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Saturday July 24, 2010 - 01:09:02 GMT
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Wall Street Turns Bullish after Stress Test Calms Traders

U.S. equity markets soared to the upside late in the trading session after treading water at the mid-session. The markets traded sideways after the release of the European bank stress tests, giving traders time to assess the results. The news that the majority of European banks passed the stress tests came as a relief to traders who shifted their interest back to earnings report and the global economy recovery.

 

The lack of any fresh economic news was another factor affecting the trade today. Earnings reports were good this morning, but with the focus on European stress tests later in the session, gains were limited. Once traders saw that the tests revealed no major flaws in the banking system, demand for risky assets rose along with stock prices. For the week, all three major indices posted strong gains during sometime volatile trading sessions.

 

Earlier in the week, the markets were crushed by commentary from Fed Chairman Bernanke who talked about the weak economy and the need for new stimuli. The markets turned around early Thursday morning when the Euro Zone reported robust gains in the industrial sector. The strong close has the markets in a position to break out to the upside, but gains could be limited late in the week as many cycle watchers are predicting the start of a major break.

 

Treasury markets traded lower after failing to mount a comeback when stocks weakened near the mid-session. T-Bond and T-Note investors took profits after strong rallies earlier in the week. Although interest rates are expected to remain under pressure over the near-term, the shifting of assets out of fixed income instruments and into equities should pressure the Treasuries. Overall, however, traders should look for a correction rather than a change in the trend. This is not likely to occur until there is solid evidence the economy is turning back up.

 

August Gold closed unchanged for the week. Traders are confused about the fundamentals at this time. The rise in stocks should pressure gold as both assets classes compete for the same assets. However, gold may rally if the Dollar gets trashed. Traders have to make a decision as to which event to follow. A decision may be made once gold tests a major 50% level at $1158.30.

 

The U.S Dollar Index had a roller-coaster ride this week although it managed to finish only slightly lower. Based on the November 2009 to June 2010 trading range of 75.03 to 89.22, this market is now testing a major 50% level at 82.12.

 

Over the past two weeks, the pace of the decline has slowed as the market approached the 50% retracement level, but following this week’s inside trading range, may be set up for an acceleration to the downside. A break through 82.12 is likely to trigger a sharp break into the next retracement level at 80.45.

 

Traders should turn their attention to this index this week because of the possibility of stronger than average volatility and the potential for a support base to form between the 50% and 61.8% retracement levels at 82.12 to 80.45.

 

The Weekly Euro had a volatile, two-directional trade this week, ping-ponging between a 50% support level at 1.2783 and a 61.8% resistance level at 1.2998. Technically, the weekly chart formed a closing price reversal top, but will have to trade through 1.2732 to confirm it. A confirmation of this pattern is likely to trigger a 2 to 3 week correction back to 1.2452 to 1.2316.

 

A failure to confirm the reversal top and a close over 1.2998 will be a bullish signal. Look for an acceleration to the upside if this occurs since the chart indicates no major resistance on the weekly chart until 1.3510.

 

On Friday, the Euro was up in early session trading in a continuation of Thursday’s strong rally before jitters about today’s stress tests triggered a profit-taking correction. From an early session high at 1.2965, the Euro broke to 1.2793 shortly after the New York opening.

 

The September Euro spiked to 1.2910 immediately after stress test results began being released, but sold off quickly as traders were disappointed with the results. Although only a small number of European banks passed their stress tests, investors remained skeptical about the methodology used by the regulators. Many viewed the guidelines used as too easy on sovereign debt.

 

As expected, Germany’s HRE, Greek’s Atebank and Spain’s Banca Civica failed their tests, but most banks passed even in hot spots such as Greece and Spain.

 

The biggest concern for investors was that stress tests excluded the possibility of sovereign debt default. Sovereign debt held in portfolios was distinguished from sovereign debt held to maturity. Debt held for trading is expected to be marked to market; debt held to maturity is not.

 

The problem with this separation into two different types of debt means that it is possible that losses by banks will be underestimated. This could hurt the financial health of European Banks and undermine the credibility of the banking system.

 

The concerns being raised by investors put pressure on the Euro at the mid-session, but a late session rally in U.S. equity markets triggered a short-covering rally in the Euro, pushing it higher for the day. While the news about the bank stress tests is unsettling, risk takers decided that nothing out of the ordinary was revealed so traders turned their attention to higher risk assets like U.S. stocks in what can best be described as a relief rally.

 

The British Pound rallied sharply higher on Friday versus the U.S. Dollar and the Euro. Friday’s rally was ignited by the news that the U.K. economy grew almost twice as much as economists forecast in the second quarter in the fastest expansion for four years. The strongest gains were seen in the services, manufacturing and construction sectors.

 

The bullish economic news out of the U.K. was damaging to the U.S. Dollar because it was solid proof that the economy was recovering at a time when the Fed was forecasting a weaker GDP for the U.S. Friday’s report may be the evidence the Bank of England needs to begin hiking its historically low benchmark interest rate. In the meantime, the Fed is pondering applying more stimuli as well as renewing its quantitative easing program. Treasury market traders are already pricing in a rate hike for September 2011, this is up from an earlier forecast of Spring 2011.

 

The improving economy and the possibility of a sooner-than-expected rate hike make the GBP USD a more attractive investment at this time. Technically, the Pound/Dollar had an inside week which indicates impending volatility. The strong close puts this market in a position to take out the April swing top at 1.5523. A breakout above this level may run into selling pressure inside of a major retracement zone at 1.5635 to 1.5967.

 

Although the initial reaction to the stress tests was bearish for the Euro, traders quickly realized that the news was already in the market. In my opinion, European Central Bank President Trichet’s comment earlier in the month that banks would need to raise capital and a rumor last week that eleven banks would fail the test was spot on. Today’s report revealed that seven institutions didn’t have enough capital and may need to raise more than $4.5 billion.

 

Analysts around the globe are saying that the stress tests weren’t stringent enough and that the release of the results failed to alleviate market concerns about the banking system’s vulnerability to sovereign-default risk. Nonetheless, investors spoke today by trashing the Dollar and rallying stocks, this could be an indication that they have put the tests behind them and are turning their focus on the global economic recovery. This means that economic reports are likely to carry more weight in the weeks ahead.

 

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