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Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

By , Chief Currency Strategist
07 December 2012 03:06 GMT

The fundamentals, technicals and market conditions are all saying different things about the bearings of general risk trends. Looking at the charts, we see global equity indexes particularly winded at prominent resistance levels after aggressive advances. Similarly, from the FX side, the EURUSD, AUDUSD, NZDJPY and other risk-sensitive currency pairs (coupling a high yield or fundamentally-troubled currency to a safe haven) are staring down their own chart defined ceilings. Yet, here too we have a consistent, bullish bearing.

In contrast, the Fundamental outlook is riddled with uncertainties and ‘fat tails’ that could severely undermine investor confidence moving forward. We can take our pick amongst the threats. Providing the splashiest headlines is the United States’ impending Fiscal Cliff. However, that isn’t the only issue at hand. The Eurozone financial crisis, Japanese election, speculative capital swell in emerging markets and the spreading global recession are all ongoing and ill-defined concerns. Each is capable of stoking panic should systemic crises emerge, but they can also be the source of relief rallies – something we have seen recently.

Discerning the mix between fundamentals and technicals and its net influence on the markets would be difficult enough, but there is a third factor that further complicates (or perhaps refines) the situation. Market conditions are essential to how and where we move. If there is a serious lack of speculative participation and there is little support for trend development – as we are seeing now – it will be difficult to initiate major breakouts or reversals in anything short of a dramatic change in underlying fundamental themes.

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_4.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Read the Introduction to Risk Trends and the Risk-Reward Indicator Here.

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_5.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

When it comes to sorting through all the conflicting information, speculative bearings and lingering uncertainties in the market; our first step should be to assess whether conditions are such that they can actually support the big technical breakout or feed a fundamental driver if they are put into action. Historically speaking, the period between the US Thanksgiving holiday and the end of the year sees a steady withdrawal of speculative interests from the market as traders square off their books for the fiscal year and others simply cut or reduce positions knowing that a lack of participation normally curbs trend development until the New Year begins. A further complication this time around is the fact that the level of investor interest has trended lower since the financial crisis. In fact, exposure (measured through S&P 500 futures open interest) is at its lowest level since 1997.

Given the level of market depth, it will be extremely difficult to jump start and maintain trends in either direction. If we consider the essential process of developing a deliberate trend for the market, more important than the initial shock that encourages movement is the readiness for capital on the sidelines to enter the market as new highs or lows are established. Naturally, when there isn’t enough a market to extend the extremes on price movement, progress quickly stalls and is eventually retraced.

Many traders are tempted by the proximity of pairs like EURUSD and AUDUSD to prominent technical levels against the backdrop of heavy event risk. Bullish or bearish, it seems all the elements are there for a big market movement. However, when we consider the backdrop discussed above, we can see a very difficult picture. Low liquidity can certainly leverage volatility and thereby overrun the nearby technical levels, but trend development will be exceptionally difficult. To spark and feed a trend against this backdrop, we need a fundamental development that can override the natural complacency that has descended of the market. And that isn’t wholly impossible.

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_6.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Risk–Reward Index vs Market Standards

Complacency in risk (as we seen in the five-year lows from the FX Volatility Index) is the centerpiece for driving a ‘risk off’ theme. The overextended position of equity indexes like the S&P 500 and high-yielding currency pairs like AUDUSD is most exposed to an overwhelming risk aversion drive that forces both the deleveraging of risk exposure across the board and drives up the cost of insurance (what implied volatility essentially measures). The general outlook of a global economic slowdown and dislocation of financial markets doesn’t seem to be threatening enough to stir fear. However, we could see one of the extraordinary threats to the system implode. Either news that the Eurozone will withhold payment of Greece’s next tranche of aid on December 13 or the US government fails to resolve the Fiscal Cliff can ignite such a fear.

Yet, while those are sizable risks, the more likely outcome for both is for satisfactory outcomes for both. For the ‘risk on’ scenario, would the immediate resolution (postponement) of these two of these risks be enough for a strong risk appetite rally? It’s unlikely. The first consideration is that resolving these threats is not the same as laying down the road to strong growth and higher yields. It is a ‘relief’ rather than strength. Furthermore, capital markets have never really fallen back to oversold territory; and we have already seen in the recent bounce from these various assets that short-term risk premium has already been significantly discounted.

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_7.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Majors Correlation to Risk Trends (How Influential is Risk Appetite)

Below, are charts that show the price action for the majors against the correlation that the pair runs against the Risk-Reward Index. The closer to 1.0 the correlation, the pair will move in lock step with risk appetite (optimism rises and so does the currency pair). On the other hand, the closer a reading is to -1.0 means the closer the pair moves in exactly the opposite direction but at the same pace as risk trends.

This is valuable information for fundamental traders. If you recognize a currency pair is highly correlated (positively: close to 1.0, or negatively: close to -1.0), we know that we should be watching factors that change sentiment to offer us guidance on that particular pair. Alternatively, the closer to 0.0 the reading, we know that there is less influence from risk trends and we can trade independent of that bigger theme.

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_8.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_9.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

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Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_11.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_12.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_13.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

Forex_Strategy_Risk_AUDUSD_Reversals_Tempting_but_Troubled_body_Picture_14.png, Forex Strategy: Risk, AUD/USD Reversals Tempting but Troubled

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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07 December 2012 03:06 GMT