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Stocks Down, Bonds Up as Risk Aversion Creeps into Markets

U.S. Equity markets are under pressure this morning as sellers showed up after Japan reported a weak GDP figure. Treasury Bonds are trading higher in response to the possibility of a weaker global economy.

Talk is circulating that the Fed may have inadvertently cast a pall on the market last week when it decided to shore up its balance sheet by moving funds from mortgages to Treasury Bonds. This may have sent a message to traders that the central bank is making room for more stimuli. Its action in no way injected any confidence into the fragile markets.

Today investors will have three reports to digest to help determine the outlook for the economy. These reports should help shed a little light on the progress of the recovery. Even if they turn out better than expected, the economy is still facing a huge challenge since all indications are showing that economic activity has stalled.

The NY Fed Empire Manufacturing Index is expected to show that manufacturing activities expanded in August to 7.50 from 5.10 reported in July. This report should be no big deal since manufacturing has been steady.

Net Long-Term TIC Flows are expected to show a surplus. This reports measures foreign investment flowing into the U.S. This report often shows a surplus, but the figure usually offsets the trade balance deficit. In fact some say it is reported to cover-up the trade deficit. Although there is a surplus at this time, an economic slowdown in the U.S. is likely to cause foreigners to curtail their interest in U.S. investments.

Finally the NAHB-Housing Market Index gets reported at 9am CDT. This report should be up from the June figure, but this increase could be deceiving since housing took a beating in June following the ending of the tax rebate program.

So basically, these reports aren't expected to trigger much interest following their initial releases. The focus will remain on the longer-term picture and an interpretation of the Fed's next move.

The U.S. Dollar is trading mixed against most major Forex markets, posting gains against the commodity-linked currencies and losses against the Euro, Yen and Swiss Franc.

Early in the session, the Dollar was trading a little firmer, but was unable to hold gains after Japanese second-quarter gross domestic product data showed the nation's economy slowed to a crawl. The sluggish GDP report helped China move up to become the world's second largest economy.

The reported slow down in the Japanese economy also may have strengthened the government's case for a weaker Yen. For weeks the government has warned that the high price of the Yen may be damaging demand for Japanese exports, thus hurting the economy.

At the close on Friday, the Yen posted a reversal bottom for the week. This was an indication that traders were looking for a possible intervention. The lack of follow-through to the upside means this reversal bottom has not been confirmed.

The main driver in the Dollar/Yen market the past few trading sessions has been the anticipated moves by the Japanese government and the Bank of Japan. So far all the rhetoric has amounted to a "verbal intervention", but this has been enough to scare the weaker shorts into covering their positions.

This week Prime Minister Naoto Kan and central bank Governor Masaaki Shirakawa meet to discuss the value of the Yen and its effect on the economy. Look for increased volatility in the Japanese Yen as traders try to forecast the government's and BoJ's next move.

Friday Recap

The two-day pause in the break in the equity markets made me search for some missing factor which may be lurking in the charts. At this time, the break taking place from the 1127.75 level in the September E-mini S&P 500 appears to be a normal 50 - 62% correction of the 1002.75 to 1127.75 range. This makes 1065.25 to 1050.50 the next potential downside target and an area which could make stocks attractive to buyers.

Something struck me as interesting about the developing pattern because the market has a tendency to trade in a range once it makes its retracement as buyers and sellers jockey for position. In this case the market is holding above this area almost in the same manner that a boxer would hold up the head of his opponent before landing a knock-out punch.

After browsing the internet this afternoon I came across an AOLNews.com story written by Carl Franzen about the "Hindenberg Omen" which he described as "an obscure technical analysis tool that proponents believe is uncannily effective at signaling the necessary preconditions, there is at least a 25 percent chance that such a significant drop is nigh."

Given I am at a loss for words after describing the same pessimistic outlook for the economy several times this week and predicting the correction into the retracement area, I believe I am going to take some time this week to investigate the "Hindenberg Omen" in combination with some of the other Gann tools that I typically use to analyze a market.

That being said, hopefully I will have something interesting to contribute to the analysis report on Monday morning. At this time I continue to believe that stocks are not going to move higher until 50% corrections at a minimum take place in all three major indices. In addition to reaching this level on the daily chart, this test of the retracement zone is very critical to the structure on the weekly chart since it sets up the possibility of a secondary higher bottom.

I have said many times before that the first rally from a major bottom is most likely short-covering and that the real buyers step in once the market corrects the first leg up. Well we are approaching this level at this time so it will be interesting to see if buyers show up once the retracement is complete.

My gut feeling is that next week will be a very volatile market. I get this feeling from my growing concerns about what will happen if the Japanese government intervenes. Will it be like mixing an acid with a base? I'm not sure, but if it intervenes in a big way then I'm not sure stock traders will know what to do. Based on how investors have reacted to sell-offs in the Yen before, stocks could rise substantially. But this current weakness has been based on the poor outlook for the economy so there is a chance that stocks may do the opposite and break sharply following an intervention. Either way look for an expansion of volatility.

The U.S. Dollar finished the week sharply higher after posting gains against all the major currencies. The catalyst behind this week's strength was the action by the Fed to stabilize its balance sheet by shifting assets from mortgages to long-term debt. This sent a signal to already worried investors that the Fed was making room for the possibility of a prolonged downturn in the U.S. economy. Investors sought safety in the Greenback on concerns that the slowdown in the U.S. economy may soon trigger a halt in the global economic recovery.

As pessimism soared regarding the outlook for the strength in the global economy, investors moved funds into the Japanese Yen in the typical flight-to-quality fashion, but a few comments from the Japanese government, much stronger than the usual "verbal intervention" rhetoric, caused investors to scramble out of the Yen as the threat of an actual intervention began to be taken more seriously. After reaching a 15-year low earlier in the week, the Dollar/Yen rallied as the fear of an intervention trumped the desire for safety.

The Japanese Yen finished lower and in the process posted a weekly closing price reversal top. This formation, once confirmed by a follow-through rally next week, often leads to the start of a 2 to 3 week retracement to a major 50% level, currently identified as 1.1176.

The current two-day break in the Yen has most likely been a reaction to the "verbal intervention" by the Japanese government earlier this week. Some traders feel the government will intervene at this time, but doubts still linger about its effectiveness.

According to the Bank of Japan minutes from the July 14-15 meeting published overnight, the BoJ is closely monitoring the effect of a strong Yen and falling stock prices on the economy. If one interprets this to mean that the BoJ is seriously considering an intervention at this time, then this news will act as the catalyst to drive the Japanese Yen lower.

Throughout the entire financial crisis the Dollar and the Yen have both benefitted from investors' unwillingness to hold on to risky assets. Most of the rally in the Yen has been traders seeking shelter in safe-haven assets. The possibility of a rally in the Dollar/Yen exists at this time because speculators feel the Japanese government will intervene in order to protect the interest of its exporters. One key to this rally taking place will be whether a stock market break will trigger a flight-to-safety rally, thereby limiting gains in the Yen following an intervention. In other words, if equities break hard, will the news of an intervention be enough to counter-act the demand for the lower risk Japanese Yen. If not, then the Yen seems destined to move higher.

The Euro closed sharply lower for the week. This currency pair accelerated to the downside following a change in trend earlier in the week when the market crossed a swing bottom at 1.3119. Downside momentum is building which could drive the Euro into a major retracement zone at 1.2605 to 1.2433.

Although recent economic data has suggested a developing recovery in the Euro Zone economy, some traders feel that this is backward thinking since the reports are based on stale data. Going forward, investors remain skeptical about future growth especially if a slowdown in the U.S. economy spreads globally.

The British Pound finished the week lower after finding resistance at a .618 retracement level at 1.5967. Once the rally stalled and buyers became scarce, the trend easily turned down on the daily chart when a swing bottom was crossed at 1.5819.

The downside move accelerated earlier in the week after the Bank of England lowered its outlook for growth. This added to the concerns that the implementation of new austerity measures and higher taxes will tie up the economy and possibly trigger a double-dip recession. Further adding to the weakness was a report that U.K. home prices fell for the first time since July 2009, indicating that there is more supply than demand. Tight credit and employment worries have kept many potential British homebuyers on the sidelines.

The strong rally in the Dollar was the story this week, but next week, the focus will shift to the Japanese Yen. Shorts are nervous about whether the Japanese government will intervene and may begin to panic as the government debates what to do about the high priced Yen. The longer the government takes to make a decision, the higher the Dollar/Yen may rally, before moving sharply depending on what the decision turns out to be. Either way one looks at it, the Yen is set up for a volatile week.

Even if the Japanese government intervenes, many investors feel that hedge funds and institutions will treat this as a buying opportunity following a sell-off. Some traders feel that no matter what the government tries to do, a weakening global economy will eventually overcome the benefits of an intervention. This is the primary reason why Japanese officials are taking their time before taking action. It doesn't make sense to flood the market with Yen if it is only going to be used to set up more selling opportunities.

The huge rally in the Dollar Index, following a test of a Fibonacci retracement level at 80.45, could continue next week if the Greenback is treated as a safe-haven currency. The charts indicate that this market could rally to 84.69 before finding any solid selling pressure.

 

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