How Will The Markets React?

Traders have already witnessed the impact of thin volumes ahead of the Thanksgiving holiday, and things could get worse as some of the US and Asian markets are closed or will close early on Wednesday, Thursday and Friday. This has already played out during the most recent Asian trading session, as the Hang Seng Index plummeted 4.15 percent while the Nikkei 225 Index plunged 2.46 percent, helping to lead European stock indexes like the DAX and FTSE 100 down over 1 percent during the early London hours. Meanwhile, government bonds have rocketed higher while the Japanese yen currency crosses have tumbled, making it very clear that risk aversion remains the primary driver of the markets and that lower volumes will only exacerbate large moves. Indeed, the global financial markets remain a precarious place, as mortgage lenders and investment banks alike announce almost daily their billions of dollar in losses and write-downs as the carnage of the US housing recession takes its toll. Even worse, the problems are not contained to the US, as the event has led to a widespread credit crunch in places like Canada, the UK, and even Japan. Now, the markets don’t even have rate cut hopes for the US Federal Reserve to rally on, as mounting upside inflation risks are likely to force the bank to keep rates steady in December. Nevertheless, flight to safety has pushed bonds higher, including fed fund futures, leaving them to price in a 92 percent chance of a 25bp cut next month. Given the potential for mispriced interest rate expectations, continued risk aversion, and high volatility, carry trades including the yen crosses and equity markets could dive throughout the rest of the week.

Bonds – 10-Year Treasury Note Futures

With Treasuries continuing to climb within an ascending channel and low volume keeping conditions stable, the bullish price action on the daily charts appears to be safe. Indeed, bond markets in the US will close early on Wednesday and Friday and will close for the entire day on Thursday. As a result, the potential for Treasuries for the remainder of the week lies at polar extremes: conditions may either be rather boring or very volatile, and much of this will depend on stocks and more broad based financial news. With Asian equities down sharply overnight, Wall St. could also take a hit and propel Treasuries higher on Wednesday, and possibly Friday as well.

FX – GBP/JPY

Given the jittery nature of the global financial markets since mid-August – when the US subprime-collapse story rushed to the forefront – investors have been wondering just how profitable carry trades will remain. Indeed, consolidation in the GBP/JPY pair above 224.00 has seen price form a descending triangle, which is a highly bearish signal. Furthermore, a head-and-shoulders formation on the daily charts along with a double top at the October and early November highs near 240.00 suggests that GBP/JPY may be preparing to break significantly lower. The credit crunch that has taken a toll on stock markets around the world, as well as indications that the equities in regions like Asia are severely overbought, have only exacerbated the volatile moves in GBP/JPY and this may remain the case in coming days. During the most recent Asian trading session, indexes like the Hang Seng and Nikkei ended the day down sharply in response to softer FOMC growth outlooks. Will US stock markets follow suit? European markets sure have, with the DAX and FTSE 100 down over 1 percent. It appears that thin volumes will keep price action choppy throughout the week, and with financial market news doing little to support the case for additional carry trade gains, GBPJPY could finally take a dive this week.

Equities – Dow Jones Industrial Average

The Dow’s bounce from the 13,000 may prove to be short lived, as the index pulled back from resistance at 13,350 last week to fall back below the 200 SMA at 13,236. This week, the Dow has barely managed to keep above the critical 13,000 level, as thin volumes have kept the pair trading choppily and the FOMC minutes failed to give the index much in the way of directionality, as the central bank cited both downside risks to growth and upside inflation risks. With inflation pressures in the US confirmed to be growing rapidly, there is little chance that the Federal Reserve will cut rates in December and this is the sentiment that may take hold on Wednesday, as it did in Asia and Europe. As a result, the Dow could finally make a sustained break below 13,000, with further declines target the August lows just above 12,500. However, if traders opt to keep out of the markets ahead of the US holiday, the Dow may simply consolidate until next week.

Terri Belkas is a Currency Strategist at FXCM.