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.
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.
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.
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.