Forex Trading Weekly Forecast - 09.10.2012

US Dollar Hits Four Month Low, Fed Decision to Make or Break Trend

Fundamental Forecast for US Dollar: Neutral

• August NFPs disappoint, but risk trends still rally – a sign of QE3 hopes?
• ECB offers another means to fight the Euro-area’s crisis, and ease global fears in the process
• EURUSD rebound strong under dollar selling, but positioning shows lack of conviction

The dollar was dealt a hefty blow this past week. The Dow Jones FXCM Dollar Index (ticker = USDollar) dove into four-month lows Friday with its biggest single-day decline in 10 weeks. From a chart of the USDollar or EURUSD, it seems as if the dollar has had the floor ripped out from underneath it. However, selling momentum is not guaranteed. In fact, it will be more difficult to sustain than many may suspect. Whether or not EURUSD overtakes 1.3000 and AUDUSD surmounts 1.0600 is a matter for the Federal Reserve to decide.

To gain a sense of the dollar’s orientation over the coming week, we need to assess what fundamental themes are in control and what will provoke their development moving forward. Without doubt, the greenback’s greatest adversary moving forward is the Fed rate decision scheduled Thursday (16:30 GMT). Yet, why is the policy meeting so influential to the currency? Because of its direct impact on the currency’s value (via money supply and yields) and the sway over risk appetite trends (the greenback is the market’s preferred safe haven currency).

Market-wide investor sentiment (risk trends) carries the greatest sway over the dollar and broader capital markets. That is where the bulk of the benchmark’s losses were founded this past week. Though most would point to Friday’s August NFP figures as the most influential event for this past trading cycle, the ECB rate decision was arguably the bigger coup. The European policy authority decided to satisfy speculative demands / hope for more support to end the Euro-area’s two-and-a-half year debt crisis. In a new, unlimited bond purchase program (Outright Monetary Transactions – OMT), the greatest single threat to global financial stability has been put on ice.

Yet, lessening the pressure on the world’s largest collective economy doesn’t naturally translate into a return to growth and competitive rates. Therefore, the progress made was likely more of a relief rally than a genuine trend shift. The prospect for a serious rally moving forward requires a renewed buying interest for carry currencies and equities (at or near multi-year highs). That responsibility falls to the Fed. Similar to the buildup in expectations for the ECB to satisfy traders’ expectations with the OMT program, the capital markets have shown a serious swell in speculation for a fresh stimulus program from the Fed.

Establishing to what degree the market is pricing in QE3 or an equivalent program by the central bank is important to gauging the reaction. If the consensus were for nothing to happen at the meeting and the Fed stayed put, there would be little reaction. Alternatively, if the masses were expecting a large-scale asset purchase (LSAP) program and nothing was offered, the market would react with a sharp selling of risky assets (Aussie dollar, Euro, US equities, etc) and sizable rally for the dollar.

With the dollar’s abrupt drop through the end of this past week (as well as the buoyancy in gold and Treasuries), it is clear that the market expects more external buying from the world’s largest central bank. Expectations were certainly amplified by the disappointing headline NFP reading, which rose by ‘only’ 96,000 jobs. Yet, looking at the S&P 500’s four-year high, gold’s surge above 1700 and the dollar’s sharp tumble to multi-month lows; there is a sense that the market is expecting too much from the Fed – both in terms of scope and influence of further support schemes.

Setting the scene, in the lead up to the event; the masses will throttle back in adding into exposure ahead of announcement – that will translate into a tamed trend, but it could also amplify volatility. There are three components to the event: the policy decision (16:30 GMT), the release of the fundamental forecasts (18:00 GMT) and Chairman Bernanke’s press conference (18:15 GMT). Any new program would likely come from the decision itself, so that is make-or-break. And, anything short of a blatant QE3-like program could be construed as a ‘disappointment’. Meeting expectations is difficult enough given current levels. Beating them could be near impossible. – JK

Euro Surges Despite Existential Threats – Does it Survive Week Ahead?

Fundamental Forecast for the Euro: Bearish

• European Central Bank announces unlimited bond buying program
• Euro initially tumbles on ECB announcement, but aftershocks send EURUSD flying
• Will the Euro survive the month of September?

The Euro posted its single-largest weekly advance against the US Dollar (ticker: USDOLLAR) since February as a new bond buying plan from the European Central Bank eased Euro Zone tensions and forced many speculators out of their short positions.

Yet the Euro isn’t out of the woods yet: a critical German court ruling on the legality of European bailouts could rule recent ECB efforts null, while a potentially pivotal US Federal Open Market Committee decision could force substantial FX volatility.

The ECB announced unlimited bond purchases for at-risk governments via the Outright Monetary Transactions (OMT) program, and yields on 10-year Spanish Government bonds fell by their most in at least 20 years on the news. Yet the ECB put a clear caveat on the “unlimited” support; any given country would need to submit to the terms of the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM) to receive aid from the central bank. The critical provision may prove a tough pill to swallow for the country in clearest need of fiscal aid—Spain.

The Spanish government has instituted deeply unpopular fiscal austerity measures in a bid to stabilize Spain’s balance sheet, but they would almost certainly be forced by the EFSF/ESM to institute further belt tightening despite overseeing a domestic economy mired in recession. The material bounce in Spanish bond prices/drop in yields suggests that most view plans as favorable. It’s nonetheless obvious that Spain and the Euro Zone are not out of the woods just yet.

A highly-anticipated German Constitutional Court ruling due September 12 could ultimately render debates over the ECB’s bond buying irrelevant. European bailouts have always been deeply unpopular in Euro zone paymaster Germany, and legal challenges against the ESM will come to a head as its highest court rules on its legality.

FX Options markets show that traders are paying surprisingly little for Euro/US Dollar volatility, and that fact in itself suggests that most put low odds on an adverse German ruling. But the existential threat to the Euro as a currency remains real, and we can’t ignore the possibility that the court could effectively undo endless efforts to keep the European Monetary Union intact.

If the Euro survives the German ruling on the 12th, it will look to a highly-anticipated US Federal Open Market Committee (FOMC) policy decision to drive further volatility on the 13th. Sharply disappointing US Nonfarm Payrolls data for August increased odds that the FOMC would vote for further Quantitative Easing (QE3) measures and effectively print US Dollars to boost growth. Some claim that there is a 50% chance of QE3 on the Sept 13 announcement, and the Dollar’s reaction to disappointing NFPs data suggests it stands to fall further on such an announcement (sending EURUSD higher).

There’s a lot riding on the week ahead, and it will be critical to watch whether the recent wave of Euro/US Dollar short-covering continues on make-or-break event risk out of Europe and the US economy through the second week of post-summer trading. – DR

Sterling To Benefit From Policy Outlook Despite Overbought Signal

Fundamental Forecast for British Pound: Bullish

• Pound Gains As UK Economy Keeps Growing In August Though Risks Persist
• BoE Survey Predicts Future Inflation of 3.20%
• Retail Traders Short British Pound as it Tests Highs

The British Pound continued to appreciate in September, with the GBPUSD rallying to a fresh monthly high of 1.6033, and the sterling may track higher in the week ahead should the economic docket reinforce an improved outlook for the U.K. As the Bank of England holds the benchmark interest rate at 0.50% while maintaining its asset purchase target at GBP 375B, a slew of positive developments should dampen the central bank’s scope to expand its balance sheet further, and the Monetary Policy Committee may endorse a wait-and-see approach throughout the remainder of the year as growth and inflation picks up.

Although U.K. jobless claims are expected to hold flat in August, the trade deficit is projected to narrow to GBP 9.000B in July, and a batch of positive developments should increase the appeal of the sterling as it limits the likelihood of seeing additional monetary support. At the same time, U.K. Prime Minister David Cameron announced plans to create 140K new jobs by easing regulatory requirements for homebuilders, and the new initiatives to shore up the ailing economy may keep the BoE on the sidelines especially as the Funding for Lending scheme is already underway. As the central bank refrains from releasing a policy statement, market participants will certainly turn their attention to the BoE Minutes due out on September 19, and the MPC may sound more upbeat this time around as the economy gets on a firmer footing. Moreover, we may see Governor Mervyn King scale back his dovish tone for monetary policy amid the recent uptick in price growth, and the central bank may curb its forecast of undershooting the 2% target for inflation as the region appears to be emerging from the double-dip recession.

As the bullish sentiment surrounding the British Pound gathers pace, we should see the upward trending channel in the GBPUSD continue to take shape, but we will be keeping a close eye on the relative strength index as it approaches overbought territory. However, the sterling may continue to outperform its major counterparts as the BoE appears to be slowly moving away from its easing cycle, and we will preserve a bullish outlook over the near to medium-term as the fundamental outlook for the U.K. gradually improves. – DS

Source : Dailyfx.com