As we noted last week, expectations had gotten so low that markets were ready to bounce on little justification. That’s what they did.

PRIOR WEEK: Reaction Rally On Dubious Justification

Remember the sovereign debt issue from a few months ago?

It was supposed to be like cockroaches. Greece was to be like Bear Stearns. The dominoes would start falling. The facile analogies came day after day.

By Martin Denholm

So much for that global financial crisis. The currency market has shrugged off the world’s woes over the past three years and blasted into the stratosphere.

The shortfall in the loss of U.S. jobs created a risk-on environment spurring immediate gains for equity index futures, while sinking the dollar and bonds. Yields surged as the 10-year U.S. note sank by three-quarters of a point.

The euro is pushing its luck with the dollar even ahead of the critical employment report due out later this morning. Having touched $1.2854 already this morning, the euro is teetering on a surge to perhaps $1.2925 if today’s jobs report softens the perceived need to hold dollars on safety grounds. That aside, the euro seems to have several other tailwinds boosting its appeal at the moment.

by Brad Zigler

Real-time Monetary Inflation (last 12 months): -2.1%

This week, gold turned in another mixed performance against the world's reserve currencies. In addition to its appreciation against the U.S. dollar, bullion gained 0.3 percent against the yen and 0.6 percent vs. sterling. Gold gave up 0.5 percent to the euro and 0.9 percent to the Swiss franc.

by Market Rewind

Wednesday’s Wall Street Journal reported foreign-exchange currency trading volume at over US $4.0 billion per day. [See "Currency Trading Soars"] While the ETF currency tracking indices have neither the volume, round-the-clock possibilities, nor the narrow spreads, they do make for convenient means of testing various currency pairs performance.

I wrote a few days ago that I thought we were seeing evidence of growing instability in the FX markets. The problem is with the “Strongs”. The Yen and the CHF are both at near records against the dollar and they are at records versus the Euro. These records are a cash machine for the FX crowd. The CBs know it and they do not like it.

IMHO the only thing that is going to stop the cycle of the Strongs getting stronger is coordinated intervention where the NY Fed took an active and visible role. We are not going to get that. I think that is an important conclusion. If that is not the case then the door is open for continued (irregular) strength of the strong pair. Consider this from Bloomberg:

Wondering whether the world has put the spring eurozone sovereign debt crisis behind it? Check out this succinct summary of the massive issues confronting Ireland.

The NY Times article written by Messrs. Simon Johnson (former IMF chief economist) and Peter Boone (research associate at the London School of Economics) clearly articulates the overwhelming obstacles faced by just one of the euro currency member countries.

As the U.S. dollar approaches an important bottom and U.S. stocks appear to be near a pivotal top, we here at EWI are prepared for trend changes. But most investors will be caught off guard, as there doesn’t appear to be any fundamental rationale for markets to turn now. So we’ve highlighted a few items that are likely to become front-page news after the next wave of decline has begun. Most prognosticators and Monday-morning quarterbacks will blame the decline on events like these, but, in reality, markets make the news (not the other way around).

Current clues: The three regions of Belgium are seeing increasing tension that may lead to a break-up. What would happen to its sovereign debt obligations, which stand at 100% of GDP, should the language-divided country splinter? Keep in mind that this country is larger than Greece in terms of its share of global GDP (.8% versus .6%).

The Swiss franc is back to all-time highs against the euro, and the extrapolations have begun. This morning, Bloomberg reports that UBS expects the franc to remain strong for the entire decade:

The Swiss franc will stay strong and investors should hold it as a proxy for the old German deutsche mark as the currency benefits from economic growth and its status as a haven, UBS AG said.

There was little to read into Thursday’s initial claims report ahead of an expected 100,000 dip for U.S. employment throughout August. Yet the better tone indicated by the health of global manufacturing and what earlier appeared to be a bolt-out-of-the-blue in the shape of returning consumer confidence continues to weigh on bond prices. For a second day yields are moving rapidly higher.

Despite yesterday’s solid gains, developed markets still have a host of issues that they must deal with before returning to pre-recession levels. At the forefront of these concerns are troubles regarding high unemployment rates and heavy debt burdens which both threaten to choke off any potential recovery in the West.

While things have been gloomy across much of the globe, European markets have seen brighter outlooks in recent weeks thanks to robust growth out of European heavyweight Germany. However, the continent does not appear to be out of the woods just yet with weak data coming out which showed lower than expected retail sales in Germany and a sharper than expected decline in Italian manufacturing levels. These conflicting data reports along with continued weakness in American markets, looks to put today’s ECB meeting into focus.

A couple of U.S. data points have forced several bears to rethink the prospects for the world’s largest economy. Strength in consumer sentiment and manufacturing output have also lowered demand for dollars for fear of a second recessionary wave. It remains curious as to why the pressure remains on the Japanese yen even as the dollar gives back further gains. Clearly such pent-up demand infers that we’re not out of danger just yet. In the meantime commodity-sensitive currencies appear to be building a head of steam as the clouds appear to be lifting – for now at least.

Back in April, I noted with respect to Greece that “the bear case is terrifying, and the bull case is very hard to articulate”. So it’s extremely useful to have a clearly-articulated paper from the IMF, entitled “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely”, which puts the bull case much more vividly than I’ve seen it before.

At its heart is this table (click to enlarge):

Early September is very important for the financial markets; especially for the bulls. Numerous elements are in place for a rally to take hold now. The markets have been weak and the bears have been in control. If the bulls cannot make a stand soon, it will be a bad sign for risk assets. The good news for the bulls is several factors, across numerous markets and asset classes, are pointing to a possible rally in risk assets:

• Bearish sentiment is high at the moment. Sentiment, especially as it approaches extremes, can serve as a contrary indicator.
• The Fed has signaled they are willing to print more money if needed. Right, wrong, or indifferent, the markets are anticipating more quantitative easing from the Fed. The Fed's next meeting is only three weeks away. Markets look forward. A rally in risk assets for a few weeks is not out of the question.
• Currency and interest rate markets are acknowledging the possibility of the Fed cranking up the printing presses. In recent weeks, the U.S. dollar and the 10-Year Treasury have been firmly in the bears' camp, but they are sitting near logical points of reversal. Recent rallies in the 10-Year Treasury have been showing signs of fatigue, which also points to a possible reversal in interest rates.
• Better than expected manufacturing data from China and better than expected growth in Australia have been reflected in the copper market. Emerging market stocks closed yesterday at a logical point of reversal; this morning's news from China and Australia could spark a rally.
• Despite weeks of disappointing news on economic progress in the United States, the S&P 500 and Dow have yet to revisit their June lows, which is hard to believe given the recent lack of interest from buyers. When markets do something you do not expect, it is time to pay attention.
• Monday's sell-off appeared to be a win for the bears, but unlike recent down days for stocks, total market volume contracted relative to the volume during Friday's Fed-induced and broad-based rally. The S&P 500 and Dow have both held at logical reversal points
• Since a picture is worth a thousand words, we can show most of these concepts on the charts below. When you examine the charts, ask yourself, "Based on the actions in the past from market participants, is it logical for this market to reverse near current levels?" If the answer is yes, then the next thing to look for is some confirmation from the markets, which can come in the form of market breadth (advancing issues vs. declining issues), volume, and whether or not a broad cross section of markets are moving in the same direction (stocks, commodities, interest rates, currencies, etc). This analysis was completed after Tuesday's close (8/31); so none of Wednesday's (9/1) gains are reflected.

Below is an "after" and "before" chart (click to enlarge) showing an area of a possible reversal for the S&P 500.

If you had slept through 2008/2009 you would truly wonder what that financial markets hysteria was all about – in the world of FX, it’s as if the credit crisis never happened. At least that is the impression one gets by taking a first glance at the recently released data from the Bank of International Settlements (BIS) in Basel, Switzerland. The growth of the foreign exchange appears relentless reaching a mind boggling $4 trillion in average daily turnover in April 2010. Here are a few of the highlights of the BIS report:

• Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion.
• The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007.
• The increase in turnover of other foreign exchange instruments was more modest at 7%, with average daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps grew strongly. Turnover in foreign exchange swaps was flat relative to the previous survey, while trading in currency options decreased.
• Foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions account for 35%.
• The percentage share of the US dollar has continued its slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained relative to April 2007. Among the 10 most actively traded currencies, the Australian and Canadian dollars both increased market share, while the pound sterling and the Swiss franc lost ground. The market share of emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won.
• The relative ranking of foreign exchange trading centres has changed slightly from the previous survey. Banks located in the United Kingdom accounted for 36.7%, against 34.6% in 2007, of all foreign exchange market turnover, followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%).

The modern world moves at a breathtaking pace, even when most of us find ourselves on holiday. No sooner do we receive, read and start to digest one set of economic data than we find ourselves pushed to think about what the next set will look like.

The clearest recent illustration of this undoubted reality is to be found in peculiar twist of events which meant that just as the news reached us that the German economy had expanded at a record rate in the second quarter, at almost the very same moment Federal Reserve officials meeting in Washington decided to significantly downgrade their economic outlook for the United States, saying the “pace of recovery in output and employment had slowed in recent months” and was likely to be “more modest” than anticipated in the near term. But this followed a month of May when it seemed Europe’s economies were on the brink of disaster, while over in the United States some sort of recovery was on the cards.

Outside markets likely helped Crude oil trade higher today because the inventory report certainly wasn’t bullish. We maintain that if $71.50 can hold on a closing basis on the October contract, a bottom is in the making. Our upside target into next week is $77.25-$78.50. For the last four sessions natural gas has been back and forth in a 20 cent trading range. Like a coiled spring the longer this lasts the larger breakout we project. As most followers know we’re advising lightly scaling into November longs and to purchase November and December call spreads, expecting that move to be up.

Don’t call it a correction; the Dow is higher by 240 points and the S&P by 30 points as of this post. On a further appreciation of 3% bearish plays in the S&P will be back on our radar for clients. Treasuries appear to be putting in a major top; both 30-year bonds and 10-year notes. As for traders start tracking the December contract as opposed to September. It will take a close below the 20 day MA for confirmation; in 30-year bonds 131’22 and 10-year notes at 124’22.

I’m puzzled by the tack that the WSJ is taking in describing the latest triennial BIS report on FX trading. (Incidentally, neither the WSJ nor the FT actually bothers to link to it, while the NYT/Dealbook doesn’t seem to have covered it at all.)

In any case, the WSJ headline talks about how investors are looking to “growing economies”, and the story says this: