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Yesterday witnessed a slightly more contemplative mood in financial markets, with some mild profit-taking in risk assets and currencies after some heady moves over recent days and weeks. A number of developments appeared to trigger this more reflective disposition, including the growing tension between China and Japan, the protests across the Muslim world directed at the United States, Israel’s increasingly hawkish rhetoric towards Iran, a sharp increase in bond yields for Mediterranean sovereigns and Chinese growth concerns.

The single currency, which has led the way in forex markets recently, drifted below 1.31, the Aussie fell back to 1.0437 (see below), and the yen was on the defensive amidst fears that the dispute with China will scupper trade between the two Asian super-powers. Many market participants and commentators are still scratching their collective heads attempting to understand how the euro has managed to climb so far so quickly.

Guest post by Forex Broker FxPro

Traders are also still sceptical of the ability of the single currency to sustain these lofty levels – they remain significantly net short, although not to the extreme they were back in mid-year. Indeed, the extent to which traders still prefer to be short the euro is matched by their bullishness on the Aussie.

Interestingly, as we have been suggesting, EUR/AUD has been heading consistently higher over recent weeks, in direct contrast to how traders are positioned. Being short EUR/AUD was incredibly profitable from mid-May through to the middle of August, but two-thirds of the gains during that period have already been given back.

Commentary

Gold is gearing up. Gold has had a four-week winning streak, something that has not been seen since the early part of June. The down-move in the dollar has combined with a stronger inverse correlation between gold and the USD in recent weeks, this now standing at -0.79 (based on four-week moving average) – the most extreme of the year so far.   Gold is just 2% below the highs of the year and just under 9% below the all-time high seen in September of last year. The belief is gathering pace that renewed quantitative easing efforts from the US Federal Reserve, combined with the latest efforts from the ECB and possibly more efforts from Japan this week, will lead to a deterioration in sentiment towards paper currencies. A story around this could be constructed for the US (core inflation certainly higher since QE began) and the UK, where core inflation has been some 1% higher since early 2009 vs. the prior 3 ½ years.   But for the eurozone and Japan, the story is different, with core inflation lower since early 2009, by 0.5% for the eurozone and 1.0% for Japan.   On a notional basis, this is not that surprising, given that Japan’s stimulatory efforts are older and more stretched and the ECB has only just embarked on a (still) conditional program to buy securities more actively. This mixed data on inflation suggest that it’s a more subtle picture with regards to quantitative easing and gold, but nevertheless the picture has been improving.   The $1,790-$1,803 area remains key on the upside, as this has proven a key resistance level a couple of times in recent months. If this can be broken, the charts and also dollar correlations are looking a lot more positive for gold bulls going to the year end.  

Another double top in the Aussie. For those who use technicals to inform their forex trading strategies, it is worth noting that another double top has been recorded by the Aussie dollar. Back in the first half of August, the 1.06 level proved a very difficult nut to crack, and once again the AUD has beaten a hasty retreat after briefly reaching a 6m high of 1.0625 on Friday. Part of the explanation for the reversal is that the euro, which has been very much at the forefront of forex market developments recently, has experienced some profit-taking ahead of key meetings this week between various European leaders. Also weighing on the Aussie is continued concerns over the pace of growth in China. Yesterday, the Shanghai Composite lost another 2%; for the year-to-date, down 5.5%, and is the only major emerging equity market to record a loss so far in 2012. As we have been suggesting recently, we continue to like the idea that the Aussie will be confined to a trading range bounded by 1.06 on the top-side and parity below. For those that followed this suggestion on Friday, it appears that the 1.06 level was again a good place to set up short positions.