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Wednesday July 7, 2010 - 12:53:03 GMT
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U.S. Stocks Called Lower as Traders React to Asian, European Weakness

U.S. equity markets are trading lower this morning ahead of the opening in New York. Although the markets closed higher on Tuesday, they started to peel back gains about mid-session on concerns about consumer discretionary stock losses and a slow down in global growth.


Recent weakness in U.S. economic reports have been driving up demand for risk, but last night’s break appears to have started as traders reassessed the U.S. economy’s impact on continued global growth. Investors are also taking risk off the table after more information about the European bank stress tests was revealed.


European regulators are expected to reveal today how they intend to test the health of the Euro Region’s banks. The purpose of the tests is to simulate the impact of a severe economic shock to the banking system. The regulators will be attempting to restore confidence in the markets, but investors appear to be skeptical about the credibility of the test results. Many feel that the tests will not be stringent enough. This is raising concerns this morning which is leading to long position paring and the subsequent selling of riskier assets.


Currency markets are also feeling pressure this morning especially the Euro and the commodity-linked markets. Emotions are running high in the markets which could fuel a self-off once the New York currency session opens. Without any major U.S. economic reports for guidance, traders may react to the fear developing over the upcoming bank stress tests. Overnight, the Euro weakened on a smaller than expected gain in the Euro Zone GDP and a weaker than expected German factory order report.


September Crude Oil is bouncing off of technical support overnight, but this slight gain could be overcome by renewed selling pressure because of predictions in a drop in demand triggered by the weakening global economy.


On Tuesday, the September E-mini S&P 500 posted a closing price reversal bottom after investors turned up demand for higher risk assets. This pattern will have to be confirmed by a trade through 1038.50. Oversold conditions and a weak U.S. economy helped to boost equity markets throughout the day after a strong showing in Asia and Europe overnight boosted demand for risk. This bullishness was clearly in the U.S. markets on the opening. Later in the morning the U.S. announced a slowdown in U.S. services. This news weakened the Dollar and drove up equity markets.


A weaker economy means the Fed is likely to keep interest rates low, driving up demand for higher risk investments. Investors are treating the weak U.S. economic reports as a sign that liquidity and low interest rates will remain intact for a prolonged period of time. With Ten-Year Treasuries yielding close to 3.00% investors are going to be looking elsewhere to boost their return on investments. This place is likely the equity markets.


Technically, the reversal bottom formation suggests a move to perhaps 1066.00 over the next 2 to 3 days, but trades have to remember the pattern has yet to be confirmed by a follow-through rally.


Despite the weaker ISM services report on Tuesday, September Treasury Notes failed to rally to a new move high. This is a sign that the market may be overbought and getting ready to correct. Depending on how the equity markets behave, T-Notes may begin to feel pressure if traders decide to pull money from the safer Treasuries to reinvest in the higher-yielding equities. The chart indicates room to the downside with 121’00 a possible downside target. If stocks fail to follow-through to the upside, then expect yields to continue to drop on renewed buying interest.


Stocks and bonds are at a critical juncture and something will have to give. Either investors are going to keep forcing yields lower by buying the T-Notes or they are going to begin dumping T-Notes in favor of a better return in stocks. Watch for a pick-up in volatility.


August Gold broke sharply lower on Tuesday. With the U.S. economy weakening traders are beginning to factor in extremely low inflation or perhaps deflation and are selling off gold positions. Furthermore, the unwinding of the Gold/Euro spread is also putting downside pressure on gold. Technically the chart pattern suggests there is plenty of room to the downside with a possible test of a 50% price at $1158.30 likely sometime this week. Gold may reverse its short-term direction if stocks see downside pressure today.


On Tuesday, the U.S. Dollar hit a six-week low against the Euro driven by greater demand for risky assets and a hawkish comment from the Reserve Bank of Australia. A mid-morning report showing that the U.S. Services Sector slowed last month also contributed to the Euro’s rally on the prospects of a weaker outlook for the U.S. economy.


The recent strength in the Euro versus the Dollar is an indication that investors are adjusting positions and absorbing the shift in the recent economic data. Tuesday’s turnaround in many of the Forex markets demonstrates investor willingness to buy riskier assets.


Recent weak U.S. economic releases have encouraged traders to move into a market psychology where poor data triggers Greenback weakness. Earlier in the year, investor sentiment was the opposite. At that time, weak data triggered flight-to-quality buying of the Dollar.


Although a reading over 50 still indicates an expanding economy, today’s ISM report showing a drop from 55.4 in May to 53.8 could be a sign that the pace of the expansion is slowing. This news helped drive an already weak Dollar sharply lower almost immediately after its release. Later during the trading session, short-term overbought conditions helped the Greenback regain some of its earlier losses. 


Last week’s upside momentum in the September Euro continued Tuesday morning. Technically, the main trend is up. The charts indicate that the market has a clear shot at reaching a major retracement price at 1.2783.


Another sign that investors were shifting sentiment toward more risky assets was the sharp rise in commodity-linked currencies. Early in the Tuesday’s trading session, the September Australian Dollar reversed an overnight sell-off after the Australian central bank issued a hawkish policy statement. The intra-day rally put the Aussie in a position to form a closing price reversal bottom after forming a support base inside of a retracement zone at .8469 to .8378. 


Fundamentally, the market was supported by hawkish comments from the Reserve Bank of Australia. In its policy statement, the Australian Central Bank kept its benchmark interest rate unchanged at 4.5%. It did, however, indicate that further rate increases are to come even if inflation continues to increase and China’s economy slows. Tuesday’s strong rally reflects the fact that speculators had been looking for more dovish comments from the RBA.


The strong rise in U.S. equities and a firm crude oil market also triggered a sharp rise in the September Canadian Dollar. Tuesday’s chart action indicates that further strength is likely now that it appears that investors have decided to explore the long-side of riskier assets.


Tuesday’s statement by the RBA also is a strong indication that the Bank of Canada will hike interest rates at its next meeting on July 20th. Speculators had been positioning themselves for a neutral stance by the BoC. Although the RBA left its benchmark rate unchanged, its hawkish comments leaves open the strong possibility that another rate hike is imminent. Yesterday’s sharp turnaround in the Loonie was most likely short Canadian Dollar traders making a hard, fast adjustment to the possibility of higher interest rates.


Weaker U.S. economic data and a shift in risk sentiment also underpinned the September Japanese Yen. Although this currency pair appears to be rangebound while forming a support base, traders can begin to anticipate a break if U.S. equity markets begin to mount a short-covering rally. This break will most likely be fueled by investors reapplying the carry trade strategy to the Japanese Yen. When this occurs, investors borrow funds in the lower yielding Yen to invest in riskier assets such as U.S. equities. Further evidence about a slow down in the global economy may trigger a resumption of the current rally.


Although there is likely to be profit-taking breaks along the way, there has been a notable shift in investor mentality toward more risk. Traders should be aware that weak U.S. economic reports are likely to drive traders out of the Dollar and into more risky assets. The logic behind this shift is that central banks will continue to keep the markets liquid. This means interest rates for the weaker nations will continue to remain low. Aggressive investors will be looking to find a place to put their money to work in an effort to earn better yields in exchange for higher risk.




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