Forex Trading Weekly Forecast 02.21.2011

US Dollar Requires Continuous Support to Post a True Recovery

Fundamental Forecast for the US Dollar: Neutral

• FOMC minutes boost growth expectations but rate speculators want a clear bearing
• Though core CPI seems tame; evidence of building pressures via commodities coming to light
• The US dollar backed off this past week; but technical patterns suggest a coming reversal

This past week was not a favorable one for the US dollar – though from a fundamental perspective, the developments would actually lay the ground work for timely rebound. In this performance, we see one of the primary reservations for the dollar to establish a true and lasting recovery: the absence of support from a critical fundamental driver. There are three prominent elements that can reasonably be expected to provide enough leverage for the greenback to truly lay into a rally. In order of how quickly they can reasonably be expected to spark a dramatic shift in the market, the three themes we need to keep an eye on are: the threat of a sharp drop in risk appetite and unwinding of yield-based positions; the inevitable switch to a hawkish interest rate regime; and relative outperformance in economic activity. Two of these interests have slowly started to firm up for the greenback recently; but progress has been limited. And, looking out over the coming week, there is nothing to project more meaningful progress. That said, the dollar could once again flounder in volatile but ultimately aimless congestion until speculation decides to alter course through one of these themes.

Running down the list of our major drivers, underlying investor sentiment may carry the greatest risk of volatility for the dollar and financial markets at large; but it is interest rate speculation that has the better chance at making perceptible progress. There is little doubt that the Federal Reserve will keep its benchmark lending rate near zero until the very end of the year or perhaps into the first quarter of 2011. However, that does not mean that rate expectations won’t come into the picture until then. If we are to stick to the timetable that has been laid out by policy officials, the second round, $600 billion quantitative easing program the Fed is pursuing will end in June. After that, given market conditions, the central bank will start to unwind its stimulus facilities. This isn’t exactly a rate hike; but it withdrawals so-call ‘hot’ capital from the market. This is a necessary processor to a rate hike and it has the further effect of stifling leveraged risk appetite – thereby reversing the flow of funds from cheap US loans to higher-yield assets abroad. What’s more, even before this inevitable move; the market will speculate and position ahead of the actual effort. And, with a June expiration on the program, we may have to wait a few more weeks before interest becomes serious (perhaps after European financial concerns clear the March summit). Yet, when capital markets are as stable and bloated as the S&P 500; speculation tends to enjoy a greater influence over direction.

Where does that leave relative growth expectations? Unlike risk trends and yield forecasts, this particular driver is always in the background. Economic forecasts have been developing for months; and with the first reading of 4Q GDP; it has raised the benchmark for activity levels. However; there is still a disconnect for expectations of truly robust performance. That gap is largely due to the high unemployment rate. As the backdrop for the labor market doesn’t change very quickly, the fundamental guidance this particular concern provides will be more nuanced. On that front, we have plenty of event risk in the week ahead. The February consumer confidence survey from the Conference Board will be particular interesting for its details on spending plans and the assessment of growth and employment trends. The durable goods figures and Chicago Fed’s national activity index for January will provide a timely read on the positive contributors to growth; while the housing statistics (price, new and existing home sales) could highlight an ongoing anchor.– JK

Euro Advance to be Short-Lived, Sharp Correction in the Horizon

By Michael Wright, Currency Analyst

Fundamental Forecast for Euro: Bearish

- Euro Regains Footing on ECB Comments

- Euro Likely to Advance Against U.S. Dollar

The euro halted its three week decline against the greenback as inflation concerns continue to drive the single currency higher, while market participants shrug off rising yields amongst indebted countries in the bloc. Looking ahead, currency traders should not rule out prices pushing back towards the 1.37 area as technical developments begin to paint a bullish picture.

This past week, the EURUSD broke above two key levels of resistance as risk appetite regained its footing. One key factor driving the euro was the Federal Reserve upgrading economic growth in the world’s largest economy to 3.9 percent which was higher than previous projections, according to the minutes of the central’s bank’s latest meeting. The result was risk positive, helping to push the euro higher. Secondly, hawkish comments by European Central Bank Executive Board member Lorenzo Smaghi added fuel to the euro fire as Mr. Smaghi said that the central bank may raise rates as price pressures mount. At the same time, Mr. Smaghi said that “as the economy gradually recovers and global inflationary pressures arise, the degree of accommodation of monetary policy has to be monitored and, if needed, corrected.” These comments pushed the euro past the key barrier of 1.6. Though recent developments point to further gains in the single currency, traders should caution a sharp reversal as the yield of troubled economies continue their northern journey.

Looking ahead, EUR traders will be faced with industrial new orders, economic confidence, and the M3 money supply. The M3 money supply is of great importance due to the fact that it serves as the broadest measures of money supply in the 17 member euro area. As an increase in money supply tends to lead to price inflation, a better than forecasted release could fuel price concerns which has been the main driver behind the euro as of late. However, as lending markets remain subdued, traders should not rule out a dismal release. Furthermore, market participants should also closely monitor the bond markets as both Ireland’s elections and Portugal’s funding requirements are key risks for the markets ahead of the highly anticipated EU summit in March.

Taking a look at price action, the EURUSD has extended its two day advance to test the 20-day SMA for resistance. Meanwhile, the slow stochastic indicator has flipped to the upside, pointing to additional gains, while the pair managed to crossover above its descending 4 hour channel. So long as downside risks remain capped by 1.36, upside risks remain.

Japanese Yen To Hold Range As Near-Term Rally Tapers Off

By David Song, Currency Analyst

Fundamental Forecast for the Japanese Yen: Neutral

• USDJPY: Pullback to Yield Long Entry
• FOREX TREND MONITOR: Dollar Eyes Recovery vs Euro, Yen
• Asian Reserve Diversification Has to Be Playing its Part in Latest Price Action

The Japanese yen recouped the losses from earlier this week, with the USD/JPY falling back from a fresh yearly high of 83.96, and the exchange rate may continue to push lower in the days ahead as it carves out a near-term top in February. Nevertheless, the Bank of Japan raised its fundamental assessment for the first time in nine-months after holding the benchmark interest rate at 0.10% earlier this week and said that the “economy is gradually emerging from the current deceleration phase” as the central bank takes unprecedented steps to stimulate growth.

Central bank Governor Masaaki Shirakawa said that “exports and production are showing sign of resuming an uptrend” as the global recovery gathers pace, and went onto say that the recent depreciation in the exchange rate has helped to ease the deterioration in the terms of trade as policy makers aim to encourage an export-led recovery. In turn, the BoJ expects to see a gradually recovery unfold over the coming months, but noted that the outlook for future growth remains clouded with uncertainties given the ongoing weakness within the U.S. and European economies. As market participants continue to diversify away from the greenback, demands for the Japanese Yen may gather pace over the near-term, and the USD/JPY should work its way back towards the lower bounds of its recent range as the low-yielding currency regains its footing.

As the near-term rally in the dollar-yen tapers off ahead of 0.8400, the correction in the exchange rate could gather pace over the following week, and the pair may work its way back towards 81.00 as it searches for support. The technical developments suggest that the USD/JPY will continue to trend sideways over the near-term as the 20, 50 and 100 day moving averages converge with one another, and currency traders may get an opportunity to play the range going into March as the pair looks poised to retrace the advance from earlier this month.

British Pound to Pull Back as Rate Hike Bets Moderate

By Ilya Spivak, Currency Strategist

Fundamental Forecast for British Pound: Bearish

• British Pound Gains as Retail Sales Surge in January
• Bank of England Report Shows Prices, Growth to Slow
• UK Inflation Accelerates to 4%, Fastest in Over 2 Years
• Pound Finds Support at 1.60 vs Dollar, Aims at Feb High

Monetary policy expectations are firmly in focus for the British Pound, with the correlation between GBPUSD and the UK-US 2-year Treasury yield spread at the highest in six months on 20-day percent change studies. This turns the spotlight on the Bank of England as policymakers release minutes from February’s meeting of the rate-setting MPC. While Sterling’s performance was second only to the Franc last week as the aforementioned yield spread moved 5.8bps in its favor, risks for the week ahead appear skewed to the downside with near-term rate hike expectations looking increasingly like wishful thinking.

Last week, rate hike bets were kept alive as BOE policymaker Andrew Sentence delivered a blisteringly hawkish speech on Thursday, saying the central bank’s inflation forecast was “too optimistic” and encouraging a rate hike to – among other things – strengthen the Pound as an additional bulwark against price growth. While such fighting words are certainly music to the ears of GBP bulls, they are also nothing new: Mr Sentence has been the lone hawk on the MPC for a long time, and this kind of rhetoric is surely to be expected. Although Martin Weale joined Sentence in the call for a rate increase in December, the two represent just two members of a nine-strong committee and would need to convince at least three others to back their position, an outcome that looks decidedly unlikely over the near term.

Meanwhile, last week’s publication of the BOE’s Quarterly Inflation Report revealed a central bank that was far less hawkish than Mr Sentence or market rate hike bets would suggest. Policymakers acknowledged that inflation had accelerated faster than they had predicted and openly projected more of the same through the first half of this year, but still maintained that higher prices owed to “temporary” factors including a value-tax increase as well as higher energy and import costs. This was followed by the now-familiar promise that inflation would moderate as these temporary forces fade. Perhaps most interestingly, the BOE said that this moderation assumed the “Bank Rate moves in line with market interest rates,” which according to the report amounted to 50bps in rate hikes this year. This apparent validation of benchmark rates at 1 percent by the end of 2011 stands in stark contrast to where market expectations sit today, envisioning a BOE that is substantially more aggressive.

On balance, the meeting minutes release is likely to broadly mirror the inflation report considering the latter served as the primary basis for February’s policy decision, with the greatest risk being that Martin Weale backtracked on his support for a rate hike in light of the fourth-quarter GDP drop (the broad-based nature of which will be expanded upon in a revised release later in the week). Even if this doesn’t materialized however, another restatement of the bank’s baseline scenario is likely to underscore the disconnect between its thinking and the markets’, opening the door for correction lower both in tightening expectations and the Pound.

Source : www.dailyfx.com