Euro falls on German bank downgrades:

Just after 0928 EST this morning Standard and Poors cut the ratings on five German banks to negative and within minutes the EUR/USD came lower from the 1.3368 level down to the 1.3271 key level by the 1030 EST time frame. At the same time of the announcement the S&P 500 futures failed to move above the 912 level, dropping several points and that certainly set-up a perfect storm for the euro to tank. Banking downgrades are never a good thing and with Germany being Europe’s largest economy, news like this is just plain bad for the euro.

The reason a banking downgrade would pressure a currency and cause it to sell is because of the risk factor. Money managers make their decisions based on these type of risk factors and when a bank is downgraded, especially to negative, it requires a shift in money-flows and the overall risk plan for how money and assets are managed.

A few traders asked me if I took a euro short after this news came out. No, I did not short the euro, but what the news did was get me out of a profitable euro long knowing the EUR/USD had to drop because the fundamentals of a German bank downgrade would make it impossible for the euro to move up any higher and would pressure it lower, especially with the S&P 500 futures and spot crude moving lower respectively at the same time the bank downgrade news hit the markets.

And that’s pretty much how market participants handle a situation like this… euro longs produced good profits earlier in the day, then we get a banking downgrade, so market participants are given a great reason to start booking their profits and the euro buying ceases causing price action to move lower, then stops begin getting triggered on those traders who either missed the news or had no understanding of how that would impact the FX market, and you know the rest of the story…

As soon as the S&P 500 and futures recovered after 1400 EST, the euro was back up to the 1.3350+ level in NY afternoon trading.

Stress test results leaked:

All 19 banks undergoing the so-called stress test “passed” but many were deemed under capitalized and will now be required to raise money. I’m not sure how an insolvent bank passes a stress test, but oh well… Here are the results:

  • Wells Fargo needs to raise $15 billion
  • Citi needs to raise between $5 and $10 billion
  • GMAC needs to raise $11.5 billion
  • Key Corp needs to raise $3.3 billion
  • SunTrust needs to raise $3.3 billion

What about Bank of America? There’s a whole of speculation and rumor for BOA, some are saying they need $30 billion, some are saying they need $35 billion, others are saying they need $70 billion, and the last I heard, they don’t need to raise any capital at all… Metlife and Regions Financial also failed the capital requirements test and they too need to raise capital. Goldman Sachs, JP Morgan, Bank of NY, AMEX, and Morgan Stanley all passed the capital requirements test. Keep in mind, this is just the information the Fed and Treasury have been leaking to the markets and they may not be the exact official numbers, we’re just getting the numbers the Fed wants us to know. The official results are scheduled to be released tomorrow.

What I’d like to know is not how much capital these banks needs to raise but why they need to raise billions upon billions. It’s like if you wake up with your rash all over your body, you don’t go to the doctor just to have him say, “you’ve got a rash”, you go to the doctor for him to tell you what the rash is, what the cause is, and how to fix it. We all know a lot of those banks are insolvent but what we’re not being told is why they are insolvent, so to me, this test is just another joke and pointless exercise in futility.

ECB rate event outlook:

Tomorrow is the moment the market’s have been waiting for… will the ECB follow the Fed and BOE or won’t they… first of all, lets look at a few of the facts:

  • The Eurozone fundamentals are abysmal
  • Germany remains in full recession
  • European banks remain under pressure and continue being downgraded
  • European growth is expected to contract by 4.00%
  • Debt-to-GDP levels are above EU standards
  • Evidence of consumer and producer disinflation
  • Eurozone unemployment expected to rise to 11.5%

Those are just a few of the issues, with the worst being continually contracting growth, rising unemployment, and the worst of all, potential deflation. Europe is under performing against the rest of the world and the European banking system continues to be fractured. Some of the worst banks on the planet are European banks… they remain highly leveraged, insolvent, and on the brink. I’m talking about crap banks like RBS, UBS, Fortis, ABN etc.

Now if it wasn’t for the euro’s tight correlation to the S&P 500 and the European bourses tight correlation to Wall St. equity markets, there’s no telling how nasty things would be looking right now. So, in regards to what the ECB will do with interest rates, I expect the ECB Key Lending Rate to be reduced by 25bps to 1.00% and the deposit rate to remain at 0.25%. Should the ECB cut rates by more than 25bps, that would be viewed as a shock to the markets and we should expect to see the euro sell-off, likewise, if the ECB holds rates at 1.25%, this too would be a shock and the euro should gain good ground against the dollar.

Non-standard measures–

The real question for tomorrow is, what will the so-called ‘non-standard measures’ be? And will there even be an announcement of non-standard measures? As we’ve talked about many times the past two weeks, various members of the ECB governing council have been talking the euro up and talking it down in addition to giving strong rhetoric for or against the use of non-standard measures. There’s a clear divide on the governing council and some members have come out strongly against buying debt, quantitative easing, and adding more fiscal stimulus.

In it’s current state, the Maastricht Treaty forbids the ECB from buying sovereign debt. Basically, law forbids the ECB from doing what the Fed is doing with Treasuries. But as we all know, central bankers are masters of creativity and political spin. We have no idea if any backroom deals were made to somehow magically make it legal for the ECB to buy European sovereign debt, so I think we go into tomorrow’s rate event knowing there’s a good potential the ECB announces a plan to buy government debt. The probabilities for this happening are not high, but they exist nonetheless.

In order for it to even make logical sense for the ECB to buy sovereign debt they would have to reduce their key lending rate to at least 0.75% but more likely to 0.50%. No matter how you slice it, it makes zero sense from an economic and fundamental standpoint to go down the route of quantitative easing when the bank refinancing rate is at 1.00% or higher. No central banker with half a brain cell would go down the quantitative easing route and forced currency devaluation when interest rates are still higher, they would first take rates low and at least to 0.75% before starting that program.

But, there’s no way me or anybody else can predict what Trichet will reveal during his 0830 EST press conference in regards to these non-standard measures, I don’t even want to speculate on it anymore. I will not attempt to pre-position myself I’d rather allow Trichet to reveal what he wants and say what he has to say, and then go from there. That being said, if he does reveal a quantitative easing plan, I’ll change my bias not to buy the USD right now and I’ll sell the euro against the dollar, no questions asked.

Potential euro risk–

Beside the debt-buying risk, the euro is also at risk should Trichet give strong rhetoric about deflation and or disinflation fears in Europe. I cannot stress enough how terrible deflationary pressures are on the euro, it’s really a terrible thing. Some of the Eurozone’s data shows true disinflation happening in Europe. If Trichet decides to put the spotlight on this issue and warns that deflation could be a real credible problem for Europe, the euro should get hammered. Deflation is a very bad thing for a currency…

That’s all I’ve got to say on the interest rate event. All the market movers will be watching, listening, and dissecting Trichet’s every word so do yourself a favor and tune-in. You can watch it here at 0830 EST / 1230 GMT.

New anti-hedging rules from NFA:

Several traders have asked me to comment on the new hedging rules from the NFA. After 15-May, US-based retail FX brokers who are members of the NFA will prohibit the use of hedging (holding a long and short position on the same currency pair). In my opinion I don’t see an issue here, reason being, the vast majority of retail traders are under capitalized and don’t even belong in the spot FX market to begin with, and when they hedge they get themselves in even more trouble and only hasten a margin call.

It’s said over 90% of all retail FX traders lose money and I believe this is due to the problems of under capitalization, over-leveraging, and terrible risk management. I do not advocate under capitalized retail traders making an attempt to hedge their positions. If they can’t properly manage 1 position, having to manage 2 opposing positions isn’t going to make their life any easier or their trading any better. Hedging should be the last thing on the mind of a retail FX trader, learning proper risk management, how to safely use leverage, and how to better time their trades should be the top priority, especially if the trader is under capitalized and doesn’t have the buying power to play in this market in the first place.

Retails traders who are disciplined enough to manage hedged positions can get around this new regulation by taking their money to either a non-NFA member broker or to a non-US based broker. Being a member of the NFA doesn’t necessarily make a broker “safe” or scrupulous. The NFA is not a government agency, it’s an independent self-regulatory agency, and brokers pay a fee to be a member, they don’t gain membership based on their own merits or high standards. In other words, just because a broker is a member of the NFA doesn’t mean they don’t and won’t pull typical broker scams.

For those traders who are upset about this, I suggest filing a complaint against the NFA itself. Hedging is a common practice in trading, it’s standard fare, so if you don’t like the rule, I’d say the best thing to do is file a complaint against the rule maker. You can file a complaint against the NFA right on the NFA’s website… you can click here to access the complaint form. The NFA’s own ID number is: 9999998, and in the description box you an state your case against them.

Thursday trading:

The ECB rate event will be what I’m most focused on between now and the next 16-hours. Once we find out what the non-standard measures are, what the ECB’s latest monetary policy is, and what Trichet’s view on economic conditions and deflation are, all markets will finally have much more clarity and will be able to take things from there. Again, it’s pretty simple, if the ECB decides to monetize debt and or sounds the alarm on deflation, I would not be long the euro.

The other big event on Thursday of course is the BOE interest rate event. I’d be surprised to see BOE take their interest rate below 0.50%. They could do it, dropping their rate another 25bps but now that they’ve already started their own brand of quantitative easing there’s really no need to take the interest rate any lower.

For US markets, we get Intial Claims and then a Bernanke speech at 0930 EST. Later in the afternoon the ‘official’ results of the stress test are due to be released, but at this point I don’t see that factor doing much to hurt Wall St. The Fed did a great job casually leaking information in order to allow Wall St. to digest it all over time instead of hitting them in one shot.

As mentioned last night, I remain highly bearish on the USD and JPY. Buying the dips on the EUR/USD, GBP/JPY, and EUR/JPY has been a great trade for some easy profits but obviously this could all change tomorrow, purely based on the ECB’s monetary policy. If the ECB wants the euro lower, it won’t be a mystery based on what Trichet has to say at the press conference. The ECB has been great at talking the euro up and down the past few weeks.

In reality, the euro is just as much trash as the dollar, there is no fundamental basis for a stronger euro, but again, due to the stronger EUR/Equities correlation, the euro will almost always gain on the dollar overall when the S&P 500 and crude gain, which sends the USD Index lower. But the ECB’s monetary policy could certainly bring a temporary reprieve to some of the euro strength we’ve seen since failing to break below that 1.2901 mega key level a few weeks ago.

Pre NFP–

Once we get the big interest rate events off the plate, the market’s focus will then shift on Friday’s NFP, and that means the usual amount of book squaring and pre-positioning that goes on with market participants. This morning ADP’s NFP printed at -491K vs. an expected print of -644K. That upside surprise instantly caused the analysts and market economists to totally rethink their NFP forecasts and almost all of them dropped their forecasted range, hinting at a better NFP print for Friday.

I’m really not convinced NFP even matters much for Friday. A nasty print and surge in the unemployment rate is probably not going to knock Wall St. back too far, if at all. The bulls on Wall St. remain firmly in control, just like the bears were earlier this year, and the longer this rally drags on, the more the shorts get squeezed out, and the more the stragglers begin chasing the market up. And what that all means for us FX traders is, as long as the rally on Wall St. holds and crude keeps moving to the upside, the dollar and yen will need to go even lower, it just cannot work any other way. Wall St. really is a great trade indicator.

As always, strict risk and money management will be imperative on Thursday and Friday. I will have EUR/USD key levels posted before the 0830 EST Trichet press conference and I’ll be in the chat during the event.

-David