Forex Weekly Trading Forecast - 01.31.11

US Dollar sets Stage for Larger Reversal Ahead of NFP Result

By David Rodriguez, Quantitative Strategist

• US economy expands at strong pace on growing personal consumption
• Forex futures and options sentiment suggests US Dollar near important bottom
• View our six-month US Dollar Outlook

The US Dollar saw a potentially important turnaround through late-week trade, setting the stage for continued strength in a pivotal week for fundamentals and perhaps broader market sentiment. US Nonfarm Payrolls data will dominate foreseeable event risk in the week ahead, but the usual slew of early-month economic data could likewise spark important Greenback volatility. Early indications suggest that a late-week US Dollar bounce could be the start of a larger recovery.

Volatility expectations picked up ahead of what promises to be an eventful week with highly-anticipated NFP data due Friday. Yet earlier Personal Income and Spending, ISM Manufacturing, ADP Employment Change, Initial Jobless Claims, and ISM Services results could likewise drive important US Dollar moves. Consensus forecasts point to fairly muted job growth through the first month of 2011, and the domestic Unemployment is expected to tick higher as a result. The recent US Federal Open Market Committee interest rate decision showed that officials remain concerned with weak employment growth, and said concerns are central to the FOMC’s decision to stick with ultra-accommodative monetary policy. Thus markets will watch with interest to see if January’s figures confirm the Fed’s fears and point to lackluster job creation—likely keeping the US Dollar relatively weak amidst aggressive Quantitative Easing and record-low interest rates from the central bank.

A generally strong wave of US economic data arguably leaves risks to the topside ahead of important data releases. Conference Board Consumer Confidence data shows attitudes on labor market conditions improved considerably through January, while Q4 GDP numbers likewise showed an important pickup in consumer spending. All of this will amount to little, however, if NFP’s disappoint significantly to the downside. Thus we will watch with interest to see how early-week economic data shapes expectations for later-week results and market reactions to said data.

It is a potentially pivotal stretch for the US Dollar amidst a noteworthy reversal through Friday trade, while the US Dow Jones Industrial Average likewise saw a noteworthy pullback from lofty highs. We have made little secret of the fact that we expect the US Dollar to strengthen through 2011, and indeed several DailyFX analysts have recently gone long the Greenback on what could be the bounce we have expected. It is always especially difficult to time market reversals, and we may need to see considerable US Dollar continuation to claim that this is theturn. Suffice it to say, it will be interesting to watch whether the coming days will live up to expectations and produce the volatility we have come to expect from the first trading week of the new month.

Ongoing unrest in Egypt may be another important theme to watch. Yet making any sort of definitive forecasts on a fast-shifting situation seems a fool’s errand. It is something to keep an eye on, as any significant flare-ups in tensions would likely benefit the safe-haven USD. – DR

Euro Ready to Tumble on Risk Trends or EU Financial Troubles

By John Kicklighter, Currency Strategist

Fundamental Forecast for Euro: Bearish

- The EU sells its first round of EFSF bonds to remarkable demand

- EURUSD takes a significant step towards reversal

For three weeks, EURUSD steadily climbed while the other dollar-based majors struggled for meaningful direction. This comparison alone should tell us that the responsibility for this specific pair’s performance fell not to the dollar but to the euro. Indeed when we look at EURJPY, EURGBP and the rest of this shared currency’s crosses; we see the same performance. This collective climb was founded not on a surge in confidence for the region and its currency but rather a sign of relief after its outlook had deteriorated so thoroughly thanks to financial, growth and yield concerns. It is important to differentiate between a rise in confidence and the moderation of fear. One naturally carries little momentum while the other can sustain its own trends. Which is which? That is an important question to ask considering the euro suffered its first real setback in three weeks this past Friday.

Establishing the source of the euro’s fundamental strength is a critical first step to analyzing where the currency will head going forward. In the rally that has established itself through the bulk of January; there hasn’t been a genuine improvement in conditions. Instead, the steady selling pressure that had developed in the months before was starting to ease up. ‘Confidence’ was found in the open-ended proposals for increasing the bailout facilities, reducing emergency loan yields, selling bailout bonds, allow EFSF debt purchases, finding the ability to intervene in the bond market and other remarkable suggestions. There is no doubt that officials have been seriously discussing these initiatives; but the likelihood that valid concerns will be put aside to dramatically increase stimulus efforts is low. In fact, we have seen adamant opposition to increasing the bailout program, selling bonds that are guaranteed by all the EU members and other controversial issues. This week, EU officials are scheduled to discuss these exact issues on Wednesday; but it has been expressly suggested by participants that few accords will be struck in this event. And, while it may seem that no agreements would be a non-event; in fact, it is a reminder that these same concerns have been circulating for some time and they have consistently butted heads instead of finding a solution. It will be hard to maintain a relief rally under that reality.

Another key, exogenous event will be the Portuguese sovereign bill auction for the same day. It was a smart move to schedule the sale on the same day as the meeting as the market will hold off from a panic while EU officials are convening on the possibility that there is some meaningful resolution that makes it through. Nevertheless, this event will still be seen as a gauge of the market’s confidence in Europe’s financial health just when doubt is starting to bleed through. And, taking stock of the skew in the market full coverage will be met with skepticism while a short-fall in demand will stoke bearish sentiment.

As for the economic docket, we will be watching for a feel for relative growth (following the US and UK GDP releases) as well as rate speculation. For growth, the German employment data, regional jobless rate and manufacturing and service sector activity figures will give a good sense of what we should expect the benchmark for the region’s GDP reading will be in the weeks ahead. Interest rate speculation – another of the key relief rally points – will also come into view. The ECB rate decision will not come to a change in policy; but we will be analyzing for any additional, subtle changes in tone. As we have seen before, even slight change can lead to significant leverage in price action. - JK

Japanese Yen To Benefit From BoJ, FOMC Interest Rate Decisions

By Michael Wright, Currency Anal

Fundamental Forecast for the Japanese Yen: Neutral

• Japanese Yen Marking Time
• Japanese Trading Bias Unclear

The Japanese yen pushed higher against the U.S. dollar this week, climbing some 1.69 percent as developments in the world’s largest economy failed to meet market expectations. The rally in the yen is quite impressive due to the fact that the S&P slashed Japan’s rating to AA- from AA. Looking ahead, the USDJPY is unlikely to break out of its current triangle formation unless the economy gains momentum on the back of positive fundamental developments. Until then, traders should not rule out the yen benefiting from dollar weakness in the near term. The slew of risk scheduled for next week may provide color to the bleak picture.

For most of 2010, the yen was benefiting from its safe haven status amid uncertainty in the global economy, rather than developments in the region. The yen is considered a safe haven because the current account surplus reduces Japan’s dependence on borrowing from abroad. It is important to note and attribute the yen’s rally last year to its safe haven appeal because as the world’s largest economy stabilizes, the yen is expected to lose ground. As of late, the U.S. has yet to show these positive fundamentals. Annualized economic activity in the U.S. rose 3.2 percent in the fourth quarter amid economists’ forecasts of 3.5 percent. Though the headline number was a disappointment, the final sales of domestic product posted a 7.1 percent gain which marked the highest reading since 1984. The component bodes for the economy because it means that businesses are spending again. However, this component was not enough to push the USDJPY higher as durable goods missed predications in December, while employment remains subdued. Next week, market participants will be faced with the highly anticipated U.S. nonfarm payrolls report. A better than expected release could potentially lead the USDJPY to break out from its current level.

Taking a look at Japan’s developments, the Standard & Poor’s downgraded the country’s debt rating from AA to AA-, citing that the country is facing a debt burden of 11 trillion dollars. Meanwhile, the Bank of Japan is expected to keep borrowing costs between 0 and 0.10 percent as the recovery seems to be slowing. This may lead the central bank to play a bigger role in aiding the economy return to the road of recovery. Looking at the USDJPY, the pair seems to have worked its way into a triangle formation. Indeed, price action has been a bit choppy, thus, currency traders should stay on the sideline and wait for clearer developments. -MW

British Pound To Face Headwinds As Growth Prospects Deteriorate

By David Song, Currency Analyst

Fundamental Forecast for British Pound: Neutral

• British Pound Sells Off As GDP Contracts
• GBPUSD: Bulls Retreat from 1.60 Figure
• British Pound Rallies as the Bank of England Minutes Reveals a 6-3 Split Amongst Officials in January

The British Pound pared the advance from earlier this month as economic activity in the U.K. unexpectedly weakened in the fourth-quarter, and the sterling may face additional headwinds over the following week as the outlook for future growth deteriorates. The U.K. economy contracted 0.5% during the last three-months to mark the biggest decline since 2009, and fears of a double-dip recession could intensify as private sector activity remains subdued.

The economic docket for the following week is expected to show mortgage approvals increasing 46.5K in December following the 48.0K expansion in the previous month, while the gauge for manufacturing is expected to fall back to 58.0 in January from 58.3 in the month prior. As the rebound in economic activity tapers off, the slew of event risks could spark a selloff in the exchange rate and lead the GBP/USD to retrace the rally from the monthly low (1.5405) as investors weigh the prospects for a sustainable recovery in Britain. In turn, the Bank of England may continue talk down the risk for inflation as it expects the ongoing slack within the real economy to bear down on price growth, and the central bank may adopt a dovish tone for future policy as the fundamental outlook remains clouded with high uncertainty.

Nevertheless, the BoE policy meeting minutes release earlier this week showed a 6-2-1 vote count as Andrew Sentance and Martin Weale saw scope to start gradually normalizing monetary policy, while board member Adam Posen pushed to expand quantitative easing by another GBP 50B in order to encourage a sustainable recovery. As the central bank struggles to balance the risk for growth and inflation, there is likely to be growing split within the MPC, and the dissenting views among the committee could translate into further British Pound weakness as interest rate expectations falter. However, as BoE Governor Mervyn King expects inflation to accelerate over the coming months, there could be increased pressures on the central bank to dampen the rise in price growth, and a growing number of the MPC may heed to Mr. Sentance’s call as consumer inflation expectations heighten. Accordingly, hawkish comments coming out of the BoE could prop the exchange rate going into February, but any advances in the British Pound could be short-lived as the economic outlook weakens. - DS