And now the good news

The good news is that investors are finally getting used to bad news. In turn that makes it possible for counter-intuitive rallies especially in equity markets, which is leading intraday moves in currency markets and mitigating somewhat the strength of both the dollar and the yen. Last week’s 34-year high in American job layoffs is a good case in point in which bad news, void of any kind of silver lining spawned a significant reversal in equities and fixed income. In turn the extreme readings of currency volatility have subsided to more manageable levels. However, we’d say that this process in which investors are able to weigh their options and digest incoming news will still lead them to conclude that there is no good news in sight.

Instead of fretting over whether Congress will or won’t make funds available to tide over the Big Three, investors have extended their horizons to understand that an initial $15 billion in funding comes with the caveat that March will be a key deadline for submitting overhaul and survival plans to a yet-to-be-named so-called ‘Car Czar,’ whose purpose in life will be to act as judge and jury to continuously play devil’s advocate with the industry. In effect, the role will be to argue that the $15 billion package is merely an acquisition of time and that bankruptcy is inevitable. To investors, buying time helps sentiment hugely and allows them to focus on the potential positives of revival rather than the prospects of unprecedented bankruptcy in 2008.

S&P 500 companies on average saw third quarter earnings decline, which in turn has inspired analysts to rein on predictions of 23% EPS growth for 2009 to a more reasonable 9%. Investors have adjusted their thinking process to adopt such changes and are now hunkered down in relative safety. In seems as though the risks in the equity market are no longer to the downside but to the upside as the buyers’ drought of 2009 has turned into a sellers’ drought.

Such a scenario is playing out as the new norm. While the dollar and yen have risen to reflect safe haven status, they are no longer making a fresh advance. We are likely to see this churning process continue until investors change their view on the horizon of the problem. Because open-ended government stimulus is staring us right in the face, investors have a sense that there is a ‘get out of jail card free’ option attached, which is once again buying time.

The major risk to the dollar and yen is that investors fearful of missing out on value send index values higher forcing a reallocation into riskier assets, such as foreign bonds, stocks and currency. This would be a major case of the tail wagging the dog and would be built on a scenario of vignettes of good news driving an otherwise extremely negative picture. Incrementally positive movements in the stock market would inevitably undermine the sanctity of dollar and yen longs earning zero per cent return and create dumping sessions as supposed risk appetite returns.

However, the flaw in this is the fact that although time is a great healer, we still face the reality of major bankruptcies not only in the auto sector, but as highlighted this week with Tribune Company’s filing for Chapter 11 protection. As we know, markets face a wall of worry, but when they fall the transition can be executed with extreme speed.

Volatility may have abated for now, but the negative backdrop with the anchor not yet even touching the floor remains a major concern. Implied volatility on the euro came in most dramatically over the week by 18% to stand at 19.3%. A surprise rally in confidence helped boost it to $1.2950 against the dollar. However, the confidence reading from the ZEW was merely less negative than previous. Implied volatility on the Aussie dollar dropped 15% to 25% after the unit stabilised as the RBA slashed interest rates. Once again investors reacted positively to depressed stock prices and a higher consumer confidence reading. We still think it’s a bad move to discuss any prospects for decoupling for the Australian economy given the continued bad news out of China, which acts as the heart of Asian trade.

In Britain the depth of recession was reinforced by data showing tumbling home sales and the first back-to-back monthly decline in retail sales since 1995. It should be of no shock to any of us that negative data is piling up, but its ability to drive currencies lower is now becoming questionable in the near term. What remains to be seen is whether the pace of economic drop off continues. Even if it does, investors will adapt their expectations accordingly in light of the response to the US employment report.

Looking at our table showing put/call ratios for PHLX World Currency Options we observe a distinct pattern of bearishness surrounding prospects for the euro and the pound where readings above 1.0 indicate an overweight amount of bear put posturing by currency option players. The yen is balanced at exactly 1.0, while the option market has us believe that the Canadian and Australian dollars will rally while the Swiss franc also has a bias towards call options attached.

We have to add in to the mix here that while speculators have been thrown out of the commodity markets with extremely violent moves, one has to question just how much more selling there is left to drive down energy prices. Crude oil’s gentle rally will help both Aussie and Canadian currency values and in the case of the latter might even help offset heightened political risk.