Forex Weekly Trading Forecast - 12.21.09

US Dollar: Will Thin Liquidity Leverage or Thwart the Dollar’s Rally?

Fundamental Outlook for US Dollar: Bullish

- The dollar develops strength through interest rate forecasts, relative growth projections and risk aversion
- Consumer-level inflation revives the argument for hikes but FOMC holds the line
- The dollar keys in on potential breakouts against the Euro, Australian dollar, British pound and Canadian dollar

The dollar rallied against all of the majors this past week. In fact, on a trade weighted basis, the greenback has rallied for nearly three weeks and climbed over five percent trough-to-peak. More importantly, putting this strength into perspective, the advance has tentatively called for a meaningful trend reversal in the reserve currencies favor. This is a long-overdue reversal considering its initial decline developed through most of 2009. However, this rally will carry the qualifier “tentative” until after the abnormal trading conditions of the year-end period pass and the underlying investor sentiment finally collapses under its own weight. We are heading into a highly reactive and malleable period the markets; and nascent trends can be quickly snuffed out or heartily amplified given the right combination of conditions. Which combination should we expect of the greenback?

The most impressionable and vague dynamic for the currency market over the next few weeks is general trading conditions. Most of the Western world will shut down for the Christmas holiday; but liquidity will drop off well before the actual markets close and will remain depressed until after the turn of the year. History has shown us instances where similar situations have stabilized markets and dampened volatility; but there have also been cases when the leveraged influence of speculators has amplified price action and setoff meaningful breakouts. Though we cannot truly tell which level of activity is in store for the markets next week, the abundance of potential energy and a busy economic docket warrants caution. Considering the aggressive move the dollar has made over the past three weeks, the currency is working with considerable momentum. Extending or retracing this move would merely be a factor of speculative interest (which there will be no shortage of through the end of the year).

There are a few prominent drivers that should be monitored. Interest rate speculation has been a major contributor to the dollar’s strength so far; and the consensus forecast for a hike in June is closing in. This also ties directly into the currency’s standing on the risk spectrum. The benchmark US market rate (the three-month Libor) is still edging towards record lows; but its pace has slowed. This factor has certainly contributed to the dollar’s malaise as investors have moved from diversifying safe haven assets to using the currency to fund the reemergent carry trade. However, a long-term assessment of financing tells us that US rates will rise eventually (and more likely soon). And, though the Japanese Libor is trading at a premium now; the government’s fight against deflation means the cost of financing in the Land of the Rising Sun will be far cheaper over the long-term. Finally, the most prolific threat to volatility is underlying risk trends. While the appreciation in a number of asset classes can be attributed to risk appetite; in reality, sentiment has been in a holding pattern for the past few months. A clear break from the Dow (above 10,500 or below 10,250) would likely command a significant reaction from the dollar.

And, while there are major fundamental themes in the background, it is important to remain conscious of scheduled event risk. The economic docket is littered with notable releases that can leverage volatility during the thin liquidity conditions. Top event risk though the period is the personal spending and income data for its updates on consumers – the critical component of growth. Other notables include: new and existing home sales; durable goods; and the Chicago Fed’s National Activity Index. We may be in for a crazy week.- JK

Euro Forecast Bearish on Sharp Shift in Forex Sentiment

Fundamental Forecast for Euro: Bearish

- S&P downgrade of Greek sovereign debt rating threatens euro
- Euro Zone PMI data shows noteworthy expansion, may force ECB’s hand
- Euro/US Dollar very closely linked to gold prices
- Eurobarometer survey suggests labor market hasn’t seen worst yet

The Euro finished the week nearly two percent lower against the resurgent US Dollar, leaving momentum firmly to the downside for the previously high-flying European currency. Bullish Euro Zone economic data was not enough to offset fears of monetary union stability; Standard & Poor’s joined Fitch Ratings and cut Greece’s sovereign debt rating to a single notch above junk status. Combined with news that Austria nationalized its sixth-largest bank, developments in Greece helped sink the euro to fresh lows against the dollar and other currencies. Bullish Manufacturing and Services PMI data had seemingly little effect, while optimistic German IFO Business Confidence numbers barely elicited a positive reaction from the domestic currency. CFTC Commitment of Traders data now shows that Non-Commercial traders have gone net-short the Euro for the first time since May, and the sharp shift in sentiment suggests risk remain to the downside in the weeks ahead.

Three consecutive weeks of declines nonetheless leave the single currency at high risk for a short-term bounce, and a holiday-shortened week of trading may produce especially choppy price action for the Euro/US Dollar pair. Limited economic event risk promises little in the way of direction, and the Euro may take its cues from developments in other markets. Minor exceptions include German GfK consumer Confidence data on the 22nd, while Industrial New Orders results will be released the following day. Neither report has been known to elicit strong reactions from the euro, but relatively illiquid FX market conditions could potentially make for exaggerated moves on second-tier economic data.

Traders should otherwise keep an eye out for market reactions to UK and US Q3 Gross Domestic Product revisions on the 22nd. Global financial markets have generally outperformed through recent months on a bullish wave of economic data. Positive surprises in US GDP figures have encouraged speculators to bet on the end to the broader global recession, and any changes to growth figures could have a similarly dramatic effect on risk sentiment. Though unlikely, material downward revisions to US or UK GDP could sink financial market risk appetite and would likely force further euro losses against the safe-haven US Dollar and Japanese Yen.

Holiday-shortened trading weeks typically bring uneventful price action, but traders should be mindful of exaggerated price moves on pronounced illiquidity. Indeed, trade executions tend to be poor during holiday periods and many would do well to keep position risk light on a potentially unpredictable week of price action.

Japanese Yen to Fall Against US Dollar on Bond Yields Outlook

Fundamental Forecast for Japanese Yen: Bearish

- Bank of Japan Strikes Dovish Tone, Keeps Policy Unchanged
- Japanese Firms Plan Record Spending Cuts in the Fourth Quarter

The US Dollar pushed sharply higher against the spectrum of major currencies last week as markets reacted to a decidedly upbeat interest rate announcement from the US Federal Reserve. Most significantly, Ben Bernanke and company said “deterioration in the labor market is abating,” which traders took as validation of the boost to the priced-in Fed rate hike forecast over recent weeks that was set off by better than expected outcomes for November’s nonfarm payrolls and retail sales reports. The US central bank is widely expected to look at the jobless rate as the key gauge for timing a reversal of its ultra-loose monetary stance, and a Credit Suisse gauge now shows that the market is pricing in 81 basis points in monetary tightening over the next 12 months, up from just 52bps at the beginning of December.

Meanwhile, the Bank of Japan struck a decidedly dour tone, saying the current momentum of self-sustaining recovery is insufficient and warning that overcoming deflation is a critical challenge, with the bank unwilling to tolerate CPI at or below 0%. The bank added that although the economy is picking up, the pace of improvement will be moderate until the middle of the 2010 fiscal year. This suggests the Japanese central bank may be starting to cave in to pressure from the Ministry of Finance to continue on with its liquidity-boosting asset purchase programs, a prospect that promises to underpin domestic bond prices and keep yields contained as the government issues a record amount of debt to finance the gargantuan fiscal deficit.

On balance, this monetary policy landscape seems to point to gains in USDJPY. Japan’s savings rate is high relative to other developed countries, reflecting the expense of living on an island with limited space and scarce home-grown resources. This translates into Japanese investors’ preference for safe, liquid assets that offer stable income over a long period of time. Typically, this means government bonds. While both Japan and the United States will have to introduce a good bit of new supply to finance their deficits, the latter will not have a central bank that is actively supporting prices and keeping a lid on yields. Indeed, the Fed ended its purchases of US Treasuries in October and looks to be laying the groundwork to begin raising borrowing costs next year. USDJPY is now 81.3% correlated with the yield on the benchmark 10-year Treasury note, suggesting that the currency may gain as traders digest last week’s updates to the US-Japan monetary policy balance.

British Pound Breaks Out Ahead of BoE Minutes, Final 3Q GDP Report

Fundamental Forecast for British Pound: Neutral

- Retail Spending Contracts in November
- U.K. Labor Conditions Unexpectedly Improve
- Public Sector Borrowing Rises at Record Pace
- U.K. Consumer Prices Top Forecast

The British Pound broke out of its narrow range and slipped to a fresh monthly low of 1.6053 this week following an unexpected drop in U.K. retail sales, and the GBP/USD is likely to face increased volatility as the final 3Q GDP report and the minutes of the Bank of England policy meeting are scheduled for release over the following week. Meanwhile, the central bank held a cautious outlook during its semi-annual Financial Stability report and said the “probability of default by U.K. real estate companies have increased significantly,” and said smaller firms will face “significant” challenges going forward as the central bank anticipates loan-related losses to intensify over the following.

At the same time, the central bank said the withdrawal of government support may fuel volatility in asset-prices, which could also trigger an unwinding in dollar trades, and noted that “banks remain exposed to any further deterioration in macroeconomic and market conditions, which could substantially raise the cost of funding and capital rising.” Nevertheless, a separate report by the BoE showed inflation expectations for the following year were firmly anchored at 2.4% in November, which should allow the central bank to maintain its current policy going into 2010, and the minutes of the December policy meeting are likely to highlight a dovish outlook for future policy as the MPC continues to see a risk for a protracted recovery.

On the other hand, the final 3Q GDP reading is expected to show a 0.1% contract amid an initial forecast for a 0.3% drop in the growth rate, and the data is likely to encourage an improved outlook for the region as policy makers see the economy emerging from the worst recession since the post-war period. Furthermore, the British Bankers Association’s gauge for home mortgage approvals is forecasted to increase to 43K in November from 42.2K in the previous month, which would be the highest reading since November 2007 however, the ongoing slump in service-based activity may continue to weigh on the outlook for future growth as it accounts for more than two-thirds of the real economy. As market liquidity thins ahead of the holiday season, we are likely to see increased volatility paired with erratic price action as investors worldwide go off-line in observance of the Christmas holiday but nevertheless, as risk trends continue to drive the FX market, a rise in risk appetite could push the exchange rate higher as the U.S. dollar remains the most popular funding-

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