Why is the current sell-off more critical than August and February?

The dislocation in global equity markets extends into European trading as risk appetite is slashed across the board, sending the US dollar higher against all currencies with the exception of the yen. The Japanese currency is the broad winner as carry trades that previously took place at the expense of the yen are unwound by selling existing holdings. These holdings are in gold, oil, equities as well as higher yielding currencies. The current market sell-off is especially more dire than the turmoil of February and August because of escalating probabilities of a US recession.

Unlike in the last two market corrections earlier this year, when the selling largely resulted from drying liquidity, eroding confidence among banks and hedge fund losses, the current developments are a result of concrete signs of a contraction in economic growth that will extend into corporate results, increased layoffs and falling consumption. Earning earnings of continued losses from the nation's biggest banks (Citigoup, Bank of America and Wachovia), recession forecasts from transportation companies (which are effective barometers to the US economy), suggest that the economic slowdown is now extending to the real economy, beyond the pricing of credit derivatives and sub-prime mortgages.

This weekend's G7 communique on currencies is being overshadowed by the events in equities, especially because the official statement consisted of largely unchanged language, urging China for faster appreciation in its currency and reiterating the undesirability of excessive currency moves. One aspect worthy of note is US Treasury Secretary Paulson's veto of French, Italian and German proposals to warn of Europe 's troubles resulting from the falling dollar. This indicates that Paulson's persistent touting of the strong dollar policy, is merely a rhetorical tactic aimed at slowing the pace of the decline in the currency rather than reversing it.

The retreat in gold reflects the breadth of the current selloff

The fact that gold prices are finally retreating off their 28-year highs of $760-65 highs indicates the depth of the losses in carry trades, where traders are obliged to scale down in their gold net longs to meet losses in equities and high yielding currencies. Net longs commitments in gold contracts in the NY Mercantile Index have reached an all time high of 202K, after 9 consecutive weekly gains in net longs.

We have long warned that gold is highly overstretched in relative terms, where the deviation must not exceed more than 110%-112% of the average. We expect the retreat in gold to extend towards $730 per ounce before end of this week, and potentially a cycle low of $720 per ounce.

Euro retreat is mainly corrective, eyes $1.4050

The pullback in the euro is largely a result of risk aversion unwinding dollar shorts and not a change in Eurozone fundamentals. Aside from the G7 making no remarks about the euro strength, the ECB continues to stick to its ant-inflation mantra. It maybe argued that a decline in global growth may weigh on Eurozone growth and dampen rate hike expectations. But we should not ignore the role of foreign central banks and Sovereign wealth funds buying euros on the dips as part of their FX reserves balancing act.

EURUSD eyes interim support at 1.4050, followed by key foundation at $1.4020. Key support stands at 1.3965, which is the 38% retracement of the rally from the August low to the latest all time high. Upside capped at 1.4180, followed by 1.4225.

USDJPY rebound seen limited as dollar relegated to low yielding league

USDJPY is off its 113.22 low but we expect renewed losses near the open of the US equity session is expected to target the 113 figure, 50% retracement of the rally from the January 21 low to the 1214.12 high. Since USDJPY is widely used gauge of risk appetite, the potential for an inter-meeting Fed cut prior to the Oct 31 announcement, or a 50-bp rate cut at the scheduled meeting, may surprise to the upside and trigger a dosage of risk appetite, weighing on the Japanese yen. Nonetheless, further easing would mean further erosion in the dollar's yield foundation, thus, relegating it to the league of low yielding currencies. This will not only limit the upside move in USDJPY but also accelerate the anticipated rebound in gold. Upside capped at 114.40, followed by 114.70.

Sterling plunges by 2.5 cents, targets $2.0200

Sterling is victim to its own high yielding composure as risk appetite is sharply curtailed. Considering the sub 2.0% inflation and increased downside risks in UK housing, the currency market sell-off is likely to revive expectations for a 2007 rate cut from the BoE. Despite data showing stronger than expected retail sales and provisional Q3 GDP growth, the onset of slowing US growth and the threat of a slowdown in the Eurozone raises the risks of downside external demand.

GBPUSD faces interim downside target at $2.0250, followed by $2.02, which is the 50-day MA. Central bank demand at the $2.0190 level is noted as the British currency continues to offer high yields and the UK economy the highest growth rate in the G7. Upside capped at

Our sterling bearishness is especially reiterated against AUD (0.45), NZD (0.3820) and CAD (1.98). Cable eyes $2.0320, followed by $2.0280. Upside capped at 2.0340, followed by $2.0390.