Carry trade disruptions as the waterfalls provide a good soaking

There has been a lot of commentary recently about the inverse relationship between the US Dollar and the S&P 500. What is perhaps more extraordinary from an inter-market analysis perspective has been the very strong correlation between one of the principal carry trade pairs - the Australian Dollar/Japanese Yen - $AUDJPY - and the MSCI Emerging Markets Index.

Using the daily changes in the EEM and the daily changes in the North American closes for the cross rate, it is possible to derive the correlation coefficient value and the chart above shows the result of the linear regression of daily changes from the beginning of January 2007 through the close on October 30, 2009. The coefficient of determination or R squared value for the relationship is approximately 0.62 which is one of the highest positive associations that I have encountered between a currency and an index.

An alternative way of considering the relationship is to normalize the paths taken by the two instruments using as an index base the values as of January 3, 2007 and placing the trajectories on the same 2 dimensional graph. The graphic below shows the remarkable extent to which the paths taken are correlated.

While correlations are interesting to observe there is often the implied question of so what?

This brings us to the takeaway proposition which is that the strength of the US dollar and perversely the Japanese Yen - which both, for different reasons, become the sought after currencies when traders/investors lose their appetite for risk - has a big impact on the attractiveness and viability of the carry trade. Put simply if the carry trade begins to lose its appeal - and both legs of (say) the Aussie/Yen trade are going in the wrong direction from the point of view of those long the carry trade - then there is a period of rapid unwind which can be very disruptive, especially for those asset classes which are being funded by proceeds and financial engineering predicated on the carry trade.

Returning to the high R squared value - this has existed across the almost three year period under review and shows that when the currency pair drops so does the EEM.
In the last few sessions the currency pair has been exhibiting some erratic behavior which is of a hybrid nature - a roller coaster ride with spectacular waterfall like features for the passengers to really give them a good soaking.

As the carry trade loses its appeal so does the appetite for risk assets and this becomes part of the larger framework in which dollar strength - resulting not only from the actual unwinding of many other currency pairs but also from the flight to safety mindset - is not a positive for global equities.

Daily Form October 30, 2009

Inter-market Technical Analysis using algorithmic pattern detection

FRIDAY OCTOBER 30, 2009       02:45 ET

The market bounced back from an oversold condition following Wednesday’s decisive moves to the downside. The better than expected GDP numbers helped sentiment, but one was left with the suspicion that a lot of the buying yesterday was from those who were still short from the more technically adroit decision making that prompted the recent weakness.
IWM, the proxy for the Russell, did not exhibit a robust recovery as would be expected if the primary motivation behind the rebound was a true celebration of improving fundamentals which would play to the benefit of the smaller cap stocks. Traders, in my opinion, need to embrace the higher beta stocks again if there is going to be another strongly bullish impulse. Overall I am leaning to the view that we are still not through with this corrective episode and I would still be targeting 550 on the Russell 2000 or about 55 on the IWM

Similar comments to those above for IWM can also be applied to the sector fund which tracks the DJ Transportation index.

Earlier in the week I noted that the US dollar seems to be unable to sustain any momentum on the upside and the relapse yesterday in, for example, UUP should actually be seen as providing additional comfort for the equity bulls. Having said that the forex dynamics could be subtly shifting away from the carry trade as the intraday action on Wednesday revealed just how illiquid certain sections of the market became when the funds en masse wanted to exit some currency pairs.

The AUD/JPY made a very swift recovery in yesterday’s North American session, although as the four hour chart below reveals some of that rebound was given back in overnight trading in Asia. From a technical perspective a re-test of the top of the channel that I alluded to in yesterday’s commentary and during my contribution to CNBC’s European Closing Bell should be monitored closely for signs of waning enthusiasm and negative divergences. Should they appear the likelihood would be that we need to go back towards a test of the lower channel boundary which equates to a cross rate of about 78.

Daily Form October 29, 2009

Inter-market Technical Analysis using algorithmic pattern detection

THURSDAY OCTOBER 29, 2009       05:54 ET

Scanning charts this morning I was taken by the number of key trend lines which have been violated in the most recent sell-off.
The KBW Banking Index (BKX) is one of the most troubling and I have simplified the charts today (partly so that they reproduce more clearly when I appear on CNBC’s European Closing Bell this afternoon) to show the basic violations and the critical possibility that what is still, at present, an expected correction, could potentially give way to a much more serious breakdown. Should the selling continue liquidity issues may re-present themselves as many hedge funds and trading desks all try to head for the same exits at the same time.
As can be seen the bottom of the green cloud on the right hand side of the chart - which is not much more than 2% below yesterday’s close - could potentially provide support in coming sessions. If this breaks the next chart level where there is price support would not be until around 36 which would make the extent of the correction from the recent top something approaching 25%.

While watching the action in equities and foreign exchange I was reminded of one of the lesser known technical analysis patterns which I have occasionally documented - the somewhat facetiously named Niagara Falls pattern which, unsurprisingly, resembles a massive waterfall. The intraday chart for the AUD/JPY cross rate quite clearly showed a waterfall pattern as those who could not get enough Australian dollars until recently, and used the yen as the funding currency, found themselves with two losing legs at the same time.
Looking at the longer term pattern the channel has been rejected at the upper level and the probability now suggests that a test of the bottom of the channel may be required in the intermediate term.
The question which poses itself in connection with such a possibility is the issue raised earlier this week - i.e. will equities and other risk appetite issues be able to withstand such a degree of dollar strength as many carry trades are unwound? There are reasons to be concerned that they will not.

As a follow up to a commentary earlier this week the Russell 2000 acted as an early warning that the equity rally was overdone and now we have almost achieved the retrenchment to the 550 level that was anticipated here in recent comments.
Similar concerns arise for the viability of the support level provided by the chart support and Ichimoku cloud as were expressed in relation to the banking index.

The Nikkei 225 (N225) chart is the most problematic of the ones which I scrutinized closely this morning.
The series of violations of the fan lines (not based on Gann angles) and the most recent break again below the 200 day EMA and below the green cloud, provides potentially the counter-argument that what is unfolding is just a "healthy" correction.
If the Japanese yen continues its strengthening, which again is tied into the carry trade and forex safe haven seeking, the prospect increases that the Nikkei may begin to show that the direction ahead for global equities is more decisively downwards.

Daily Form October 28, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

WEDNESDAY OCTOBER 28, 2009       06:37 ET

There are signs that the carry trade unwind is creating some seismic foreshocks. The Russell 2000 (RUT) acted as the canary in the coal mine over the last few weeks and sent a clear message that the high beta stocks were not the place to be as the prospects of a correction began to gather momentum.
The target on the chart below of 550 would suggest that the correction would be in the order of about ten percent from the recent highs. However there is a plausible case being promoted by some EWT advocates that a corrective wave C might be rearing its ugly head. If the latter is the case, and it seems a little premature to be calling that in my humble opinion, then the outlook for equities, over the longer term, most definitely is not rosy.

Some readers may have wondered why the Australian dollar has featured prominently in this column over the last few weeks. My suggestion is that the rolling over of the carry trade pairs - AUD/USD and AUD/JPY in particular could be pointing to a turn of the tide with the implicit message that the easy money that has been made this summer within the emerging markets and commodities could be drawing to a close.

The main motif on many charts is the breaking of some reasonably prominent trend lines. The 4 hour chart of Germany’s DAX as of Wednesday morning trading reveals just such a break and reviewing potential levels of support it is not difficult to once again - as with the diagnosis of the Russell 2000 chart - see the capacity for a 10% correction from the mid-October highs

The Nikkei 225 (N225) put in a valiant effort to regain its foothold above the breakdown level alluded to here a couple of weeks ago but with strengthening of the yen the near term outlook is for a retreat towards a re-testing of the early October lows near 9700


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

AKS  AK Steel Holding Corporation  

AK Steel Holding (AKS), also mentioned here about two weeks ago as looking vulnerable was also very weak in the steel sector

X  United States Steel Corp.  

US Steel (X), which was mentioned here last week was a notable casualty in yesterday's sell-off on very substantial volume and there is no obvious level of chart support for some considerable distance.

COW  iPath DJ AIG Livestock ETN  

Here are comments regarding one of the long selections made here this month

The exchange traded fund, COW, which tracks the livestock sector, could be preparing to emerge from an extended recovery process and even if the immediate outlook is uncertain the chart patterns suggest that, in the medium term, this could make further upside progress.

Daily Form October 27, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

TUESDAY OCTOBER 27, 2009       06:34 ET

The divergences to which I alluded in yesterday’s commentary - primarily involving the US equity market - caused an anxious market to sell off rather abruptly in the early going. While those more persuaded of the need to find a fundamental or news related item to explain such market movements were attributing the drop to bank downgrades and intervention in the forex market, the growing technical divergences have been evident for all to see for some time.
Although I did not see Nouriel Roubini’s appearance on CNBC’s Squawk Box I did catch some of the edited clips and I think he spelled out well the precarious nature of the "mother of all carry trades" theme.
As Roubini suggested the irony that equity traders now face is that the worst development for global equities would be a strong dollar.
The intraday chart for the S&P 500 highlights the sell-off which must have sowed some seeds of doubt for some of those propagating the Panglossian spin on recent macro-economic/financial developments. The possibility of a repeat performance of the July 2007 abrupt unwind in the carry trade might induce them to re-examine their cornerstone premises if the US dollar no longer cooperates by dropping every day.

Sometimes a picture is worth a thousand words and that applies to the carry trade phenomenon. Several readers of this column have asked about the carry trade and why it is becoming an increasing part of my focus and the chart below may help to throw light on the matter.
Incidentally the course which I shall be presenting in London in late November in conjunction with Thomson/Reuters (details are available at the link at the top of this commentary) will include an in-depth look at the influence of the carry trade on global capital movements and asset allocation.

Another factor behind the "unusual" movements in the markets yesterday, highlighted by a resurrection (even if it may be short-lived) of the US dollar, was the move up in yields across the entire Treasury spectrum.
As discussed here a week or so ago the five year maturity may be the best to monitor as it moves further into a pronounced triangular formation.
A surprise break out to the upside on yields, which might be a requirement for the pressure now being put on the US administration by those holding trillions denominated in the global reserve currency, would apart from strengthening the dollar also not be favorable to US banks operating their own more domestic version of the carry trade - i.e. riding the yield curve.

The KBW Banking Index (BKX) is living somewhat dangerously and as the trend lines drawn suggest it is quite vital that it finds support near current levels.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm


As previously discussed in relation to the KBW Banking Index, one would expect the current price area to offer some support, and the exchange traded fund, KBE, provides a vehicle for an immediate term opportunity on the long side.

IEF  iShares Lehman 7-10 Year Treasury  

IEF, is a fund offering from iShares, which tracks the price on the 7-10 year section of the US Treasury yield curve and thus moves inversely to yield. The fund dropped below its 200 day EMA level yesterday on increased volume.

UUP  PowerShares DB US Dollar Index Bullish  

The exchange traded fund which represents a play on the upside possibilities for the US dollar index, UUP, is revealing some positive technical divergences. But having said that it has been doing so for several weeks and still seems to have the buoyancy of a lead balloon.

GDX  Market Vectors Gold Miners ETF  

GDX, which tracks the gold mining sector, is approaching a price zone where the long side would be worthy of consideration.

Daily Form October 26, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

MONDAY OCTOBER 26, 2009       06:16 ET

Friday’s action in the US session raises some interesting dilemmas for the bulls.
On the one hand there is still much evidence that funds are enamoured with the carry trade, the emerging markets and commodity related stocks as evidenced by supportive technical conditions in the ETF’s for those geographical and specialty sectors. On the other hand there are more signs that for US based investors the domestic market is sending some clear warning signals.
Two indices that I have focused on in the last two weeks are registering some cause for concern - the Russell 2000 and the DJ Transports. Both are displaying more evidence of rolling top formations.
Below is the IWM chart which can act as a surrogate for the Russell 2000 and for the first time since July this instrument is showing a clear movement towards the Ichimoku cloud formation, and at the same time there are also relatively weak RSI and MFI readings.

The IYT sector fund is a proxy for the DJ Transportation stocks and the story is similar to the one for IWM.
The prospect of more dissonance between the behavior of largely US based high beta and transportation stocks and the large DJIA blue chips coupled with the still healthy appetite for exposure to emerging markets reflects a market environment which is, to use an overworked expression, uncharted .
At the Tradewithform website one of the pattern templates which tracks the degree to which certain stocks are registering divergences which often indicate short covering candidates, produced a large number of signals following last Friday’s session.
In an anxious market there is both a high propensity for the bears to run for cover on sudden bursts of enthusiastic buying, as well as for signs of technical weakness to make fund managers holding long positions consider converting some of their market exposure back into cash.

Yet another sector fund which is not acting well from a technical point of view is XSD, representing semiconductor stocks and mentioned here recently. Once again it has entered the Ichimoku cloud pattern for the first time since July and the volume chart indicates that the larger volume spikes are associated with the red candlesticks rather than the green ones.

In addition to the evidence of rolling top patterns in some key US indices, there is also need to pay some attention to some of the less widely followed currency pairs within the carry trade. Periodic checks on the AUD/CHF pair would be well advised this week.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

SEA  Claymore-Delta Global Shipping  

Continuing with the schism already touched on i.e. between growing caution about the US economy coupled with an underlying belief in the global recovery story and a passing of the baton from the US to the emerging markets, the sector fund SEA which represents a bet on recovery of international trade, could also present an opportunity on the long side at the $13.20 level.

EWW  iShares MSCI Mexico Index  

EWW, an exchange traded fund which tracks Mexican equities, is one of the funds, alluded to in my remarks above, where a bout of short covering would not be surprising.

Daily Form October 23, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

FRIDAY OCTOBER 23, 2009       04:27 ET

Yesterday’s recovery affirms my view that, despite the growing prospects for a significant correction, trading desks are still having too easy a task in squeezing the overly anxious short sellers who seem to have a fetish for wanting to call the exact top.
There are several fairly obvious divergences developing, not only for equity indices but also within other asset classes, and yet the prevailing objectives of the major funds is to tap into abundant liquidity at virtually zero rates of interest, exploit the carry trade and keep asset prices moving higher.
The hourly chart for the S&P 500 shows how the potential penetration below the Ichimoku green cloud posed the risk of a rather severe technical break in early trading yesterday, and that those who mounted the heroic rescue efforts will now have to sustain the extraordinary efforts today to improve the momentum profile for the weekly close.

Many charts are revealing upticks in the intraday average true range readings and the VIX is reflecting the heightening of implied volatility by registering large body candlesticks.
Notably despite the recovery yesterday the VIX was unable to reach back to the intraday low seen in Wednesday’s session.

The exchange traded proxy for the Russell 2000, IWM, is one of several indicators which I use to monitor macro themes and I shall simply reiterate my concern that the action in recent days seems to have gravitated away from the high beta universe of stocks towards the large cap and strategic DJIA stocks where index levels are currently being monitored very closely in the mainstream media.

Taking a long term perspective on one of the currency pairs which I track closely, AUD/JPY, the rate is now entering a zone where the long term line of support/resistance drawn on the chart will act as an attractor to daily price action, but where the risks of an upward trend exhaustion are increasing.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

GS  The Goldman Sachs Group Inc.  

Goldman Sachs (GS) has registered back to back trend days - one red and one green - and notably yesterday's was an inside pattern suggesting that there is some directional uncertainty present for this barometer stock.

BAC  Bank of America Corporation  

Bank of America (BAC) is struggling and as illustrated by the price and volume chart the bank was not able to make progress even with the overall market rally yesterday.

IYT  iShares Dow Jones Transportation Average  

The chart for IYT, which tracks the performance of the Dow Jones Average Transportation index, shows a possible double top pattern with a slightly lower high in mid October and it would seem that a more thorough testing of the $65 level needs to be made in coming sessions.

Daily Form October 21, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

WEDNESDAY OCTOBER 21, 2009       06:13 ET

Several themes touched on in yesterday’s column have delivered the anticipated results and the general tone to today’s trading in Europe suggests that the usual favorites of the high risk appetite brigade are looking a little stretched and tired.
The chart below captures exactly the move that I anticipated in yesterday’s GBP/USD discussion and even included the cute false breakout highlighted in yellow on the chart.

The DAX index is beginning to show some intermediate term topping characteristics and could be about to drop below a key support level.

The sterling bears who had set the targets on parity with the euro are now facing a break below a critical level which could see a lot of traders having to cover short positions in sterling which could also help to propel the British currency ahead in other cross rate trading.

The currency pair which I have mentioned a lot recently, AUD/JPY, is making larger moves and the range expansion with a negative tilt in yesterday’s trading was coinciding with some S&P 500 weakness.
It will be worth watching this important carry trade pair for signs that the support level around 83.45 will be tested, and possibly have to be ratcheted down, in today’s North American session.

Daily Form October 20, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

TUESDAY OCTOBER 20, 2009       06:17 ET

In Monday’s column I remarked that the pattern on the Rogers Commodity Index (RCT) had the capacity for a breakout from an interesting basing pattern, and the ongoing march of energy and other industrial/agricultural commodities is providing confirming evidence of this pattern.
DBC, an associated sector fund, as well as COW have performed well since being recommended here and other commodity funds such as DBB, DBA and MOO are worthy of consideration.
As the US dollar continues its slump and the enthusiasm for other currencies is not wholehearted, there is clear evidence that the appeal of commodities as a proxy for purchasing power is increasing.
Eventually, my growing intuition is that a new basis for international settlements will emerge and complete the circle with a new global reserve unit of account being established which will rest upon a basket of commodities along with an assortment of paper currencies.

GBP/USD has rallied back towards the $1.65 level, and, as illustrated on the 4 hour chart, the Bollinger bands are constricting along with a drifting of the RSI values in the neighborhood of the 70 level. The pattern would suggest an initial pullback which, provided it is not severe and attracts higher volumes, could be constructive for sterling in the intermediate term.

The DAX index in Germany could not quite reach back to the intraday high seen in last Friday’s trading and registered an interesting green trend day, which was still an inside pattern with reference to Friday’s formation.

The exchange traded fund, SLV, which tracks the price of silver is revealing some divergences. As suggested elsewhere, the momentum for the miners of the more senior of the precious metals provides some additional plausibility to the notion that the two metals could be headed for a period of consolidation.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

POT  Potash Corp. of Saskatchewan Inc  

Potash (POT) broke away on substantial volume and looks to be targeting highs around $120 seen in June.

GDX  Market Vectors Gold Miners ETF  

The gold mining sector fund GDX is revealing fading momentum.

IGW  iShares Semiconductor ETF  

Last week I suggested that the semiconductor sector was showing some signs of fatigue and pointed to the performance of XSD, and today the focus is on similar waning momentum for another fund for semiconductors, IGW.

Daily Form October 19, 2009

Inter-market Technical Analysis Using Algorithmic Pattern Detection

MONDAY OCTOBER 19, 2009       06:50 ET

Late last week I commented that the Russell 2000 was deviating somewhat from the larger cap indices in failing to make a new high despite the DJIA topping 10,000 and the S&P 500 moving up towards the 1100 level.
The Nasdaq 100 index (NDX), which represents a concentration of higher beta stocks than say its large cap counterparts in the S&P 500, should also be monitored this week for any suggestion that the large trading desks are looking more carefully at their high beta exposure which will, should there be a waning in the animal spirits, drop faster than the broader market does.

Back in late September, during a guest slot on CNBC’s European Closing Bell I discussed the outlook for the FTSE 100 Index (FTSE). Essentially the point that I made was that 5200 represented an area of potentially strong resistance from a technical point of view. Subsequent market action would, I suggest support that view.
The reasoning from a wave point of view can be laid out as follows.
From the March low at 3460 the index moved up 1060 points to the 4520 level in May where it hit the first corrective wave bringing it back down to 4140. Adding back the same length of wave to the third wave which we still appear to be in gives a target of 5200 almost exactly. There was some pullback from the 5200 level in early October but if the third wave is still intact there is a possibility that we could be looking at a 1.618 target on its length which would put us closer to the 5800 level.
My slight discomfort with this notion, and without resorting to explanations involving more complex EWT structures, is to suggest that the customary robust and strident personality of a third wave needs to assert itself soon or the possibility of a fourth and corrective wave is increasing.

The ascent of AUD/JPY since early October on the 4 hour chart is quite remarkable. There were some wobbles during last week’s trading and this week I shall be watching for evidence that there could be some waning of momentum as traders attempt to surpass the recent 84.20 top.

Sterling, which is always one of the more lively instruments in the sandbox, faces resistance at the two levels indicated on the chart as it attempts to defend itself against the naysayers who want to see parity with the eurozone currency.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

X  United States Steel Corp.  

US Steel (X) appears to be vulnerable and SLX the chart for the steel sector should also be watched during this week's trading.

ZQK  Quiksilver Inc  

Quicksilver (ZQK) reveals a rather nasty red trend day from Friday. Interestingly there is supportive back testing data which shows that following such a decisive uni-directional move down to a support level a bounce has a high probability. This could present a quick recovery trade for those willing to take a short term opportunistic view, despite the evidence that longer term the most likely direction is down.

KOL  Market Vectors Coal ETF  

Another basic industrial sector as represented by the KOL fund, is also revealing some divergences within a pullback channel.