New Year Seasons and Forex Analysis

The market action continues to show a market that isn’t sure what it wants to do here in the short term – and larger players are undoubtedly waiting for the New Year before putting on any meaningful positions. Still, volatility is easy to come by these days, especially with end of month/year fixing up today.

Even more ugly data out of the US yesterday with a larger than expected drop in home prices (not really surprising as this is oldish data from October, when the deleveraging panic was full upon us. Yesterday we discussed the idea that the December freefall in yields at the long end will likely aid a slowing of house price depreciation for the lower end of the housing market.) Consumer Confidence in December also posted a massive drop to a record low. This is a bit surprising considering the fact that the survey came after the US election, and after a huge additional drop in gasoline prices. Also, the other major surveys suggested a bit of stabilization. Still, this data is by no means a shock and speaks of the real economic pain being felt in the US economy. The mounting rate of job losses means that many are worried about their future as they see colleagues and relatives losing their jobs even if they haven’t lost their own yet. The viral effect of employment insecurity is going to result in a massive continued contraction in consumption in 2009.

With the lack of short term visibility for currency moves at present, we’ll take this opportunity to freshen up some of the developments we will be looking for in the New Year.

EUR weaker

We’ve covered this one extensively in recent days. The Euro has rallied for good reasons: it has refused to join the competitive devaluation impulse launched so aggressively by the Fed and the Bank of England and it is one of the most liquid currencies outside the USD in a world that is very concerned about illiquidity. Its economic weakness has also been less vicious so far on the whole as well, even if there are very troubled spots. But the single currency’s weaknesses may become much clearer in the New Year, including very likely bickering among the EuroZone members and the difficulty of coordinating policy among so many nations when the stresses of weak economies could make national agendas compete with the EU framework. We’re also concerned about the state of play in European credit markets, when so much debt must be rolled over in 2009 and the banks in Europe as well, particularly their exposure to Eastern Europe. The EUR is overpriced in the bigger picture – look at shorting EUR vs. SEK and NOK as a potential value play in the New Year or shorting the EUR on a trade-weighted basis.

The final deleveraging

Asset prices went into freefall in September and October of this past year as the AIG, GSE and Lehman failures shook the world and triggered a historic and vicious cycle of deleveraging. Subsequently, in November and December, governments and central banks, led by the US Fed, swooped in with astounding injections of liquidity and unprecedented expansion of the public balance sheet. Hedge funds, to avoid liquidating illiquid assets in the midst of the panic reneged on their redemption agreements when investors were looking to recoup their funds. But troubled assets are still out there and the unwinding of the black hole of risky derivative plays and troubled hedge fund strategies will continue, and this could lead to a second, very large round of deleveraging in 2009 that will also shake the currency world. This final deleveraging potential is a key reason we are reluctant to call for the immediate devaluation of the greenback. In the past, bouts of risk aversion have seen a boost in the USD. And, due to the US’ already very advanced state of economic weakness, it may be the first major country to show signs of stabilization. Any large scale rally in the USD should be seen as a historic opportunity to sell the currency, however.

Asian currencies stronger

The need to address global imbalances due to the destruction of the old paradigm of Asian oversaving and reinvestment in the US and the resulting overspending and excessive debt creation there. Eventually, the USD must continue to weaken, though the timing looks uncertain for the greenback’s next sell-off. The clearer trade is to be long a basket of Asian currencies – perhaps against the overvalued EUR to start. Consider EURJPY and EURCNY shorts in the New Year.

Moves from New Years Past

Here we offer a brief recap of moves in EURUSD from the past few years. It is clear from recent years that the first trading day of the New Year (January 2nd for 2009) often sees large moves, even if they don’t necessarily predict the subsequent direction.

• January 2002 - The single currency celebrates its inaugural year as a real currency and the first trading day of the year sees a sharp 2% rally. But that was the top for the month as EURUSD dropped 5% by the end of January – to the low of the year below 0.8600 before rallying over 20% into the end of the year

• January 2003 - EURUSD swoons on the first trading day of the year, but then picks up the old rally impulse to new highs well above parity as the world moves close to the Iraq war and the weak and low-yielding USD has become a popular funding currency for carry traders.

• January 2004 - EURUSD continues its rally from December unabated until mid-January, when at a spectacular new high of 1.2900, it suddenly swoons mid-month and then spends much of the year until the US election trading in a wide range.

• January 2005 - After rallying spectacularly into year end after the US election to a high above 1.3600 and on the themes of central bank reserve diversification, the EUR kicks off the New Year with a vicious sell-off already on New Year’s Eve. This is followed by further weakness toward 1.2750 by early February, presaging what would prove a difficult year for the Euro.

• January 2006 - after doing nothing for two weeks in December, EURUSD snaps to attention on January 3 with a sharp 2% rally that would prove the beginnings of a rocky climb into mid-year from the lows of late 2005.

• January 2007 - EURUSD rallies sharply on January 2nd in a weak attempt to look at the 2006 highs above 1.3300, but then crumbles sharply in the subsequent days. But the mid-January lows were the lows for the year.

• January 2008 - EURUSD sells off sharply on New Year’s Eve after a late December rush higher, but that move is reversed with a sharp rally on the first trading day of the year that market a renewed attempt in the subsequent days to challenge the high of the time at 1.4965.

All the best to you and yours and Happy New Year!