumer Confidence surprise (doubly so from the confusing improvement in the Michigan data) triggered a further collapse in market confidence that rewarded the USD rather than the pro-risk currencies - the old pattern, in other words.

The US Consumer Confidence number is made of two equal parts: present situation and expectations. The present situation component moved to a three month low and - very much like the weekly ABC number - has never come very far off the near historic lows established last year. The expectations component dropped to a three-month low after posting a new 20-month high in May.

In the recent past we have theorized that the Euro might eventually be rewarded to some degree for its liquidity whenever a risk sell-off gets particularly steep. This was certainly the case back in mid-May, the first time risk aversion caught the overly short Euro FX market by surprise and saw a huge squeeze in Euro shorts, despite the fact that most of the market's misery was seen as triggered by trouble in the EuroZone sovereign debt market. That's the way the market's twisted logic works sometimes, and this time around we could see tremendous upside for the likes of EURAUD, EURCAD, etc.. if the  head and shoulders scenario for risk plays out and the bear continues its fearsome growl

EURAUD
The huge short squeeze from May only yielded to a grind back toward the cycle low, which is also the record low for this currency pair. This echo rally could set up a sequence of another 1000 pips or more higher as long as risk aversion remains the theme.

EURAUD and rate spreads
Here's a chart showing EURAUD vs. 2-year swap spreads. Of course, some of the divergence here suggesting that EURAUD is underpriced is due to the sovereign debt issue that Australia has almost entirely escaped, but the last squeeze showed us that market positioning can sometimes trump all else.

Looking ahead
Let's see how the weekly US ABC consumer confidence number compares with the monthly Conference Board number. We suspect there may have been a drop in the former considering the latest Obama poll ratings, the action in the markets, and the sense of utter helplessness stemming from the oil spill, not to mention continued high joblessness.

Again - watch out for the Australian housing data tonight, with a poor showing in either prices or volume potentially offering further reason for a capitulation in Aussie longs (and any rally a possible excuse for new bears to lever up now that the 0.8550 area has fallen). Tomorrow we have Canada's GDP number for April, the US ADP employment report for June, and the June Chicago PMI.

Stay careful out there as always.