Forex Weekly Trading Forecast - May 17, 2010

US Dollar Climb Growing Increasingly Speculative on Risk Aversion

Fundamental Outlook for US Dollar: Bullish

- Sovereign debt risk takes over for fundamentals to leverage a dollar rally
- Consumer confidence and spending rise, bolstering the case for a meaningful economic recovery
- EURUSD is on the verge of 6-year lows, will the pair enter the next phase of a bear wave?

Traditionally, when we say the market is risk averse, it means that speculative interests are unwinding or deleveraging. Therefore, the masses have come to expect the US dollar – as the market’s current safe haven – to appreciate with the influx of worried capital. In effect, we would think that the transfer of capital into the US currency and its assets would be the farthest thing from a practice of speculation. However, there is indeed a speculative element to these flight-to-quality flows; and this characteristic becomes all the more apparent when the current accelerates. Sentiment itself is a highly unpredictable but very influential component of the broader market. And, though investor optimism may sometimes seem independent of baseline fundamentals (growth, interest rates, capital flows); it in fact oscillates around the more stable, economic trends. In the end, the two will always converge. This is where we must be cautious. While risk aversion is in high gear now, it could quickly level off or reverse. If that were the case, we would find the fundamental backdrop would bestow only a modest advantage in growth over most of its counterparts and a slim yield forecast premium against the euro and pound. Armed with just these details as support; could the dollar continue to forge new yearly highs?

For this reason, we need to keep a close eye on both the developments in risk appetite trends as well as the relative health of the US dollar itself. On this first point, we are at an inflection point. In the currency market, we have already seen dramatic adjustments to the potential European crisis. EURUSD has already dropped nearly 2,800 pips in the span of six months and now the exchange rate sits on the verge of tipping into territory not plunged in four years. From a speculative perspective, making this leap would be a significant gear change for the masses. That would require another major development. For the EU situation, the situation seems untenable. There are too many signs that commitment to help out neighbors is feeble at best (especially after we have heard rumors that French President Sarkozy had to threaten a withdrawal from the Euro Zone to get German Chancellor Merkel on board for a bailout), social unrest is picking up, deficit cutting will inevitably lead to revisited recessions and the long-term issue that there is no fiscal and tax union to match monetary union. Trouble seem inevitable; but if fears subside while this takes a slow burn, risk aversion would likely similarly stall. Other threats are in the docket as well. China is confronting asset bubbles, the emerging market doesn’t have demand to support its rapid growth, and then there is the bigger issue of global sovereign credit risk. What’s more, we have not seen other speculative markets really retrace much of their 2009 build up. A breakdown in other areas could keep the dollar; but perhaps momentum would transfer to AUDUSD rather than EURUSD.

And, if we approached the fundamental picture like a technical chart, the fundamentals would be akin to the 200-day moving average. If growth and interest rates are strong enough, the dollar will rise naturally. However, we are at the point where growth is shifting from stimulus-led expansion to true consumer-based growth and the 12-month rate forecast stands at a measly 50 bps. These are not statistics that a robust trend can live off of. Yet, the US is still on a slightly more stable footing than its major counterparts; and each meaningful update has the potentially to significantly change the picture. In the coming week, the CPI is perhaps top event risk. While the Fed has said it sees little inflation pressure, this reading has held above target. Stay there long enough; and it will eventually force there hand. - JK

Euro Positioning Reaches Record Bearish Extremes – Volatility Likely

Fundamental Forecast for Euro: Bearish

- Euro hits fresh 2010 lows, contemplates next move

- EURUSD advance likely limited following 750 billion euro EMU bailout

- Extremely one-sided Euro positioning nonetheless makes short positions less attractive

The Euro finished the week sharply lower against the US Dollar, trading to its lowest levels since November, 2008 on continued fiscal crises across the single-currency bloc. An announcement that the European Monetary Union would establish a central fund to distribute direct funds to fiscally troubled members initially sent the Euro sharply higher against major counterparts. Yet markets were just as quick to sell the Euro once the initial buzz died down and traders truly assessed the substance of said package.

The greatest shock of all may have come on the announcement that the fiercely independent European Central Bank would directly purchase Greek and Portuguese debt—arguably tarnishing their reputation as an apolitical inflation-fighting central bank. Yields on Greek debt unsurprisingly tumbled as the ECB actively purchased securities, but it is worthwhile to note that sharp deterioration in financial market risk sentiment left the Greek 10-year bond’s yield at a whopping 7.71 percent through Friday’s close. One has to wonder whether such grandiose efforts will legitimately limit the fallout from continued EMU fiscal crisis.
Aggressive Euro selling certainly suggests that markets remain skeptical of bailout schemes, and momentum plainly favors further EURUSD declines.

An ostensibly busy week of economic event risk threatens further Euro volatility, but primary market focus will likely remain on the worst EMU crisis in its relatively brief history. Officials have tried time and again to stem speculation that at-risk countries such as Greece and Portugal could default on their debt obligations. Yet skeptical traders continue to demand substantial premiums on Greek bonds—despite explicit guarantees on its debt. How this all plays out will likely decide the medium-to-long-term trajectory of the Euro itself, and continued market turmoil bodes poorly for more short-term direction.

From a trader’s perspective, it is admittedly difficult to sell the Euro against the US Dollar given its substantial losses to date. Recent CFTC Commitment of Futures data showed futures positioning at a record net-short the Euro against the US currency. Such incredibly one-sided bets limit how much further the currency pair may continue to decline, and any signs of potential reversal could just as easily force a substantial rally as traders scramble to cover their leveraged EUR short positions. Recent market volatility emphasizes that traders should remain very cautious as markets grow especially unpredictable.

We maintain a cautiously bearish short-term bias on the Euro/US Dollar, but we advise against using excess leverage amidst substantial forex market volatility. Our DailyFX Volatility Indices continue near their highest levels since early 2009, and we are likely to see further extreme moves into the weeks ahead. Any surprises from the EMU and ongoing fiscal crises could force especially large moves across EUR pairs. - DR

Japanese Yen Strength Favored with Prevailing Growth Concerns

Fundamental Forecast for Japanese Yen: Neutral

- Eco watcher’s survey rose to 49.9-the highest in nearly three years

- Current account surplus widens to 2534.2 billion yen-the largest in two years

- Leading index rose to 102.8 from 98.4 as expected-highest in nearly four years

The Japanese Yen after a week of volatility ended slightly lower against the dollar but marked gains against the Euro and Pound as the European debt crisis saw the safe haven currency benefit from increasing pessimism. A monumental 750 million euro bailout package by European leaders to help Greece and the other indebted members had sparked a bout of risk appetite and sent all risky assets soaring to start the week. Indeed, the commodity dollars all held onto gains against the Asian currency with the Canadian dollar leading the way. However, if we see the broad based risk aversion that ended the past week continue to plaque markets then additional yen strength should be expected.

The fundamental picture has started to brighten for the world’s second largest economy with improving exports pushing the current account surplus to a two year high of 2534.2 billion yen. Additionally, the measurement of leading indicators which looks at account inventory ratios, machinery orders and stock prices pointed toward continued improvement as it rose to 102.8 from 98.4-the highest since August, 2006. The domestic picture has also improved according to the Eco watcher’s survey which rose to 49.9-the highest in nearly three year. The improvement in the gauge that measures sentiment of retail workers, taxi drivers and other business cycle sensitive workers is a sign that export demand is translating into broader growth. However, domestic demand remains weak and that has the BoJ looking for ways to stave off deflation which includes a new loan program aimed at encouraging private banks to lend more to industries with growth potential.

The central bank will convene this week to determine future monetary policy and with declining consumer prices still a problem, expect policy makers to leave their target rate at 0.10%. In addition to the monetary policy meeting the economic calendar is full with meaningful but unlikely market moving releases. The second reading of first quarter GDP is expected to be revised higher to 1.4% from 0.9% as the economy continues to distance itself from the recession. However, the tertiary index is forecasted to have declined by 1.5% as the service sector continues to be inflicted by weak demand. Nevertheless, the yen’s fortunes will continued to be tied to risk sentiment and considering the prevailing concerns additional strength could be expected. Yet, risky assets regained their footing in the final hours of trading and improving global fundamentals could generate risk appetite and yen weakness.-JR

British Pound to Follow Risk Trends as EU Strife Continues

Fundamental Forecast for British Pound: Neutral

- Bank of England Keeps Monetary Policy on Hold as Expected
- UK House Prices Top Expectations, Retail Sales Disappoint
- Jobless Claims Outperform, Decline for a Third Month
- Trade Gap Widens More than Forecast, Industrial Output Soars

The British Pound is set to trade in line with global equity markets as currency traders and the central bank alike are left waiting for a reading on the fiscal landscape, leaving risk sentiment as the only clear-cut catalyst in the near term.

The acute uncertainty about the UK political landscape has receded (for now), with the Conservatives bringing the Liberal Democrats into a coalition that looks fairly coherent and – at least rhetorically – committed to dealing with the nation’s gaping budget deficit. On balance, the markets have a reason to feel relieved: Tory ministers hold control of welfare, the big public services and foreign affairs, meaning the Lib Dems will not have much room to derail deficit reduction or indulge in their desire to bring the UK closer to continental Europe. All that remains now is execution. This has already begun with a pledge to reduce public spending by 6 billion pounds this year, but traders won’t be able to make a real educated guess on the new government’s resolve until it announces an emergency budget, which is expected in June.

The monetary policy landscape is equally static for the time being. BOE Governor Mervyn King and company stressed the need to rein in public finances in their quarterly inflation report but they will not be able to gauge the specifics of the fiscal landscape for some time. This likely means that policy remains on hold for now, and in any case, the central bank would surely not consider tightening given the kind of austerity measures that it expects politicians to deliver. Indeed, with the government is cutting back, it is all the more important to retain an accommodative monetary environment to assure the economy does not slide back into recession.
All in all, this leaves risk sentiment as the only somewhat straight-forward fundamental catalyst for the British Pound. The currency remains closely correlated to the MSCI World Stock index and despite being outside of the Euro Zone is still on the hook for a portion of the 500 billion euro EU stabilization fund, suggesting sterling will continue to follow the ups and downs of equity exchanges as the sovereign credit fiasco on the continent continues to play out.

Read more: DailyFX - British Pound to Follow Risk Trends as EU Strife Continues http://www.dailyfx.com/forex/fundamental/forecast/weekly/gbp/2010-05-15-0258-British_Pound_to_Follow_Risk.html#ixzz0o4jAXqLJ