The acceptance or avoidance of risk among investors is likely to continue being a key driver of currency values for the foreseeable future, so it will behoove you as a currency trader to keep your finger on the pulse of the S&P 500 as best you can. And while you may be surprised to hear this from me, being that I have a reputation as a “fundamental” trader, there as times when this can be done purely on a technical basis and in my opinion, now is one of those times.

The market exists in 3 modes; fear (risk aversion), greed (risk acceptance) and confusion. When pundits say the market is “risk averse,” for now it means that investors are shunning things like stocks and commodities as they move into the relative safety of Treasuries and the dollar. We saw this happen after the dis-orderly collapse of Lehman Bros. last September. The opposite holds true when the market is in “risk acceptance’ mode as investors flock to stocks and commodities while selling Treasuries and the USD as seen most recently during the rally which began after Bernanke’s 60 Minutes interview. Confusion is what we’ve seen over the past 7 weeks or so as stocks and currency markets basically went sideways.

Risk aversion is the reason why the dollar gained last Thursday on bad news regarding the Non Farm Payrolls report. Once the headline number came out worse than expected (and average hours worked per week dropped to 33, the lowest level in at least 40 years) investors said “no” to stocks and commodities (risk) and “yes” to Treasuries and the USD (relative safety).

Now, if it turns out you didn’t get anything off this trade, don’t feel too badly because I didn’t either. The unemployment rate didn’t jump as high as expected and the increase was much smaller than in the previous month (0.1 vs. 0.5 percentage points), while May’s loss of jobs was revised down by 23k. The biggest sector loss was in government (of all things) after the temporary census workers were let go. Meanwhile, private sector job losses continued to slow for a fourth straight month.  In a separate report on Thursday, factory orders rose for a third time in four months (and by the most since June 2008) while the number of workers filing for unemployment benefits fell. Taken together, the data led me to believe the market might overlook the worse-than-expected number of lost jobs.

In any event, the market certainly is vulnerable to a decline which may test near the November or even the March lows, primarily because earnings are still in a decline in a year over year basis, which of course means there’ll be demand for dollars. What happened after the 2001 recession may be instructive.

The S&P made an absolute bottom in July 2002, eight months after the recession ended. It re-tested near there in October and then again in March 2003. From that point, a sustained bull market ensued until October 2007 but is wasn’t jobs which sparked the rally; rather, it was a sustained growth of about 20% in corporate earnings during the preceding 12 months. Job losses continued until September of that year.

The 2001 recession was more the “garden variety” type in that it wasn’t accompanied by a severe real estate and financial crisis as is the case now, which means that the outlook for earnings at this time certainly isn’t favorable because it’s likely that unemployment will rise, hurting prospects for consumer spending. Losses at banks on their loan portfolios are likely to worsen, which will keep credit difficult to obtain and aside from that, demand for credit looks set to remain weak.  Earnings could start to look better on a year over basis once results for the fourth quarter of this year and the first quarter of 2010 are released because they will be compared to a much lower base.

On the S&P chart below the red line indicates an important support base at around 875, the bottom of the sideways channel. A breech here could indicate that the market is shifting modes from confusion to risk aversion. As that happens, the dollar is likely to gain against the euro, pound and A$, and those currencies are likely to fall against the yen.