Forex Weekly Trading Forecast - 03.20.11

US Dollar: Why is the Currency at 2009 Lows With Risk Aversion Rising?

By John Kicklighter, Currency Strategist

Fundamental Forecast for the US Dollar: Bullish

• The FOMC deviates from the ECB’s hawkish turn, keeps a neutral bearing and tone
• Despite a clear swell in risk aversion, the dollar is struggling to gain a footing in its safe have role
• A coordinated G7 effort to depress the yen could lift the dollar; but will intervention work?
• Dollar’s recovery was curbed but has it technically failed?

The US dollar did not end this past week in a good position. In fact, the trade-weighted dollar index actually broke a blatant three-year rising trendline and subsequently closed at its lowest levels since December 2009. Looking at the trend from the greenback alone over the past two months, this development may not seem so surprising. However, when we line this progress up against the fundamental developments over the past week; this breakdown comes as something of a shock. Why is the traditionally safe haven greenback falling when there was a meaningful tumble in investor sentiment this past week? There are two considerations here. On the one hand, this could speak to another phase of the currency’s fall from favor in currency circles. Alternatively, this could also be a reflection of very unique and otherwise temporary fundamental developments. Regardless, determining the dollar’s performance to this point is critical to understanding what direction it takes going forward.

First, we should start with the pessimist’s view. An uncomplicated assessment of the dollar’s slide to new lows is fitting to many traders and analysts as the greenback has been steadily losing its dominance as the world’s reserve currency and it will continue to do so through the future. That said, have expectations for the dollar really collapsed to the point that its liquidity is no longer a point of safety for the international investors looking to avoid a global liquidity crisis? Unlikely. Sure the dollar is losing its place as the most traded currency and its potential for return is in a word ‘lackluster’; but the need for liquidity during panics rises above such speculation. What’s more, the fact that a considerable amount of US capital founded or otherwise supported by Fed stimulus was invested outside the nation’s markets means there is a wave of funds that can lift the dollar through repatriation or risk aversion.

So, if the dollar is still a viable risk aversion currency, why is the currency still falling off while benchmarks for investor sentiment like the S&P 500 pitch into a meaningful reversal? This can be partially attributed to how we are analyzing its health. The Dollar Index by its very composition is primarily a reflection of EURUSD (the most liquid currency pair in the FX market by far) and USDJPY. Yet, with both of these, we have very unique fundamental considerations. For the yen-based cross, the situation is very unusual. The devastating earthquake Japan suffered on March 11th has contributed to uncertainty on a global scale; but it has also encouraged a carry unwinding and a repatriation effort. These drivers will hold wind for only so long however; and the multilateral intervention effort to boost USDJPY from the G7 certainly will help. The strength of the EURUSD advance is similarly dubious. The ECB has sounded the alarm that a rate hike could be on the slate for next month – which has blinded speculators. On the other hand, it is very unlikely this will lead to a series of hikes and furthermore Europe is facing a very real threat to its financial stability thanks to underlying sovereign credit issues.

Risk appetite anomalies can take considerable time to reconcile; so in the meantime, we need to watch timely developments. For guidance on exogenous influence; we need to watch the S&P 500, the EU summit on Thursday and Friday, the UK CPI figures on Tuesday and the situation with the Japanese Fukushima nuclear plant. Domestically, we have notable indicators like durable goods and the Chicago Fed National Activity Index. That said, Fed commentary could prove far more influential for hyper-sensitive rate speculation.

Euro Traders’ Confidence to be Put to the Test after EU Summit

By David Rodriguez, Quantitative Strategist

Fundamental Forecast for Euro: Bearish

- Euro strengthens as European Union proposes debt fix

- European Summit promises further EUR volatility in week ahead

- Euro correlation to S&P 500 remains high amidst ‘risk’ correction

The euro defied expectations and set fresh highs against the downtrodden US Dollar, fueled by a late recovery in financial market risk sentiment and expansion in emergency measures to contain regional sovereign debt crises. Early signs pointed to a potentially significant pullback in the US S&P 500 and the highly-correlated European currency. Yet by the end of the week, key developments had eliminated a good deal of uncertainty surrounding Europe and broader financial markets. A potentially busy week for European fundamentals and lingering geopolitical risks nonetheless threatens considerable volatility in the days ahead, and it will be critical to watch whether the single currency can continue its torrid uptrend against the US Dollar.

A European Union summit dominates foreseeable event risk in the week ahead, and markets will want to see further details on how recently-announced measures will stave off further sovereign debt crises in the single currency area. Officials announced an expansion to the European Financial Stability Fund (EFSF) and a creation of a permanent fund of the same size, but recent downgrades to Portugal’s sovereign debt rating emphasize that confident is still lacking in fiscal stability. Thus markets will look to the European Union summit to assuage fears. Given recent euro gains, one gets the sense that anything short of full clarity and

This heightened optimism, however, was fully offset this past week. As the week wore on, Greece received a three-notch downgrade, Spain suffered its own sovereign rating cut, Portugal was forced to pay exceptionally high rates at a debt auction and ratings agencies reported that the recapitalizing costs for Spain’s banking sector would be at least two-to-three times greater than the Bank of Spain’s 15.2 billion euro assessment. Whether or not these fundamental concerns can offset the yield forecast and dampen risk appetite remains to be seen; but the market will have a lot to consider come Monday.

After liquidity fully drained this past Friday, EU officials finally emerged from their special summit in Brussels and announced the progress made through the session. Little was expected from this gathering as it was a precursor to the official meeting over March 24th and 25th. However, the updates provided carried more significant than many would have expected. Despite Germany’s adamant position against expanding its rescues liabilities, it was agreed that the EFSF would be able to buy bonds directly in the primary market and Greece would be offered a conditional 100 basis point reduction to its emergency lending rates as well as an extension to its loans out to 7.5 years. On the other hand, officials merely voiced confidence in Portugal’s financial efforts (despite record bond yields) and noted that Ireland was not offered the same reduction in rates on emergency loans.

Where the euro goes from here is fully dependent on how confident in these commitments the market is. Lower rates for Greece are likely dependent on asset sales (a supposed prerequisite German Chancellor Merkel raised in a parliamentary meeting). What’s more, helping one EU member while neglecting Portugal and Ireland could lead the collective to failure just as surely as if they committed extra support to no one. If global market participants remain skeptical following last week’s downgrades and the realization that there is still an extraordinary demand for liquidity amongst the banks; the euro will falter. And, through it all, if the global markets are unwinding in a risk aversion bid; the euro will tumble regardless of its own internal, fundamental debates. -DR

British Pound Rally To Gather Pace On Higher Inflation, BoE Minutes

By David Song, Currency Analyst

Fundamental Forecast for British Pound: Bullish

• GBPUSD: Sell Entry Sought on Bounce
• British Pound Forecast Unclear Amidst Shift
• U.K. Labor Market Unexpectedly Improves in February

The British Pound broke out of its narrow range on Friday, with the GBP/USD rallying to 1.6255, and the rebound in the exchange rate may gather pace over the following as the headline reading for U.K. inflation is expected to breech 4 percent. Consumer prices are projected to grow at an annualized pace of 4.2 percent in February, with the core rate of inflation anticipated to increase 3.1 percent after rising 3.0 percent in the previous month, and heightening price pressures could renew speculation for a rate hike in the first-half of 2011 as the central bank’s credibility to ensure price stability comes under increased scrutiny.

In turn, the BoE minutes could reveal a growing shift within the MPC, and the central bank may show an increased willingness to gradually normalize monetary policy over the coming months in an effort to stem the risk for inflation. A quarterly survey released by the central bank earlier this week showed consumer inflation expectations increase to 4.0 percent in February to mark the highest reading since August 2008, with 62 percent of respondents expecting to see a rate hike over the next 12 months. Although, recent comments from BoE board member Charles Bean suggests that the central bank will retain its wait-and-see approach as higher interest rates impede on economic activity, and the central bank may see scope to support the real economy going into the second-half of the year as it aims to encourage a sustainable recovery.

However, the market reaction to the BoE minutes could be short-lived as Chancellor of the Exchequer George Osborne is scheduled to deliver the budget statement on the same day at 12:30 GMT, and the new coalition in Britain may expand the scope of its austerity measures in an effort to better manage public finances. As the government tightens fiscal policy to curb the budget deficit, the extraordinary measures are likely to instill a weakened outlook for future growth, and the central bank may have no choice but to retain the monetary expansion in order to balance the risks for the region. - DS

Japanese Yen to Rise as Intervention Targets Volatility, Not Direction

By Ilya Spivak, Currency Strategist

Fundamental Forecast for Japanese Yen: Bullish

• Japanese Yen Could Continue Higher Despite G7 Efforts
• Quake May Help Japan Beat Deflation, Change Yen Dynamics
• USDJPY: Standing Aside Amid Volatility, Long-Term Setup Bullish

After a week of breakneck volatility that saw the Japanese Yen surge to a record high only to rapidly reverse course amid the first coordinated G7 FX market intervention in over the decade, the outlook going forward appears anything but clear. Looking ahead, policymakers with a clear challenge vis-à-vis the exchange rate: on one hand, a stronger Yen threatens the critical export sector that will be seen as instrumental in helping the economy recover; on the other, the Yen's increasing purchasing power will help to dull the cost of recovery efforts for individual as well as public and private entities considering so many goods and resources in Japan are imported. On balance, this means Japanese officials will look tomanage Yen volatility rather than push prices in a given direction, suggesting renewed strength may be allowed to progress undeterred provided it progresses gradually.

With this in mind, the reasoning behind renewed Yen strength is compelling given the considerable headwinds still facing risk sentiment, hinting repatriation and an unwinding of carry trades will pressure the Japanese unit higher. First, while yielding a burst of knee-jerk optimism, the G7 action left core issues in the aftermath of the Tohoku earthquake largely unresolved. Indeed, casualties continue to mount, the extent of the damage and cost of reconstruction remains uncertain, and the threat of disaster at the Fukushima Daiichi nuclear power plant continues to linger.

Meanwhile, a new phase of the Libyan crisis began to unfold as the UN Security Council authorized the establishment of a no-fly zone and gave its member countries a virtually blank check to apply force to “protect citizens”, approving just about anything shy of outright occupation. As we have noted previously, markets see the situation in the North African country as a trial run for the worst case scenario in the aftermath of a protest flare-up, so the path chosen by the major powers from here (whether that is to materially intervene or not) will be weighed up as if it were happening to a far more significant crude supplier than Libya itself (i.e. Saudi Arabia). Increasingly intense unrest in Bahrain and Yemen further complicate the geopolitical landscape.

Finally, Friday will bring the much-anticipated summit of Euro Zone finance ministers that has been widely expected to produce a so-called “grand bargain” on dealing with the debt crisis on the currency bloc’s periphery. As we discussed in detail last week, the preliminary outlines of the scheme amounted to nominal progress but fell woefully short of a true bulwark against further sovereign stress, pointing to a wave of disappointed selling across the spectrum of risky assets (and to the benefit of funding currencies, including Yen) if the final version is not substantially strengthened.

Canadian Dollar Could Fall Further on Commodity Price Corrections

By David Rodriguez, Quantitative Strategist

Fundamental Forecast for Canadian Dollar: Bearish

• Canadian Dollar may have set important top
• Technical strategist remains short Canadian Dollar

The Canadian Dollar and fellow commodity bloc members were the only G10 currencies to finish lower against the downtrodden US Dollar, hurt by noteworthy corrections in oil, gold, and silver prices. A similarly significant correction in Bank of Canada interest rate expectations likewise reduced the attractiveness of Canadian Dollar bets. Looking to the week ahead, relatively Canadian economic calendar suggests that the USDCAD will move off of developments in the US and global commodity markets.

Considerable corrections in commodity prices and financial market risk barometers dragged the Loonie lower, and continued weakness would almost certainly produce the same result in the week ahead. The lowest-ever Core Consumer Price Index reading pushed Bank of Canada interest rate expectations considerably lower—leaving fundamental risks likewise to the downside. We previously argued that the Canadian currency may have set an important top (USDCAD bottom) on sentiment extremes, and such an outcome seems increasingly likely if commodity prices continue their recent reversal.

A Canadian Retail Sales report on Tuesday is the only piece of foreseeable economic event risk. Traders will otherwise need to keep a close eye on financial market risk barometers such as the US S&P 500 and its effects of risk-linked commodity prices. The US economic calendar sees similarly limited event risk. Yet considerable geopolitical risk out of Japan and the Middle East/North Africa region promises no shortage of volatility in the days ahead. - DR

Australian Dollar Pressured Lower as Risky Assets Resume Decline

By Ilya Spivak, Currency Strategist

Fundamental Forecast for Australian Dollar: Bearish

• AUDUSD: Selling Opportunity Sought Below the Parity Threshold
• Australian Dollar Gains as G7 FX Intervention Bolsters Risk Appetite

The Australian Dollar remains firmly anchored to underlying trends in investors’ sentiment, with short-term correlation readings gauging the link between AUDUSD and the MSCI World Stock Index, a proxy for risk appetite, holding at the strong end of the spectrum. This foreshadows a volatile week ahead but ultimately hints the path of least resistance favors Aussie weakness as sentiment continues to face downward pressure from lingering uncertainty on multiple key issues.

First, the G7 intervention into the Japanese Yen produced a knee-jerk burst of optimism but the underlying issues present in the aftermath of the Tohoku earthquake remain unresolved. Casualties continue to mount, the extent of the damage and cost of reconstruction remains uncertain, and the threat of disaster at the Fukushima Daiichi nuclear power plant continues to linger.

Meanwhile, a new phase of the Libyan crisis began to unfold as the UN Security Council authorized the establishment of a no-fly zone and gave its member countries a virtually blank check to apply force to “protect citizens”, approving just about anything shy of outright occupation. As we have noted previously, markets see the situation in the North African country as a trial run for the worst case scenario in the aftermath of a protest flare-up, so the path chosen by the major powers from here (whether that is to materially intervene or not) will be weighed up as if it were happening to a far more significant crude supplier than Libya itself (i.e. Saudi Arabia). Increasingly intense unrest in Bahrain and Yemen further complicate the geopolitical landscape.

Finally, Friday will bring the much-anticipated summit of Euro Zone finance ministers that has been widely expected to produce a so-called “grand bargain” on dealing with the debt crisis on the currency bloc’s periphery. As we discussed in detail last week, the preliminary outlines of the scheme amounted to nominal progress but fell woefully short of a true bulwark against further sovereign stress, pointing to a wave of disappointed selling across the spectrum of risky assets if the final version is not substantially strengthened.

Source : www.dailyfx.com