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.
ort 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.
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