Forex Trading

US Dollar: Bearish Sentiment Extreme Points to Further USD Gains

Fundamental Outlook for US Dollar: Bullish

- US Dollar rallies on positive Non Farm Payrolls data
- Forex Options markets showed considerable risk of US Dollar Bottom
- Watch for US Advance Retail Sales and Consumer Confidence in week ahead

The US Dollar finally showed signs of a noteworthy recovery and potential bottom against the Euro and other major currencies on a clearly eventful week of trading. Better-than-expected Non Farm Payrolls results and a relatively steady stream of positive economic surprises led many over-zealous analysts to declare that the economic crisis is over, but we believe such claims are very largely overblown. Non-Farm Payrolls fell significantly less than expected in May and at the slowest rate in eight months, but some perspective is clearly in order.

Since the official start of the recession in December, 2007, US unemployment ranks have risen by an astounding 7.0 million—by far the worst deterioration since the second World War. A marginal increase in the labor market participation rate likewise pushed the headline jobless rate to a quarter-century high of 9.4 percent, and a drop in Average Weekly Hours suggests that employers narrowly avoided layoffs by giving workers fewer hours. While the smaller-than-predicted jobs loss is encouraging, the economy is not quite out of the woods yet—not by a long shot. Yet economic stagnation hardly precludes a sustained and noteworthy US Dollar recovery through near-term FX trading.

The US economic calendar promises far fewer top-tier releases in the days ahead, but what it lacks in quantity it compensates with substance. Foreseeable highlights will come on historically market-moving Advance Retail Sales data, University of Michigan Consumer Confidence survey results, and international Trade Balance figures. NFP numbers showed that the US consumer lost fewer jobs than feared through the month of May, but the sizeable loss still bodes poorly for downtrodden household spending rates. Given the combination of massive wealth destruction and near-catastrophic jobs losses, the historically voracious US shopper cut back on Retail spending by a sizeable 9.4 percent through the 12 months ending in April. Median Bloomberg forecasts call for a 0.5 percent uptick in spending through May, but such predictions are mostly based on double-digit increases in gasoline prices and not a real recovery in aggregate demand. University of Michigan Consumer Confidence and Trade Balance forecasts are relatively sanguine, but they are less likely to force major US Dollar moves than the Advance Retail Sales report.

Far more significant, it will be critical to monitor FX trader sentiment and whether or not we truly hit a US Dollar bearish extreme. We recently argued that sizeable gains in US Dollar short positions seen through COT report were enough to bring a USD reversal. Yet we were probably a couple of weeks too early on that call, and this author’s trading account suffered accordingly. More recently we have seen similar extremes in Forex Options markets, and signs for a true US Dollar bottom have become increasingly difficult to ignore. As it stands, we would argue that the downtrodden US currency is likely to continue its late-week recovery against the Euro, British Pound, and other key currencies.

Euro May Fall Further If Data Signals Need for Additional ECB Action

Fundamental Outlook for Euro This Week: Bearish

- Euro Zone retail sales were slightly better than expected, suggesting economy may be stabilizing
- Euro Zone Q1 GDP was revised down to an annualized -4.8% from -4.6%
- ECB keeps rates at 1.00%, but leaves door open to further cuts

The euro ended the week down against the US dollar, but the bulk of the pair’s decline occurred on Friday following the release of better-than-expected US non-farm payroll results. Indeed, EUR/USD plunged about 200 points and closed below trendline and psychological support at 1.4000, suggesting that from a technical perspective, additional declines may be in store for the pair. There is also potential for EUR/USD declines from a fundamental perspective in light of the European Central Bank’s (ECB) recent meeting.

The ECB left rates unchanged at 1 percent, and ECB President Jean-Claude Trichet’s subsequent press conference initially offered some support for the euro, as he called current rates “appropriate” and said that recent data suggest that the Euro-zone recession may have bottomed during the previous two quarters. However, during the Q&A session, Trichet said that rates aren’t necessarily at their lowest level, suggesting there may be room for additional rate cuts. He also went on to say that the ECB will begin their 60 billion euro covered bond purchasing program in July, and will buy bonds directly in the primary and secondary markets. While the “credit easing” program is relatively small compared to those implemented in the UK and US, it is at least a start and creates potential for lower yields.

Looking ahead to next week, the Euro Zone’s economic calendar will look relatively light. Sentix Investor Confidence is anticipated to improve slightly to an 8-month high of -31 for the month of June from -34.3, as European equity markets have steadily climbed higher. Meanwhile, the German Trade Balance and Industrial Production readings for the month of April are likely to reflect the impact of weak export demand from the nation’s trading partners, as the trade surplus may narrow to 9.3B euros from 11.3B euro, while industrial output could shrink an annualized 20.5 percent. The final German CPI figures aren’t anticipated to reflect any revisions, but that would still leave the annualized rate of inflation at zero, signaling deflation potential. Finally, the ECB’s Monthly Report may not shed much more light on the ECB’s policy bias, but traders should still keep an eye out for surprising comments as they could easily shake up the euro upon release.

Yen the Default Counter Currency as Fundamentals Fail

Fundamental Outlook for Japanese Yen: Bearish

- Risk appetite stalls at multi-month highs as a dense wave of data passes
- Capital spending drops the most since records began in the first quarter
- How much momentum does Friday’s USDJPY posses? Read the weekly technical forecasts

It is no surprise that the Japanese yen has been on the short-side of so many trades over the past few months. Risk appetite has swept over the markets as optimists jump on the promise of ‘green shoots’ developing from the worst global recession in decades. However, what has been the yen’s part in this shift. It would be easy just to label the currency’s depreciation a sign of its carry currency role - though this would not be altogether correct. Through the financial crisis, capital flows naturally reversed course as large market participants unwound their extensive carry positions. Given enough time, however, this trend would naturally exhaust itself; and then the yen’s appreciation would depend on its role as a safe haven – a role never fit well. Prospects of a particularly severe recession and another decade of struggling with deflation certainly do not paint the picture of an ideal refuge from a financial storm. Now, with optimism picking up and investors able to exercise discretion in their investments; they can take a more critical analysis of the currency and its economy. The ultimate consensus on the standing of the yen from both a fundamental and sentiment perspective can be seen in the sharp sell off against the dollar (another safe haven currency) after a round of ‘better-than-expected’ US employment figures.

So, from the yen’s weakness against high-yielding and other similarly-predisposed safe haven currencies; we can deduce that the Japanese currency is met with headwinds should risk appetite rise or fall. However, as sentiment pushes to extremes, the yen will once again fall into safe haven role. This leaves us to speculate on how risk appetite will fair next week and what will be the intensity of the bias. That is the 64 thousand dollar question for a market that is so highly correlated. The standard barometers for sentiment (equity indexes, yield-heavy currency pairs, etc) have all stalled this past week. This pause was likely in observation of the heavy round of economic releases from interest rate decisions to GDP revisions to employment data. Looking ahead, there are many of these market-wide indicators. A potential dampener may be the G8 meeting in Italy scheduled for Friday and Saturday. The collective forecasts and plans of action could discourage wild shifts before the details of the gathering are released; and the event could spur the market itself given the right commentary.

In searching out the catalysts for and pace of market sentiment, we should not disregard the impact of native economic data on the battered Japanese yen. Just a short time ago, both the Cabinet Office and Bank of Japan released forecasts that called for the pace of the nation’s recession to ease going forward. This aligns itself to what other policy authorities have said and a few bright spots on the economic calendar; yet it is still a bold prediction. Skepticism will remain until objective data can confirm what the economy’s cheerleaders have professed. The most thorough measure of health next week will be the final reading of 1Q GDP, which will no doubt confirm the worst slump on record. The more timely indicators could bolster sentiment though. The trade balance, Eco Watchers survey, consumer confidence survey and leading indicators index are all expected to show measured improvements next week. This round of data will be good for minor adjustments on long-term trends; but don’t expect them to generate much in the way of volatility on their own.

British Pound at the Mercy of Risk Appetite as Fundamentals Crumble

Fundamental Outlook for British Pound: Bearish

- Bank of England keeps rates unchanged at 0.25% and quantitative easing bill at 125 billion pounds
- Consumer confidence, manufacturing activity and mortgage approvals hit their highest levels this year
- Is GBPUSD’s plunge a temporary reversal or trend revival? Get the technical read on price action.

Up until the second half of this past week, the British pound was enjoying a steady and aggressive rally against its US counterpart. However, a 22 percent rally in as few as three months with fundamentals like the United Kingdom’s is clearly a reason to be skeptical. The nearly 700-point drop over the final three days of the trading week is far from confirmation of a trend reversal; but it should be enough of a jolt to remind market participants that Europe’s largest economy is pacing the global recession and financial conditions are balanced on a knife’s edge. Looking ahead to next week, there is likely to be short-term volatility from scheduled economic releases and a close eye kept on the stability of the government’s upper echelons; but sterling traders’ real guide will be risk appetite.

How is it that the currency of an economy that is expected to suffer the worst economic contraction in the industrialized world, has ongoing troubles with credit and financial conditions, and is now seeing political turmoil has been able to produce such an impressive rally across the board? There is the argument that the currency was oversold and that the fundamental outlook for the UK has perhaps reached an equilibrium with its major counterparts. However, this is a fundamental consideration that would take considerable time to develop. The only way a currency as fundamentally depressed as the sterling would be able to appreciate so rapidly is through a sharp turn in global growth and financial condition forecasts. The appetite for capital appreciation is fulfilled through speculation that the currency was oversold. Fundamental forecasts improve as the aggressive steps policy officials took to revive the economy would help leverage the ensuing recovery. And, yield forecasts are massaged as the MPC would be expected to reign in their quantitative easing and immediately concentrate on inflation. Is it reasonable to project such an aggressive turn in sentiment and the particular influence it should have on the pound? We seen signs around the global that the pace of recession is letting up; but that is not the same thing as a return to positive growth. To maintain a rally an advance in risk appetite, we need irrefutable evidence of a near-term economic recovery. Otherwise, speculative capital is merely building a bubble that prevailing levels of risk and return cannot support

Closer to home, sterling traders will have to concern themselves with key data releases and politics. The latter subject has hit a fever pitch over the past few weeks. While the public has long held the government responsible for the economy’s current economic woes (or at least its severity), the tumult has not reached the level where resignation has been considered – until now. Local elections have shown an irrefutable lack of confidence in sitting members and Prime Minister Gordon Brown has been forced to shuffle his cabinet. However, market participants are concerned primarily with the major players in the economic crisis - the PM himself and Chancellor of the Exchequer - whose absence could derail the progress that has been made to this point. To gauge the market’s sensitivity to such a possibility, we merely need to see the sharp drop in the pound when rumor (which had to be officially dismissed by the government) that Brown would soon announce his resignation. As for data, the docket is thin but potent. Consumer spending will be measured through the BRC’s retail sales for May. Though expectations are low. For factory activity, the plunge in industrial production has eased significantly through first quarter; but we are still waiting on the first positive reading in 14 months. Housing price indicators and trade figures will round out the picture with indirect appraisals of credit availability and foreign demand.



Written by David Rodriguez, Terri Belkas, John Kicklighter, Ilya Spivak and David Song, Currency Analysts
Forex Trading Weekly Forecast - 06.08.09