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Friday saw heavy selling pressure coming into risk
assets, specifically equities and oil. However, the real driving force behind
the selling pressure is likely the result of several unrelated
economic/geopolitical events. Clearly the unemployment report had an impact
on price action, but strangely enough it would appear to those more in tune
with reality that market participants want lower prices so that the next
quantitative easing program can be initiated.
Another
key development in equities price action as of late has been selling pressure
in Apple (AAPL). A few weeks ago we witnessed a sharp downturn after prices
surged higher into a blowoff top. Earnings came out
and prices jumped again and we have watched Apple’s stock price drop
considerably since.
Friday saw
sellers circling the wagons pushing the tech behemoth down around 2.25% as of
the scribbling of this article. When AAPL was rallying it helped the Nasdaq Composite and the S&P 500 grind higher. Now
that it has clearly given up the bullish leadership role, it now appears to
be a drag on the price action of domestic indices.
Additionally
there was a mountain of economic data released out of Europe overnight which
was entirely negative. Spain, Italy, France, Germany, and the Euro-area in
general saw their Service PMI readings all come in below expectations. Europe
is moving into a recession which whether economists want to acknowledge it or
not has implications on domestic U.S. markets. The Eurozone as a whole is the
largest economy in the world. Clearly the European economy is slowing, and
our exports to Europe will slow as well.
This leads
me to the final data point which is still unknown. What will the outcome of
the French and Greek elections over the weekend mean for the Eurozone’s
geopolitical ties as well as the potential impact on the Euro currency
itself?
The answer
to that question will likely not be known until late Sunday evening; however
by the time U.S. markets open this coming Monday the cat(s) will be out of
the bag. This final question leads me to the real topic of this article. The
question I want to know is what impact these elections could have on the
value of the U.S. Dollar Index as well as gold?
As an
option trader, I am always focused on the volatility index (VIX) as well as
implied volatility on a number of underlying assets. I came across the
following chart courtesy of Bloomberg which appeared in an article posted on
zerohedge.com. The chart below illustrates the differential between European
Union equities’ implied volatility levels and the EUR/USD currency
pair.
 
Chart
Courtesy of Bloomberg
It is
rather obvious that EU stocks and the EUR/USD implied volatility levels have
diverged. Generally speaking, when volatility increases it means that price
action will typically move lower. The higher levels of volatility, the lower
the price the underlying will move. There are exceptions to that rule such as
earnings reports or key headlines which drive volatility higher, but
generally speaking high volatility levels correlate with uncertainty and
risk.
What is
particularly troubling about the chart above is that the EUR/USD currency
pair is seeing reduced implied volatility. This essentially means that the
market is not expecting any major moves in the currency pair amid all of the
poor economic numbers coming out of Europe.
For those
not familiar, the EUR/USD currency pair reflects the value of the Euro
against the Dollar. Thus, if the EUR/USD is rising, this means that the Euro
is moving higher against the Dollar. The opposite is true when EUR/USD is
selling off.
At present
implied volatility levels are quite low by comparison to European equities.
The zerohedge.com article entitled “Is EURUSD Volatility About to
Explode?” shares the following statement to readers, “The last
two times this has occurred (in the last year), EURUSD implied vol has rapidly caught up to equity’s risk.”
What that
statement means is that it is becoming more likely that implied volatility of
the EUR/USD currency pair is going to increase back in par with European
stocks. If that takes place, which based on recent data is likely, the
intraday volatility in the EUR/USD will increase thus intraday price ranges
and sharp moves will become more prevalent.
The long
story short is if implied volatility picks up in EUR/USD then it is likely
going to be quite beneficial to the U.S. Dollar. The largest concern for Fed
Chairman Ben Bernanke has to be the potential for a monstrous move higher in
the U.S. Dollar should an unforeseen event arise in Europe. An event such as
a disastrous auction or the discussion by German Parliament about leaving the
Euro could both help push the Dollar much higher than anyone expects.
A higher
Dollar is negative for risk assets and Mr. Bernanke does not like the word
deflation at all. None of the central banks around the world like deflation
because it means all of the debt they are holding and helping to prop up has
a much more significant intrinsic value. If the Dollar is worth more, Dollar
denominated debt is also more expensive to pay off.
The U.S.
Dollar Index has languished for several weeks, but recently the greenback
started to reverse higher and at this time has managed to push above major
resistance levels overhead on the daily timeframe. The daily chart of the
U.S. Dollar Index is shown below.
If the
Dollar remains firm into the bell on Friday which appears likely, the results
of the two key European elections over the weekend could provide the ammo
needed to really force the U.S. Dollar higher or lower depending on market
sentiment. It appears the Dollar wants to go higher currently, but a sharp
reversal is not out of the question.
The key
level to watch is the 80.76 price level on the U.S. Dollar Index futures. If
that level gets taken out, the Dollar could extend to recent highs and beyond
should the situation in Europe begin to unravel.
If the
Dollar surges what will that mean for gold? Generally speaking most readers
would expect gold and silver to move lower on Dollar strength. For a time,
that would likely be true, but if a real currency crisis plays out gold and the
Dollar might rally together as citizens would try to move their wealth into
safe, liquid assets.
Under that
type of scenario, gold and silver could both rally along with the Dollar.
When the moment finally arrives where the Euro begins to selloff
sharply, physical gold and silver will be tough to acquire in Europe.
In the
short to intermediate term, gold will likely continue to drift lower
searching for a critical bottom. The weekly chart of gold futures below
demonstrates the key support and resistance levels that may have to be tested
before a major reversal can play out.
Make no mistake, I remain a gold bull in the long term. However,
in the short run the Dollar has the potential to outperform gold under the
right circumstances. Ultimately it is important to recognize the distinction
between selling pressure and what would likely happen in a full blown
currency crisis in Europe which is possible, if not ultimately inevitable.
The price
action over the weekend on Monday will likely be telling and we could see the
beginning of a major move in a variety of underlying assets depending on the
election results. Clearly times have changed when U.S. market participants
are concerned about what is going on in Europe more so than domestic issues.
Unfortunately, we live in very strange times.
JW Jones
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