The volatile pair is at a cross roads. The price is resting at its near 12 month support line around the 138-140 mark. See Fig 1. The last month has seen a sharp fall in the currency pair which becomes more volatile as the risk aversion trade takes over. At the moment the world markets seem to be at yet another cross roads in the never ending narrative which is the world financial markets.
The fear due to the sovereign default risk emanating from the Euro zone over the last few weeks has been palpable. There has been a very sharp adjustment in world capital flows as investors who have been previously willing to take on more risk now change their stance to preservation of capital. This has led to money moving from global stocks (see Chart 2 of S+P500), commodities and riskier assets, back to the major liquidity source, the USD and the JPY.
Chart 2 S+P Futures
What does this mean for the GBPJPY?
Last week the pair made a low at 138.28, before rising from this long term support this week. This has been the 4 or 5th test of this area, which inevitably is trying to tell us something. I believe the GBP will break down below this area, possibly in the coming days and weeks. However, I m more inclined to think that the sharp drop in the markets may take a pause, and a rally can occur. This in theory, all things being equal that the GBPJPY should rise, and makes a candidate for a good short term long trade, perhaps 3-7 days.
Negative sentiment seems to have calmed down for the time being, as the markets seems to be taking its cue from the ECB and the other main protagonists in the Euro region, namely Germany and France that Greece will get the necessary help needed to stave of the worry that Euro zone nation will default on its debt. However, that does not mean the jitters have gone away yet. Investors remain on edge and the smallest of catalyst is all that is needed to send markets lower. One such case in point can be highlighted today when some German officials made a statement which did not mention that a bailout was guaranteed, which the markets took as a cue to reverse earlier gains.
However for the time being it seems the market is expecting a bailout for Greece if needed perhaps evidenced by the fact that Greek Bond prices rose strongly, with yields dropping some 55 basis points. This type of rally is indicative that Greece has the backing of the EU officials. I believe this sets the stage for a possibly return to risk tolerance in the short term.
I think it is important to add at least one caveat. When you find one cockroach, it is very seldom you only find one. There are definitely other cockroaches hanging around the Eurozone, in the form of the PIIGS, the unflattering acronym for Portugal, Ireland, Italy, Greece and Spain. The remaining four PIIGS will in my opinion provide a much bigger headache in the not too distant future.
How to Play a possibly short-lived return to taking on more risk?
As already mentioned I think the stage is set for a rally in higher yielding assets. The US Dollar has had a tremendous rally, which I think may be overdone in the short term, but I don't believe the dollar is done just yet.
In these volatile markets where the inter-play between the will to take on more and risk and the tendency to shun risk can turn on a dime, I am of the opinion that you need a dual strategy to play both sides of many different coins. Below in the intraday chart 3, is the GBPJPY, this is a 20 pip range candle chart. As can be seen we into the 5th day of either a base building period. A return in earnest to the risk trade should see the pair move above the 141.40 mark. I think a good risk/reward trade is to play the breakout of this range. On the other as already mentioned above, the markets still remain on edge, and it we need to allow for the risk that another cockroach can appear from nowhere.
The two price levels I think which are pivotal are as follows;
1. For the upside in GBPJPY, is a break above 140.41
2. For a downside breakout then certainly any trigger which takes the pair below 138.24
For number 1 to happen I think the markets will need to return to some normalcy with strong words and actions from the EU. The market will also have to believe them. Then some sort of rally can occur which should take the GBPJPY up to at least 145.00.
For situation number 2 to happen, there will need to be another shock or something that has investors worried. At the moment all the focus is on the PIIGS, however the UK itself has similar problems, and the GBP is a doomed currency in the long run. However for now, this is how I would play this trade. If the GBPJPY does break down below 138.24, then I think it is possible the pair could get down to near the 130.00 level.
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