Forex Weekly Trading Forecast - Dec 14, 2009

US Dollar Making Progress on a True, Bullish Reversal

Fundamental Outlook for US Dollar: Bullish

- Dollar capitalizes on mounting financial instability through its safe haven status
- A late-week surge for the dollar helped along by a jump in consumer confidence, spending
- Technicals and fundamentals clash for EURUSD outlook

There is a trend developing. The US dollar has produced notable rallies at the end of each of the past four weeks. The past two advances are the most notable. Both have come on the back of exceedingly strong economic data – the drive on the 5th was the product of strong NFPs and a drop in the unemployment rate; while the rally on the 12th would come through the merits of a strengthening consumer on sentiment and spending. This would seem a straightforward reaction to data, right? Actually, this would contradict the normal pace that the market has carved for the greenback for the past nine months where strong economic data has bolstered risk appetite and directly weighed on the dollar as a safe haven currency. So, what does this mean? Is the dollar’s role in the risk appetite backdrop changing? Is sentiment actually weaker than just the US data would suggest? Both are likely true. With the dollar looking for strength through various market conditions, the currency may be developing a meaningful bullish trend. However, playing on the well-established, fundamental roles that have been in control for over a year; a collapse in broad investor sentiment is still the most accessible catalyst for a true dollar bull trend.

As has been the case for the full year, the primary fundamental concern for the US dollar going forward is the general bearing and force of risk appetite. From this, there are two concerns. As always, identifying and measuring the influence of potential catalysts is of primary importance; but now, we also have to gauge the currency’s relationship to risk appetite itself. In the past few weeks, while the dollar’s advance has been somewhat choppy and more prominent in certain pairs (EURUSD being the most remarkable example); it has come on strong local data and developed despite stability in other key risk-sensitive markets. This is a natural development considering markets held to congestion for nearly two months now at the top of an unprecedented rally; and the dollar has carried the brunt of the burden in funding this drive. Beyond just a general dissolution of correlations, though; there are fundamental reasons for the dollar to move up the yield spectrum. The United State’s economic recovery is among the strongest in the industrialized world, the Federal Reserve is actively reducing its stimulus and the financial stability in the US markets is comparable (if not more established) to its global counterparts. All that being said, a collapse in risk appetite that balances speculative interests through profit taking is still the most capable driver for the dollar. Not only would capital return to the safety of US Treasuries and money market funds; but it would be drawn out of emerging markets and other risky areas and put into the more liquid but yield-bearing instruments in the US.

For the more definable sense of risk in this coming week’s economic docket; there is plenty of data to feed the more established fundamentals trends. For interest rate forecasts, the market is targeting the Fed’s first hike around the middle of the year – in line with Governor Bernanke’s time frame. However, such projections are not set in stone by policy makers and traders know this. The FOMC rate decision on Wednesday will offer an update on how close a hike may be. Also, interesting in this event will be any mention of more measured changes to policy like the slow withdrawal of stimulus. Realistically, stimulus and interest rates can be adjusted separately. If financial aid is maintained and rates raised, it could support the economy, help dampen any inflation that may pop up and revive the dollar. Other noteworthy indicators on deck included the CPI stats, industrial production, housing starts and the vote to lift the deficit limit. – JK

Euro Struggles Against Dollar’s Strength, Looks to Heavy Data

Fundamental Forecast for Euro: Bearish

- Tension building as Greece is on the verge of default while Spain’s credit outlook is downgraded
- ECB maintains its outlook for a moderate recovery in 2010
- EURUSD’s technical backdrop ready to support bearish momentum

The euro’s biggest fundamental driver is the health of the US dollar. This past week, the greenback forged ahead and the euro suffered for it across the board. As the primary alternative to the US currency, there has been a frenzied demand for the euro as the need for return and stability sent capital into the large market. However, when the tides turn and the expectations for return in the United States improves and the irrational fear that the benchmark currency will not just loose prominence but completely fall off; speculative capital will reverse course. At the same time, there are also factors for a fundamental weakening of the Euro Zone itself. The economic and interest rate outlook are cooling, especially when compared to the region’s industrialized counterparts. And then there is also the instability that member default and/or possible withdrawal from the union may bring.

Over the past few weeks, fear has gained traction among the speculative crowd. With the markets bound to general congestion for the better part of two months, traders are naturally going to grow weary of potential reversal threats. Initially, panic was sparked by Dubai World’s default/debt restructuring. Now, the focus is turned to mainland Europe. In quick succession, we have saw Greece’s sovereign credit rating downgraded and the outlook for Spain reduced to ‘negative.’ This speaks to the economic troubles that exist outside of Germany and France and the lack of flexibility that policy makers have in stabilizing individual economies and markets. Finance Ministers cannot take on more debt than the Union allows, devalue their currency or adjust interest rates to help their economies along. This leaves restrictive parameters on nations that perhaps cannot recover naturally and must either seek bailouts (which will take many years to work off) or consider withdrawal from the regional collective. Either outcome could severely undermine the stability of the euro.

Another gradual shift against the euro is its perceived fundamental strength. Six to nine months ago, speculators expected the Euro Zone would be the first of the major economies to recovery from the global recession and its policy authority would usher in the revival of yields. However, as the months passed; it became more and more clear that the European economy was seen falling further and further back in the pack for growth and the ECB maintained a solid front against raising interest rates until a recovery was certain. Today, growth for the region is expected to trail that of the US and Japan; and there isn’t even a clear outlook for a return to hawkish policy by the middle of the year (which is the time frame the Fed is working with). So, gradually, the fundamental advantages are slipping away from the euro; and fresh data is now gauged for its ability further throw the breaks or perhaps increase competitiveness. On this front, we have plenty of key indicators to work with over the coming week. For growth, the December PMI indicators for Germany and the Euro Zone will offer key benchmarks for 4Q activity. For the ECB, regional inflation indicators will tell officials whether they should start responding with measured rate hikes to compliment other efforts to rein in policy. Altogether, expect these indicators to offer short-term volatility and fine-tune adjustment to larger fundamental bearings; but meaningful trends will fall to the dollar and potential crisis. – JK

Japanese Yen Forecast Dims Ahead of Critical Event Risk

Fundamental Forecast for Japanese Yen: Bearish

- Japanese government announces fourth stimulus package
- Markets nonetheless ignore Japan’s fiscal plans
- View our monthly US Dollar/Japanese Yen Exchange Rate Forecast

The Japanese Yen was the top-performing G10 currency to round out the week’s trade, breaking its long-standing correlation to major risky asset classes and finishing higher despite relative outperformance in the US S&P 500. The Japanese Nikkei 225 index likewise ended the week’s trade up a respectable 0.9 percent above its open—making Yen strength an admittedly unexpected outcome. Key questions remain on the sustainability of the Japanese Yen’s advance, however, as recent IMM data points to extremely one-sided speculative positioning on the US Dollar/Japanese Yen pair. Indeed, our recent forex options and futures sentiment data showed large speculators had been the most net-long Japanese Yen since it set a noteworthy bottom in March, 2008. Speculative sentiment has since moderated considerably, but such COT data supports further JPY pullbacks and not continued appreciation.

The break in the Yen’s typically rock-solid correlation to risky asset classes makes predicting near-term price action far more difficult, and it seems increasingly likely that the USDJPY will primarily trade on developments in the US economy. The US Dollar itself likewise broke its correlation to the US S&P 500 and other risky asset classes—rallying despite stock market strength. A string of positive US economic releases may partly explain the break, and we may do well to watch a string of key US event risk in the days ahead. Hotly-anticipated US Consumer Price Index data and the US Federal Open Market Committee rate decision will likely dominate US Dollar price action, while the Japanese Yen could move on any surprises out of the upcoming Bank of Japan rate announcement.

Markets overwhelmingly predict that the Bank of Japan will leave interest rates unchanged at their upcoming meeting, but it may be important to watch for any and all references to the Japanese Yen. FX markets had recently forced the JPY to its highest levels in over a decade, but very quickly reversed course on vague threats of FX market intervention from the Ministry of Finance and Bank of Japan. Given deflationary headwinds for the Japanese economy, the central bank is staunchly against further Yen appreciation. Whether or not they comment on the fact may force substantive currency volatility in the week ahead.

Despite the breakdown in correlation between the Japanese Yen and global risky asset classes, we suspect that any major moves in global markets will force commensurate shifts in FX markets. The week ahead promises several top-tier pieces of US and Japanese economic event risk, and we expect big short-term moves from the USDJPY. Suffice it to say, traders should be on alert for substantive surprises out of a key number of highly-anticipated events. - DR

British Pound Looks Forward to Week of Considerable Volatility

Fundamental Forecast for British Pound: Neutral

- Warning on UK Sovereign Rating sends British Pound tumbling
- British Pound fails to react to Bank of England announcement
- View our monthly British Pound/US Dollar Exchange Rate Forecast

An uneventful week of British economic event risk left the domestic currency modestly lower against the resurgent US Dollar through Friday’s close. A hotly-anticipated Bank of England interest rate announcement failed to elicit major reactions from FX markets. Instead, the week’s major British Pound volatility came on news that Moody’s Investor Services expressed doubts on the future of the UK’s sovereign debt rating. Such unexpectedly sharp volatility on unpredictable news underlines FX market unease, and it remains clear that currencies can post substantial moves at a moment’s notice. The week ahead promises considerable economic event risk out of both the UK and US economies, and we expect similarly large moves in the GBPUSD through the week ahead.

Recent doubts on outlook for UK debt ratings are likely to continue through the medium to long term, as large budget deficits and a fast-growing national debt have forced rating agencies to question whether major world governments’ debt truly deserves “risk-free” status. Any further suggestions that the UK’s AAA rating is at risk could easily force substantive pullbacks in the domestic currency. But foreseeable event risk can likewise cause major moves—starting with highly-anticipated UK Consumer Price Index data due Tuesday morning.

Analyst forecasts call for a robust 1.8 percent year-over-year Consumer Price Index inflation rate through November—a 0.3 percentage point jump from the 1.5 percent seen in October. Such an outcome would leave the headline inflation rate at a mere 0.2 percentage points below the Bank of England’s 2.0 percent inflation rate, and the noteworthy month-to-month change may become a cause of concern for the inflation-targeting central bank. Said result would likely raise pressure on the Bank of England to state its “exit plans” for removing its historic monetary policy stimulus and raise interest rates to combat inflation. Officials have already committed to ending the bank’s Asset Purchase Programme in two months, but they have otherwise provided few clues as to plans for ending their historic monetary policy stimulus. Suffice it to say, markets will remain on alert for surprising results from upcoming CPI inflation numbers and their implications for the future of interest rates and Quantitative Easing.

Not to be outdone, the following day’s UK Jobless Claims data will likely provide considerable short-term volatility for the British currency. Markets predict that jobless claims rose by a relatively modest 12,500 through November—the smallest job loss since April, 2008. Given similarly bullish jobs data out of the US economy, markets are riding high on prospects for broader global economic recovery. Such optimistic expectations leave considerable margin for disappointment, and it will be important to watch whether UK Jobless Claims data can match lofty expectations. - DR

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