Friday, January 4, 2008

Gold and Silver Index (XAU)

Gold and Silver Index (XAU)SocialTwist Tell-a-Friend
Tim Ord





Above is the weekly chart of the XAU dating back to 1984. Significant lows form in the XAU when Price Relative to Gold ratio reaches below .20. We have market those instances with blue arrows in the Price Relative to Gold window. In all cases that condition marked a low in the XAU and went on to rally and in some cases the rally last over a year and produce over a 100% gain. On December 17 the Price Relative to Gold ratio reached below .20 but closed above .20 on the close of that week. We still consider this a bullish sign as the ratio is picking out a lower degree bullish turn in the market. The last time this ratio on the weekly timeframe closed below .20 was at the August 2007 low which marked the start of the major turn up. Another short term bullish sign is the weekly Stochastic RSI. Since we are dealing with the weekly Stochastic RSI, we are dealing with an intermediate term timeframe. The week of December 17, the Stochastic RSI, closed below .20 and has turned up which implies the XAU was making a low. The weekly bullish Stochastic RSI reading is coming on the heels of major support at 160 on the XAU along with Price Relative to Gold ratio hitting intra week below .20. A major trading range developed in the XAU dating back to 1984 that had support near 60 and resistance near 160. The XAU broke above 160 which should now act as support. One way to get a target price for the next resistance area on the XAU is take the distance between the high and low the trading range and add that number to the breakout area. The distance between the high and low of the trading range is 100 points and add that to the breakout area of 160, a target of 260 is achieved. A major rally up has started on the XAU from the August 2007 low. A minor wave down from the November 2007 highs to December 2007 low end a corrective wave. The next significant high may reach to 260 on the XAU.



Editor's Note: Look for Tim's new book due in February 2008 titled “The Secret Science of Price and Volume” to be published by John Wiley & Sons.

Thursday, January 3, 2008

2008 Global FOREX Outlook

2008 Global FOREX OutlookSocialTwist Tell-a-Friend
Ashraf Laidi

The currency developments of 2007 were undisputably dominated by two main themes; risk appetites trades benefiting AUD, CAD, NZD, GBP and AUD at the expense of USD, CHF and JPY, and; USD-specific selling against all major currencies including JPY. JPY amassed broad gains during periodic episodes of risk appetite reduction as global stocks sold off aggressively in the midst of subprime-related losses in the US finance/banking sector.

The two performance charts below illustrate that USD was the broadest losing currency in 2007, while the top four performing currencies against the USD were CAD, AUD, EUR and NZD. The commodity currencies of CAD, AUD and NZD were boosted by a favorable price environment for energy, metals and agriculture as well as high interest rate policies. EUR was propped by its role as the anti-US dollar and by the European Central Bank’s persistently hawkish rhetoric. While the three commodity currencies were clearly in command in the ranking of currencies’ performance against gold, no currency registered any gains versus the metal, illustrating the secular rally in gold and other commodities. As we will see below, this suggests significant implications for gold in 2008 as the onset of low global real interest rates -wide is maintained by a rising inflationary environment relative to nominal interest rates.







Current Dollar Rebound to Continue Into Mid Q2 2008

The current 4% rebound in the US dollar index off its November lows is a broad USD play emerging on a combination of end-of year repatriation by US institutions and more pronounced signs of slowdown in the UK and Eurozone. Year-in-Year out, currency markets have shown a noticeable reversal in December of the trends emerging from mid October to mid November. This has worked consistently in favor of the euro against the dollar in December of 1999, 2000, 2001, 2003, and 2005 as the single currency declined markedly during the prior 2 months in each of those years. The opposite of this pattern took place in December 2006 as the euro lost ground, reversing the gains of October-November 2006. Year-end repatriation and unwinding of cash and futures positions are behind such seasonal moves.

Fundamentally, the argument that the Federal Reserve intends to stick to its newly adopted liquidity-injecting policy, rather than reducing the fed funds rate may be less detrimental to the US dollar, while the Eurozone is seen moving towards reducing its inflation hawkishness-an element largely responsible to the euro’s recent resilience relative to AUD, GBP, NZD and CAD. Finally, the interest rate cuts from the Bank of Canada and Bank of England have cemented the cap on CAD while accelerating downside in GBP, solidifying the foundation of the USD rally.


Sources of Prolonged Dollar Rebound

1) Despite market perception that the Fed’s liquidity injection measures are behind the curve in alleviating the credit crisis and that the lack of aggressive rate cuts remains insufficient in bringing the US economy to a soft landing, growing inflationary pressures in the short-term may bolster the central bank’s non-interest rate easing liquidity solutions for the struggling money market, thus, underpinning the dollar from a relative yield perspective. This would be especially USD-positive at the expense of GBP due to more ample downside for UK interest rates. More on BoE and GBP found below.

2) The extent to which the ECB’s intransigence holds rates steady in the midst of further economic slowing is perceived by markets to be exacerbating the existing economic slowdown, business activity and investor sentiment. Markets are also fixated on the next European victim from sub-prime investment such as IKB. Preliminary reports of EUR 5 billion in writedowns from IKB banks have not bee followed by subsequent announcements from other banks.


A Repeat of 2001?

As the dollar strengthened in the last 6 weeks of 2007 despite prospects for further Fed cuts, the unavoidable question becomes whether 2008 will be a repeat of 2001, when markets rewarded currencies of growth-oriented central banks? Two business days into January 2001, the Fed delivered an inter-meeting 50-bp rate cut to start a 475-point rate reduction campaign which took the Fed funds rate to a 45 year low of 1.75% by end of the year. Although the Fed funds rate dropped below the overnight rates of all G7 nations with the exception of Japan, the US dollar outperformed all currencies in 2001.
But one of the many factors distinguishing the current environment from that of 2001 is the purpose of the Fed’s easing. The rate cuts of 2001-02 were driven by conventional dynamics of macroeconomic slowdown (cooling business activity, weak GDP growth, rising unemployment and falling equities). Today, the Fed is forced into uncharted territory highlighted by the following factors:

1. A pronounced shortage of money market liquidity, unwillingness of lending by commercial banks, uncertainty regarding the size of remaining write-downs and the resulting impact on banks’ rating, capital cushion and bottom line. Tightening lending requirements for private households and business are also expected to weigh on overall capital formation and aggregate demand.

2. The macroeconomic impact of i) falling prices of new and existing homes on construction and consumer spending 2) falling sales of new/existing homes 3) increased layoffs in housing-related industries, banking/finance and manufacturing jobs, will impose a severe test on consumer spending once the post-holiday sales season is behind us.

3. The Fed’s task of shoring up growth will be complicated by persistent inflationary pressures that are unlikely to abate as was the case in past economic contractions. The prevalent inflationary environment originating from high food and fuel prices is unlikely to abate due to weather factors bolstering agricultural supplies and a combination of supply/demand dynamics propping oil prices.

Accordingly we project the Fed to deliver 100-bps more in interest rate cuts, bringing the Fed funds rate down to 3.25% by end of 2008.
Unlike in 2001, 2008 will be accompanied by the economic spillover of broad erosion in the housing sector, dictated by falling prices, sales, construction and layoffs in related industries. Robust growth from Asian economies should also help fill in the slack from the US and Western Europe, which will likely support the Eurozone’s external economy and stabilize the anticipated downdraft from the US.


Fed’s Liquidity Injection is No Substitute for Rate Cuts

Although the Federal Reserve has distinguished its monetary policy maneuverings between liquidity injection operations (aimed at relieving funding shortages in the money market) and interest rate-cutting moves (aimed at shoring up the economy), we do not expect these liquidity measures to stave off the risk of recession. While the Fed is seen extending the expansion of its discount window via the Term Auction Facility “TAF”, we expect it to cut the Fed funds rate by 75-bps in H1 2008, taking the rate down to 3.50%. There is likely scope for 50-bps of easing in H2 that will push the fed funds rate down to 3.00% by year-end. The inflationary repercussions of the Fed’s easing will remain an in issue for the central bank, especially as food and energy prices remain robust. Although the Fed has recently begun stressing the durability of price pressures on the headline inflation front (headline CPI and PCE), an anticipated deterioration on the macro economic front (rising unemployment rate, higher jobless claims, soft post-holiday consumer demand and slowing prices/construction activity on the commercial property front) will maintain the Federal Reserve’s policy bias towards the downside, as per its December FOMC statement and November forecasts for lower term inflation and higher unemployment for 2008 and 2009. This in turn is likely to limit the dollar’s rebound against the euro, especially in the event that the ECB succeeds in maintaining interest rates at 4.00% throughout 2008. More on ECB and euro below.


Gold’s Secular Rally to Continue in 2008

While the increase in gold versus the dollar in 2007 was largely associated with an acceleration of the dollar’s declines, the strengthening of the metal was broad-based throughout the year. Gold rose 27% against the USD, 26% against GBP, 22% against JPY, 21% against JPY, 17% against EUR, 16% against AUD, 10% against CAD and 8% against NZD, totaling 146% in gains for the year against the major currencies. The global growth-backed commodity story as well as emerging inflationary pressures played a significant role in gold’s advances.

One theme expected to continue triggering further advances in gold is that of real interest rates. The modest declines in gold relative to the more protracted and uninterrupted recovery in the dollar since mid November are due to falling bond yields. As the Federal Reserve, Bank of England and Bank of Canada blitzed the money markets with over $600 billion in liquidity injections in the last two weeks of 2007, market interest rates headed lower while inflation continued to push upwards. Persistent liquefying operations of central banks are likely to highlight the luster of the precious metal relative to paper currencies, especially as the real cost of money is dragged down by high inflation and lower interest rates. The inflationary consequences of these expansionist monetary practices coupled with persistent robustness in commodity prices are expected to offset any downward pressures on inflation resulting from cooling economic activity. While the relationship between strong commodities and cooling economic growth may prove untenable, agriculture, energy and metals are likely to remain supported by supply constraints rather than demand factors.

We anticipate real US interest rates to remain pressured by a combination of an expansionist Federal policy and robust energy pressures. This should continue to reward gold versus the US dollar as well as the rest of the major currencies as inflation remains at the upper end of the targets set by most G10- central banks.

But the $900 target isn’t expected to be realized before a temporary decline to as low as $720. Periodic bouts of reduction in risk appetite are likely to trigger episodes of profit-taking in the metal. The expected pall on the metal is also expected to emerge from a modest slowdown in Chinese demand for commodities. The People’s Bank of China’s policy tightening coupled with the yuan’s 10% appreciation as well as the slowdown in the US, Canada, Eurozone and UK is likely to temper China’s appetite for metals and energy.


No Need for Textbook Recession Definition

While there has been much emphasis on whether the US economy has entered (or will enter) the textbook definition of recession --two consecutive quarterly GDP growth declines-- the consequences to the overall economy are sufficiently worrisome in the event of a back-to-back quarterly GDP growth of between 0.1% and 0.3%. The 2000-2001 recession was such an example, when GDP growth declined by 0.5% in Q3 2000, rebounded by 2.1% in Q4 2000 before contracting by 0.5% in Q1 2001. A subsequent rebound of 1.2% in Q2 2001 was then followed by a 1.4% contraction in Q3 2001. This time the impact goes beyond sluggish manufacturing and a shrinking wealth effect from falling equities, and extends to tens of billions of losses in the books of banks, which carries ominous implications for overall credit and capital formation.


EUR: Further Downside Prior to H2 Recovery

The prospects of a durable foundation in the euro lies primarily on the European Central Bank’s focus on upside price risks as inflation exceeds the 3.0% mark, its highest level in 6 years. But with the ECB also recognizing that the balance of risks for economic growth are clearly to the downside, the central bank may be closer to easing interest rates than its inflation vigilance suggests. Although the ECB has been the largest injector of liquidity since August, these operations have been proven more helpful in relieving short-term funding for commercial banks than in assisting an increasingly struggling corporate sector. With the euro retreating 5% off its highs against the dollar, any dovish overture by the ECB may risk furthering externally driven inflationary pressures, especially as energy prices maintain their lofty levels.

But just as markets punish currencies whose central banks are seen behind the curve in containing inflation, they also drag down currencies when central bank policy is perceived to be exacerbating the downside risks to growth. Signs of a possible growth contraction in Spain and Italy in Q1 2008 may prove highly euro negative especially if the ECB shows no signs of shifting away from its hawkish stance. Germany’s IFO and ZEW surveys on business and investment sentiment continue to trend lower over the past 6 months reaching 2-year lows but still do not suggest an accelerating loss of confidence. Eurozone GDP growth is expected to slow to 1.9% in 2008 from 2.5% in 2007, surpassing US growth for the second consecutive year.

We expect the ECB to continue stressing the downside risks to the economy and the upside risks to inflation, while being forced to cut rates once to 3.75% and continuing to maneuver policy via liquidity injections and FX rhetoric. In the event of persistent credit constraints and deteriorating economic dynamics, any signs of a retreat in headline inflation towards the 2.1%-2.2% range, accompanied by a decline in core CPI towards 2.0% from the current 2.3% will pave the way for another ECB rate cut. Further downside ground seen testing $1.42, while the risk of accelerating losses is projected to stabilize at $1.37. Renewed gains seen emerging in early H2, retesting $1.48 before claiming $1.55 in Q4.


JPY: Benefiting from Lower Carry Trades

Chances of further yen gains in 2007 will hinge on the interplay between further unwinding of yen carry trades and the onset of slowing demand from Japan’s major trading partners. Our expectations for further dislocation in US equity markets as well as prolonged uncertainty in global credit markets support the case for renewed yen gains as risk appetite remains under pressure and global liquidity is curtailed. And although futures speculators have boosted yen long contracts to 2-year highs against the dollar in early December, there remains wider scope for yen buying amid fresh revelations of write downs from US banks.

But we must also heed the yen’s downside risks from the downdraft of slowing growth. With 22% of Japanese exports going to Newly Industrialized Asian Economies (Hong Kong, Korea, Singapore and Taiwan) and 21% to the US, cooling economic growth should cast a pall on Japanese exports, especially with the risk of a US contraction weighing directly on Japan and indirectly via Japan’s trading neighbors. China’s absorption of 15% of Japan’s exports does play a significant role in filling the slack. But the downside risks to China’s economy may provide an indirect negative spillover on Japan, thereby exacerbating the already slowing demand from the US. With the combination of lower US demand for Chinese exports, a prolonged correction in Chinese equities, the transmission effect of the People’s Bank of China’s rate hikes and further strengthening in the yuan, the risk of a region-wide slowdown can be significant.

Internally, Japan’s 2008 GDP growth is seen slowing to 1.7% from 2.0% in 2007, still within the nation’s potential growth range of 1.5%-2.0%. We expect the combination of increased market volatility along with the onset for 100-bps of Fed funds rate cuts in 2008 to redefine the playing field for global carry trades. As a result, 110 yen is seen as the new anchor for USDJPY before retesting the 105 figure in late Q3.


GBP: Further Losses Ahead

The British pound’s breach above the $2.00 level may have been the only positive story for the currency in 2007. But even against the dollar, sterling gave up most of its 9% gains to end the year barely in positive territory up 1.0% against the greenback. The currency was the worst performer among G10 currencies after the US dollar. We anticipate continued losses in sterling as the Bank of England is seen cutting rates by 100 bps throughout the year.

Although official and IMF forecasts project 2008 UK GDP growth to slow towards 1.9% from 3.1% in 2007, the risk of a more protracted housing correction may drag growth down to 1.5% for the year, with the risk of recession an increasing possibility. The domestic savings ratio fell below zero, a level not seen since the late 1980s while household debt service soared to 14% of incomes, the highest since 1991. With over 1 million of fixed rate mortgages due for reset next year, the risks to the personal debt market are considerable. UK estimates place the number of homes to be repossessed in 2007 at 30K and 45K in 2008, the highest since the property crisis of the 1990s.
The Bank of England had already been forced into a unanimous decision to cut rates in December, one month earlier than it predicted at the November inflation report. We expect the BoE to cut by 100 bps in 2008, taking down rates to 4.50%, which would deal sharp erosion to real interest rates, currently at 3.40%.

Sterling weakness will be a major theme in currencies for 2008, which should help the US dollar obtain some stability. This also means further divergence in GBPUSD away from EURUSD, which should trigger further strengthening in EURGBP. GBPUSD downside is seen extending through $1.92, with the risk of extending losses towards $1.88. Upside remains capped at $2.06. Further carry trade unwinding is likely to drag GBPJPY towards 210, with downside acting on $235.00.


CAD: Limited Downside from the US

The Canadian dollar was the highest performer in 2007 among all G10 currencies thanks to rising prices of energy and agriculture products as well as robust economic growth resisting the downdraft from the US slowdown. Currency strength and retreating manufacturing activity did force the Bank of Canada to cut interest rates in December, partially due to some help from cooling inflation.

GDP growth is seen edging up to 2.8% in 2008 after an estimated 2.5% in 2007. With 80% of Canada’s exports going to a recession-bound US economy, the negative risks on overall growth can be significant. The 8% share of total exports going to the healthier Europe and Japan may help offset the situation. But the composition of exports is also crucial. Considering agriculture and energy exports make up over 25% of Canada’s exports, or 10% of GDP, the sector make up is expected to help the situation especially considering the expected favorable climate for commodity prices ahead.

While oil prices will continue acting as the wild card, we do not foresee any prolonged declines below the $70 level. Steady prices should be CAD-neutral, leaving the currency equation to be determined by inflation and BoC policy. We see a 100% chance for a 25-bp rate cut in Q1 2008, followed by another similar move in Q2 that will take the overnight rate to 3.75%.

Unlike most of its G7 counterparts, Canada’s currency remains characterized by high real interest rates, standing at 2.7%, versus 2.1%, 1.0% and -0.6% for the US, Japan and Eurozone respectively. Although real UK interest rates stand at 3.4%, expectations of 100-bps in BoE rate cuts have already began weighing on the British pound.

We expect a 25-bp rate cut in Q1 to boost USDCAD to as high as $1.070 as the currency sustains losses from a combination of risk reduced risk appetite and falling yield differential. One more rate cut in Q2 to 3.75% may be needed by the Bank of Canada to stave off further slowdown, but as long as the market deems these cuts as precautionary, there is upside ground for a CAD recovery in H2 towards the $US 0.95 level.


AUD: Yields & Commodities to Counter Risk Aversion

The unwinding of high yielding FX carry trades and the broad USD rebound in the last 6 weeks of the year has overshadowed the strengths of the Australian dollar and the currency’s potential to retest parity with the USD. Standing at 23-year highs versus the US dollar in November, the Aussie was 6 cents away from parity as the Reserve Bank of Australia raised rates to an 11-year high of 6.75% and signaled to do more. We expect the RBA to raise rates by 50-bps in 2008 to stem an accelerating inflation rate, already projected to exceed 3.00%, well over the central bank’s preferred target of 2.0%-3.00%.

Baring any negative price shocks in agriculture and minerals, the Australian dollar is set to be amid the highest performing currencies in the G10 in 2008. In addition to a strong yield foundation, the currency stands to gain from a favorable price environment for commodities, as the sector makes up 65% of exports. Specifically, grain prices are widely expected to pursue their upward run in 2008, delivering higher returns for wheat and barley. And with minerals making up 50% of overall exports, steady demand for items such as copper --propped by China’s power generation capacity --the benefits would combine price and volume. The latter is also expected to soften the shock from falling US construction expenditure.

Another likely boost for the Aussie is the exposure of Australia’s exports to a robust regional market. Over 40% of Australia’s exports are destined to Japan (19%), China (14%) and the Republic of Korea (8%), all of which are expected to maintain their robust expansion in 2008. Yet even, a modest cooling in these economies is unlikely to pose any headwinds for the currency.

The downside risks to the Aussie include a prolonged decline in commodities prices resulting from a global growth slowdown and extended bouts of risk appetite hitting global investor confidence as well as high yielding currencies. Accordingly, these dynamics may drag the pair down to as low as 77 cents. But as long as the RBA retains growth and inflation arguments for a tight policy, we expect the Aussie to maintain its potential to rebound from risk aversion declines. Further Fed easing will likely lift AUDUSD past the 90-cent figure and test 95 cents by Q3. Chances of seeing parity in Q4 stand at 70%.

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