Forex Weekly Forecast - 1.23.2011

US Dollar: Will 4Q GDP and a FOMC Rate Decision Offset the Euro?

By John Kicklighter, Currency Strategist

Fundamental Forecast for the US Dollar: Bullish

• Fitch warns that the US is the worst performing AAA-rated sovereign
• Existing home sales see their biggest surge on record – though the sector is still struggling
• The dollar and other markets are primed for big moves

We can’t often say that a currency or market is looking at a potentially, trend-defining period ahead; but that dollar is certainly looking at just that over the coming week. From a very simplistic technical view; it could be said that the greenback has put itself on a pace for a meaningful bearish trend through the foreseeable future thanks to EURUSD’s rally above 1.35 this past Friday. However, the experienced trader would recognize that this move wasn’t replicated by other dollar-based majors. In fact, most of these pairs would see the single currency holding well off its recent highs. So, while this standout, anti-dollar move may find some level of follow through; it most certainly is not a guaranteed trend for the greenback. But, the potential for a true trend is high with many potential catalysts along the way.

As always, we should consider risk appetite levels as the top fundamental threat. It may not be the most pressing concern at the moment; but when investor sentiment does shift, it will move the entire market and likely generate the kinds of trends that most traders pine for. And, while there are plenty of indicators to point to as tangible drivers; the most influential catalyst is risk appetite itself. It has not proven an easy task to shift sentiment in one direction or the other; so its development will require a substantial marker. Though it may not seem so now, Europe’s financial difficulties can still move the entire market. In the past weeks, we have seen some level of relief through the belief that the EU is working together to stabilize the region’s financial troubles. However, they have struggled in the past to come to key agreements; so why would it be any easier now? Other issues to contemplate: the possibility that China will hike rates; that Japan will see a debt crisis; that 4Q earnings will break the steady bearing of confidence or the US housing sector will fall to another crisis.

Yet, if we want to talk about known and scheduled threats; there are two key events to keep track of. The first chronologically also carries the least potential for a major drive for the currency. The FOMC rate decision is not likely to result in any change in the stimulus program or benchmark rate; but hawks and doves work on more subtle shades of grey. The accompanying statement’s tone can prove critical to defining the time frame for an eventual return to hikes (within 2011 or after the turn over the year); and more importantly, if there is to be a change in the stimulus program. The Fed seems intent on follow through with the $600 billion program and its originally planned maturity date; but there have been proponents on both sides that have suggested there are contingencies for changing this timing.

The most influential release for the week will be the first reading of the fourth quarter GDP numbers. The US seems on a steady path towards recovery; and investors, policy makers and consumers will look to ensure this is the case. That said, this is not as easy an indicator to interpret as it may at first seem. A positive showing may have the side effect of encouraging a quicker removal of stimulus (something that has proven to be the foundation for the recent capital market run up). Next, we need to establish whether a positive or negative reading carries more weight as a gauge for comparative growth or risk appetite. Feeding already saturated optimism will not carry as much weight as a much-needed breakdown in confidence. Another thing to consider: this is a Friday release. There will not be much time to respond to the report with full liquidity. – JK

Euro Rallies Sharply, but is this Truly Start of 2011 Uptrend?

By David Rodriguez, Quantitative Strategist

Fundamental Forecast for Euro: Neutral

- Euro rallies as German IFO Business Confidence hits Record-Highs

- European Central Bank says rates ‘appropriate’, offers few new details on debt purchases

- Euro rallies as Euro Zone officials pledge to bolster emergency funding facilities

The Euro hit fresh multi-month highs amidst a considerable improvement in European sovereign debt markets, defying expectations and becoming the top-performing G10 currency in the five-day stretch. Surprisingly robust demand for periphery debt and strong economic data sets the stage for continued strength, but it will be important to watch for results of future debt auctions amidst heavy supply from at-risk countries. A recent Wall Street Journal article points out that January euro zone bond auctions have been supported by increased investor cash flow that may slow considerably through February. Upcoming debt auctions may prove to be important litmus tests on market confidence, while an ostensibly busy economic calendar could likewise provide catalysts for sharp EURUSD moves.

Debt auctions from Italy, Spain, Slovakia, and Spain will likely command attention in the days ahead, while German consumer confidence and inflation figures could likewise spark euro moves on strong surprises. Overall momentum suggests that the euro could continue higher against the recently-downtrodden US currency. In fact, recent CFTC Commitment of Traders data shows that Non-Commercial traders— most often large speculators—are once again net-long the Euro/US Dollar as of January 18. This is a significant shift in sentiment and underlines that trends are anything but clear, and such indecision is often a recipe for volatility through short-term trade.

The DailyFX Team broadly called for euro weakness in 2011, but January has proven to be a challenging month for our forecasts and generally establishing lasting currency trading biases. We certainly have no problem admitting when we are wrong, but January is not yet over and there are a lot of things that can happen between now and the end of the typically critical month.

According to a previous study, a EURUSD rally or decline in January predicted a similar February-December move approximately 70 percent of the time (synthetic EUR rates are used prior to 1999). Thus we will watch the coming weeks with great interest and likely shift our biases accordingly. The recent weeks of EURUSD strength seems to have been largely a function of aggressive short-covering and not necessarily a secular shift in sentiment. Time will tell whether this is truly the start of a broader euro uptrend and a continuation of a multi-year US Dollar decline, and investor confidence in euro zone fiscal solvency will likely play a large role in setting price trends. - DR

Japanese Yen To Benefit From BoJ, FOMC Interest Rate Decisions

By David Song, Currency Analyst

Fundamental Forecast for the Japanese Yen: Neutral

• Japanese Yen Resistance (USDJPY Support) Extends to 8230
• Carry Interest and the S&P 500 Diverge – Which Market is on the Correct Path?
• Forex Strategy Outlook: FX Options Favor Trend Trading Systems

The Japanese Yen crept higher against the U.S. dollar and the low-yielding currency may continue to appreciate against the greenback next week as we expect the Fed to maintain a cautious outlook for the world’s largest economy. As the USD/JPY remains capped by the 23.6% Fibonacci retracement from 2010 high to low around 83.50-70, the exchange rate may continue to pare the rebound from the beginning of January, and the dollar-yencould fall back towards 81.00 as market participants speculate the FOMC to ease monetary policy further this year.

In turn, a further appreciation in the Japanese currency could reignite speculation for a currency intervention as the Bank of Japan struggles to stem the risk for deflation, and the dollar-yen may consolidate over the near-term as investors weigh the outlook for future policy. However, Japan’s Economic and Fiscal Policy Minister Kaoru Yosano said that the BoJ has “done pretty much all it can do” to curb the downside risks for the region and the central bank may continue to weigh different alternatives to stimulate the ailing economy as growth and inflation remains subdued. The BoJ is widely expected to maintain its current policy next week, but the central bank may raise its economic assessment as its chief economist, Kazuo Momma, expects the recovery to gather pace in the first-half of 2011. Mr. Momma said that the economy will “emerge from a lull and start to resume a moderate recovery” while speaking earlier this week, and the central bank may adopt a wait-and-see approach for the first-quarter as growth prospects improve.

Meanwhile, the Fed may continue to casts doubts for a sustainable recovery in the U.S. given the ongoing weakness within the private sector, and dovish comments from the central bank could dampen yield expectations as fear surrounding the economic outlook bears down on market sentiment. As a result, the BoJ and the FOMC interest rate decisions could generate a bullish reaction in the Japanese Yen, and price action may push lower going into the following month as the USD/JPY carves a lower top in January. - DS

British Pound Torn Between Risk Trends and Rates Outlook

By Ilya Spivak, Currency Strategist

Fundamental Forecast for British Pound: Neutral

• UK Inflation Tops Forecasts, Hits Highest Since April
• Jobless Claims Unexpectedly Decline for Third Month
• British Pound Resistance Extends to 1.61 vs US Dollar

As we discussed in our fundamental trends monitor, monetary policy expectations remain a key driver for the British Pound with GBPUSD continuing to show significant correlations to UK – US 2-year and 5-year yield spreads. However, the landscape is complicated by the reemergence of a significant link to broad-based risk sentiment as evidenced by a resurgent positive relationship between the currency pair and the MSCI World Stock Index, opening the door for a volatile week ahead.

On the monetary policy front, the spotlight falls on the Bank of England as it publishes minutes from January’s MPC meeting. The dramatic build in priced-in rate hike expectations for coming year (as tracked by Credit Suisse) suggests traders see the central bank as likely to err on the side of price stability, stepping off the sidelines to tighten lending conditions as inflation continues to push higher despite the threat that such action would pose to the nascent economic recovery, particularly as the more painful elements of the government’s austerity program kick in.

Indeed, the central bank argued throughout 2010 that inflationary pressure was temporary and would subside over the medium term without tightening. Clearly, this has proven to be wrong, suggesting that putting off the issue for much longer threatens to become a credibility problem for the monetary authority. A relatively robust fourth-quarter GDP reading will only add to the anticipation, with the annual growth rate set to print above its long-run average despite a shallow downtick from the preceding period. With that in mind, traders will be keen to parse the meeting minutes for any clues on policymakers’ thinking ahead of February’s MPC sit-down, an event made all the more important considering it coincides with the creation of an updated quarterly inflation forecast.

On the sentiment side of the equation, all eyes will be focused on a busy US economic calendar, with the Federal Reserve monetary policy announcement and the preliminary fourth-quarter GDP report in focus. For the former, traders will be most concerned with quantifying policymakers’ “threshold” for reducing or even suspending the second round of quantitative easing before its scheduled completion after hints at the existence of such a barrier suddenly emerged in Fed officials’ comments over recent weeks. Meanwhile, the top question for the GDP report will be whether an aggressive pickup in growth is interpreted along fundamental or risk-driven considerations, with the former being Dollar-positive while the latter being likely to weigh on the safety-linked US currency.

Canadian Dollar: Will Higher Inflation Reignite Rate Expectations?

By David Song, Currency Analyst

Fundamental Forecast for Canadian Dollar: Neutral

- Canadian Retail Sales for November Surge on Auto Sales

- Canadian Dollar Stumbles as Bank of Canada Predicts “Modest” Recovery

- Canadian Dollar Follows Crude Lower on Chinese Tightening Fears

- Canadian Dollar Stumbles after BoC Rate Decision Despite Growth Upgrade on Currency Warning

The Canadian dollar recouped the losses from earlier this month as the economic docket reinforced an improved outlook for the region, and the commodity currency may continue to strengthen over the following week as market participants speculate the Bank of Canada to normalize monetary policy further this year. However, as the marked appreciation in the local currency bears down on the recovery, the BoC is likely to retain its wait-and-see approach throughout the first-quarter as the economic outlook remains clouded with “significant” uncertainty.

After holding the benchmark interest rate at 1.00%, the BoC raised its economic assessment and sees the economy growing 2.4% this year amid an initial forecast for a 2.3% expansion in the growth rate. However, the central bank struck a neutral tone for future policy as Governor Mark Carney maintained his pledge to “carefully” consider tightening monetary policy further, and the central bank head may continue to talk down speculation for higher borrowing costs as the underlying strength in the Canadian dollar drags on foreign trade. According to Credit Suisse overnight index swaps, investors now anticipate the BoC to raise the key rate by 50bp over the next 12-months after pricing 75bp worth of rate hikes during the previous week, and interest rate expectations may continue to deteriorate over the coming months as the central bank expects the real economy to operate below full-capacity until the end of 2012. In turn, the short-term rebound in the USD/CAD may gather pace going forward, and the exchange rate may continue to pare the sharp decline from the end of 2010 as the BoC remains comfortable with its current policy.

Nevertheless, consumer prices in Canada are forecasted to increase at an annual pace of 2.5% in December following the 2.0% expansion in the previous month, while the core rate of inflation is projected to grow 1.6% after rising 1.4% in November. The rebound in price growth is likely to spark a bullish reaction in the Canadian dollar, and the data could stimulate interest rate expectations as the economic recovery gathers pace. At the same time, the FOMC is widely anticipated to maintain a cautious outlook for the U.S., and dovish comments from Fed Chairman Ben Bernanke could spur a selloff in the USD/CAD as private sector activity in Canada outpaces the recovery in the world’s largest economy. - DS

Australian Dollar Positioned to Follow Gold Prices Lower

By Ilya Spivak, Currency Strategist

Fundamental Forecast for Australian Dollar: Bearish

• Australian Dollar Drops as Chinese GDP Stokes Rate Hike Fears
• Aussie Sellers Take Out Key Trend Line Support vs US Dollar

Curiously, the Australian Dollar’s bearings are best revealed via the currency’s clear correlation with gold prices, with the high yielder set to follow the yellow metal lower in the week ahead as investors’ dominant forecast for the evolution of the global post-Great Recession recovery shift away bullish and bearish extremes.

Gold had decoupled from the risk-on/risk-off dichotomy of recent years, reflecting its appeal as a store of value for bulls and bears alike as the former camp called for catastrophic inflation on the back of ultra-loose monetary policies while the latter projected renewed collapse across asset classes as fiscal stimulus expired. However, investment demand suffered a major setback, with gold ETF holdings dropping precipitously over recent weeks. The reversal follows the recent improvement in US economic data – the bellwether for the global recovery at large – coupled with rising sovereign stress in Europe and looming slowdown in China. These have simultaneously made a back-slide into recession seem unlikely while pointing to a rebound that amounts to a long, hard slog over the years ahead.

Interestingly, the increasingly apparent shift inthe overall consensus toward this kind of recovery bodes ill for the Aussie much the same as it does for gold. A slow, protracted recovery suggests that majorcentral banks will now get their chance to catch up as the Reserve Bank of Australia– until recently the leader in post-crisis monetary policy normalization – as Glenn Stevens and company look increasingly likely to sit on their hands for much of the coming year. Indeed, a Credit Suisse gauge of priced-in rate hike expectations argues for no more than a single increase over the next 12 months.

New Zealand Dollar Forecast Bearish Amidst Downbeat RBNZ Outlook

By David Rodriguez, Quantitative Strategist

Fundamental Forecast for New Zealand Dollar: Bearish

• New Zealand Dollar falls as Prime Minster talks down interest rate prospects
• Elliott Wave analysis suggests New Zealand dollar could weaken after gains

The New Zealand Dollar was the worst-performing G10 currency through the past week of trade, falling on a noteworthy deterioration in interest rate expectations and generally lackluster economic data. The highly yield-sensitive currency fell as Prime Minster John Key talked down the possibility of higher Reserve Bank of New Zealand interest rate targets, pledging to reduce fiscal stimulus to abate inflationary pressures.

To that end, Q4 Consumer Price Index inflation numbers fell squarely in line with consensus forecasts and suggested the central bank need not worry about tightening monetary policy through the foreseeable future. Analysts unsurprisingly predict that the RBNZ will leave rates unchanged at the coming week’s meeting, leaving relatively little scope for a relief rally in the recently-beleaguered New Zealand currency.

The RBNZ rate announcement is the only noteworthy piece of economic event risk in the week ahead, and the Kiwi currency is otherwise likely to track moves in soft commodities and broader financial market risk sentiment. Consensus forecasts unanimously call for unchanged interest rates, and tame inflation and growth measures suggest that the Reserve Bank is in little rush to normalize policy. The post-decision statement will likely reflect a neutral policy bias. Barring any surprises, the event is unlikely to offer any real support to the NZDUSD. Indeed, our overall fundamental bias remains bearish for the currency amidst a downbeat outlook for domestic growth and interest rate prospects. -DR

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