What the Traders Think

The unemployment data published on December 4, 2009 gave us a rare insight into how the traders in different markets view the numbers.

Arguably, the most interesting was that of the equity traders. Stocks initially jumped higher by 150 points only to fall back and trade down 54 points, a 204-point range on the day. The initial response seems logical: stocks rallied in response to an exceptionally good number on the surface. Then the thought process evolved as traders started to look at the meaning of the bond market move lower (higher yields).

Under normal circumstances, a rally would be the correct response as a better economy means a higher likelihood of the Fed raising interest rates to stave off inflation. However, our current circumstances are not normal. In my opinion, the stock traders correctly concluded that in this case the data does not mean the Fed will raise interest rates, but that the Fed will withdraw the monetary liquidity that quantitative easing (QE) put in place to inject liquidity into the markets when they were under stress. This means the Fed will sell some of the junk paper that it bought from the banks, putting it back into the marketplace to reduce the excess monetary liquidity that was injected into the system in the time of need.

The repercussion of such actions seems to have lead to stock traders acknowledging that the Dow has been elevated to its higher levels by the excess liquidity trying to find a home and earn returns. Money gravitates to the place where it brings returns. What I am getting at here is that the equity traders are admitting that the Dow has benefited from the excess liquidity created to free up market credit and that if the QE is reversed, first by the Fed before they raise interest rates, that could cause a sell-off of stocks to buy the junk paper and the stock market in this scenario will decline on good news.

How does this affect the foreign exchange market and currency values? This is one of three instances that have occurred recently where the dollar gained value as bonds declined due to the higher yield, making the dollar more attractive. It goes against what has become the norm, where the dollar declines if bonds were sold off and stocks and commodities rise as the markets are focused on taking more risk. This is the reverse of the risk averse trade set: bonds higher, yields down and dollar higher as investors buy dollars to buy bonds if they did not already own them, leading to lower currencies, lower equities and lower commodities. The yen has not fit in this correlation due to carry trade unwinding. When risk aversion rises, the yen has for the last year followed the dollar as lower risk leads to a stronger dollar and yen. As I said, this has happened three times, which suggests to me the scenario of risk appetite/risk averse polarized choice with no middle ground, is starting to break down. This could be a very good thing as it suggests the four different asset class markets are returning to a more normal way of reacting to data.

I would keep a close eye on the US$ index. With this asset class correlation being traded as their own subsets, the US$ index has become the barometer for the dollar vs. the other currencies, with the exception of the yen for the reasons mentioned above. In my view, it is a very inaccurate way of viewing the dollar's strength or weakness as the largest part of the move has been driven by the strength of the yen vs. the dollar as the carry trade has been unwound. That being said, if the traders who are using the correlation between the dollar and commodities (especially oil and natural gas) are using the US$ index as their guide as we have seen in the last week, this inaccurate correlation does not have credence over time. I bring this up because the chart of the US$ index broke through the resistance to an upside move at 75.75 last Friday when it broke the trend line, which has been in place since March 9 when the index was at 89.45. The dollar index is made up of a basket of currencies that are weighted in the component ratios to the dollar (60 percent euros plus the others).

Gold was the other large mover due to the unemployment data and is another good example of how a fundamental economic reason triggers a technical break. Most importantly, we will have to see if this trend has the legs to keep running. The euro broke through its support line and the high of Monday's trading failed to break back up through that level that had become technical resistance. This might indicate that we have a change in trend at least in the short term. (I say short term as the short-term moving average line of five days crossed over the 20-day moving average line on Monday, December 7, indicating they have turned in favor of a stronger dollar as well.) The dollar index and the euro have also broken and are holding below the 50-day support lines, but gold is the hold out and has to break below $1,105 before I would say we have a medium-term trend change in the two currencies and gold.





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