Forex Trading

US Dollar Forecast Bearish on Clear Downward Momentum

Fundamental Outlook for US Dollar: Bullish

- US Dollar hits new lows, but do fundamentals support declines?
- Greenback falls against Euro for six consecutive trading days
- Forex sentiment points to further US Dollar declines

The US Dollar dropped like a stone on its way to fresh 2009 highs against nearly all major forex counterparts, breaking its long-standing trading range against the Euro in fairly dramatic fashion. The first full week of post-summer trading finally brought the sustained price moves we have long been waiting for. FX Trading volume increased notably through mid-week trade and fueled US Dollar losses, but fundamental “justification” for renewed US Dollar weakness was far less clear. According to FXCM execution desk data, open interest in the Euro/US Dollar jumped by as much as 20 percent before the week was through. A busy economic calendar in the week ahead suggests that the US Dollar may remain volatile, and it will be critical to see whether its recent downtrend may be sustained.

Demand for the safe-haven US Dollar dropped sharply on the week as the US S&P 500 and other major risk barometers reached fresh year-to-date peaks, and overall momentum favors USD losses. Indeed, forex options markets show that option traders are betting on further US Dollar weakness against almost all major counterparts. Yet those same options prices show short-term volatility expectations have dropped to their lowest levels in the past year. The fact that US Dollar weakness has not coincided with a general rise in forex volatility expectations suggests that currencies could return to sideways trading, but this will likewise depend on developments in financial market risk appetite. The 20-day correlation between the Euro/US Dollar and S&P 500 currently trades almost exactly at record-highs.

To that effect, traders should keep close tabs on S&P 500 reactions to the coming week of key US event risk. Highlights will likely include the historically market-moving Advance Retail Sales, Consumer Price Index, and Treasury International Capital System reports. Consensus forecasts call for a noteworthy pickup in domestic Retail Sales, but the expected surge is mostly a function of the highly-publicized “Cash for Clunkers” program that strongly boosted Auto Sales. Traders should instead watch for surprises out of the “Ex Autos and Gasoline” figure—predicted to gain a paltry 0.1 percent on the month. If numbers prove better than expected, the S&P will likely rally and the US Dollar may actually decline.

The following day’s Consumer Price Index numbers are less likely to force major US Dollar volatility, but traders should nonetheless keep an eye out for any especially large deviations from consensus expectations. The true fireworks may come on subsequent Treasury International Capital System (TICS) data. Analysts have long argued that massive US fiscal deficits could harm the US Dollar as the government floods markets with debt securities. Yet recent data shows that foreign demand for US Treasury bonds remains robust, and the US Dollar has thus far averted disaster. It remains important to watch for continued demand for Treasuries, and any disappointments could further fuel dollar losses.

Momentum plainly favors further US Dollar weakness, but key event risk in the week ahead could prove pivotal in deciding near-term direction for the downtrodden currency.

Euro Fundamentally Weak but Still the Dollar’s Counterpart

Fundamental Forecast for Euro: Bearish

- Consistent policy hawk Axel Weber says current rates are ‘appropriate’ and positive growth could be protracted
- Risk appetite weighs on the dollar and invariably bolsters EURUSD
- Momentum must be called into question with EURUSD extending yet another leg of its six-month advance

There are two general assessments of the euro: the strength of the currency of its own accord; and how it is performing against the benchmark dollar. This past week, the euro was actually depreciating against most of its liquid counterparts; yet the market was largely focused on EURUSD – and for good reason. The most liquid currency pair in the market, enjoyed another burst of momentum this past week easily clear 1.45 and set a new high for the year in the process. To discern whether this trend will continue or collapse through the immediate future, we need to discern the fundamental drivers behind the pair and individual currencies. And, it is important to note that these are two separate concerns. There are certainly a range of scheduled economic releases to take account of and the media is keen on attributing each fluctuation on readily available long-term fundamental concerns; but to develop a real sense of the current trend, we need only look to risk appetite.

When we think of currency pairs with a specific connection to investor sentiment, EURUSD rarely comes to mind. It is true that there are pairs with a far greater sensitivity to risk trend due to economic disparity, interest rates potential or other popular measures (like NZDJPY or AUDUSD); but this pair nonetheless retains a clear link to the underlying current. Being the most liquid pair in the market has its advantages. When demand for yield is on the rise, capital is drawn away from the US (which built up through the panic of the past financial crisis in the search of a safe haven) and reinvested elsewhere. Still cautious, investors will not seek out emerging markets or other high return / high risk options but rather a stable investment with a greater potential for return. Naturally, the ECB’s yield advantage, the hawkish lean of its monetary policy authority and the fact that its largest member economies actually grew through the second quarter are all favorable qualities. In turn, EURUSD’s trends follow the bearing on risk; but it manages to filter out a lot of the volatility that is common to some of the yen crosses and other highly active pairs.

Defining the relationship between currency pair and broader market is easy. Trying to speculate on the pace and direction of market sentiment is far more complicated. Looking at the collective influence of the economic calendar; there are few pieces of scheduled event risk that can single-handedly sway broader risk appetite to accelerate or reverse. However, with fundamental forecasts muted and interest in the steady advance cooling; it seems a matter of ‘when’ rather than ‘if’ speculative trends capitulate to solid economic potential.

The all-consumer, elemental trend will no doubt define direction over the coming weeks and months; but that isn’t the only concern for the fundamentally inclined. Event risk traders will have a dearth of indicators to wring volatility from. There are a few general themes to be found in the data scheduled for release over the coming week. Rate watchers will monitor consumer-level inflation data as a recovery from the headline, year-over-year reading could revive the ECB’s hawkish conviction after the authority poured water over speculation of imminent hikes by suggesting they would support growth (no doubt with G20 influence factoring in). The German and Euro Zone ZEW investor sentiment surveys are essentially forecasts from one of the most vested and reactive groups in the economy. A steady improvement is expected here; but where they find this boost is what will really be interesting. Other readings (including Euro Zone industrial production, trade and construction activity) will factor in on the long-term growth outlook; but likely come up short for volatility.

Japanese Yen Attuned to Risk Aversion, But What about the USDJPY?

Fundamental Forecast for Japanese Yen: Bullish

- Final reading on 2Q GDP reports a smaller than expected 2.3 percent pace of expansion
- Cabinet Office says “economy is showing movements of picking up” and lists record unemployment as a difficulty
- Is USDJPY oversold after this past week’s plunge to seven-month lows?

After a strong surge in risk appetite through much of the week, the market finally broke from momentum this past Friday. However, we can’t call this stall a reversal – at least not yet. Gauging the overall sentiment in the market, we find that the benchmark Dow is just off 10-month highs, the dollar set a new low for the year and money-market funds are at their lowest levels since late October of last year. All signs are still pointing to a healthy appetite for yield with relatively little concern for market disruptions. However, the fundamental quality of this rally looks more and more bleak when compared to the fresh highs these assets reach with each week. How far can this divergence extend? That depends on how stable risk appetite is.

There is little doubt that a demand for capital returns is leading the markets higher. For those assets that are considered low-risk or risk-free, we can see yields are still brushing recent historical lows. With the risk-premium of a possible financial crunch left out of the equation, we are left with a reflection of growth potential and an outlook for benchmark lending rates. Considering the generally accepted forecast for a protracted and choppy recovery, it is no wonder that the rate of return is so low. In contrast, capital markets have measured a six-month advance that has paid off with capital gains for earlier adopters. However, when expectations for steadily appreciating speculative securities dies down, we may very well see a wave of profit taking that gathers more momentum than the advance that brought us to our current highs. How long can sentiment build on itself? That is impossible to tell. There is – theoretically speaking - enough fuel to keep the trend going until the fundamental backdrop improves. The money that has been sidelined in Treasuries, money markets, savings accounts and other low-risk coves is only a six to eight month off the highest levels seen in recent memory. For scale, the ICI Investment Company Institute’s measure of total assets in money market funds was at $3.54 trillion at the close of last week – less than 10 percent off its January highs. On the other hand, the limited drawdown in safety funds to this point suggests caution is still the rule of thumb. After a record collapse in cumulative wealth after last year’s financial crisis; it wouldn’t take much to cut the flow of capital from the sidelines off and encourage speculators to take profits.

Another consideration for yen traders that perhaps does not receive enough attention is the unwavering correlation between the Japanese currency and risk appetite. The Japanese yen has retained its status as the primary safe haven currency among the majors thanks to the abundance of funds in the country and a forecast for interest rates being held near zero for far longer than other countries that are just waiting for inflation to perk up and growth stabilize a little more. In the background, though, the Japanese economy will struggle to recover from its record recession and the damage to its already weak financial markets can be long-lasting. Already, we can see that many of the yen crosses are still carving congestion well off recent highs despite the fact that equity benchmarks are climbing higher.

The yen’s link to risk is particularly important for USDJPY. The dollar was considered a safe haven through the worst of the financial crisis thanks to the liquidity and securities of US Treasuries – and yet, the yen maintained its negative correlation to risk trends even against the greenback. It is unusual then that over the past four weeks, USDJPY has steadily plunged nearly 800 points when risk appetite has invariably risen. Long-term risk appetite, policy views (the Japanese want cheap exports) and interest rate forecasts (the Fed has put a hold on rates to mid-2010, but the BoJ hasn’t even discussed hikes) all favor the dollar over time. But, in the meantime, the benchmark three-month US Libor rate is at its lowest level on record – and subsequently at a discount to its Japanese counterpart.

British Pound May Falter on Signs of Falling CPI, Widening Fiscal Deficits

Fundamental Forecast for British Pound: Bearish

- UK industrial production was stronger than expected, showing the first back-to-back increase since September 2006
- The nation’s trade deficit narrowed in August thanks to a 5 percent rise in exports
- The British pound rallied after the Bank of England left rates, QE stance unchanged

The ascent of the British pound against the US dollar over the past week suggests that the currency has experienced broad strength, but this certainly was not the case. In fact, the British pound fell roughly 1.3 percent against the New Zealand dollar, dropped 0.9 percent against the Japanese yen, and slipped a slight 0.3 percent against the euro. Furthermore, the British pound was second only to the greenback in being the weakest of the majors over the past month, with GBPJPY having plunged almost 5 percent. Overall, despite recent improvements in economic data, the combination of the Bank of England’s liberal quantitative easing stance and bleak outlooks regarding the fiscal health of the nation creates significant bearish pressures for the British pound. That said, this isn’t incredibly apparently in GBPUSD, but is more easily seen in pairs like GBPJPY and EURGBP. This could change in the coming week though, as GBPUSD ran into falling trendline resistance drawn from the July 2008 highs at 1.6735.

Looking ahead to next week’s event risk, the UK’s consumer price index (CPI) reading for the month of August is expected to rise 0.3 percent, but the more important part of this report is that the annual rate of growth, which is more closely watched by the Bank of England, is forecasted to fall to 1.4 percent, the lowest since October 2004, from 1.8 percent, keeping inflation within the central bank’s acceptable range of 1 percent - 3 percent, but below their 2 percent target. If CPI falls more than projected, the British pound could pull back sharply as the markets will anticipate that the BOE will expand their quantitative easing efforts even further before year-end. On the other hand, if CPI holds strong – which seems possibly in light of the rise in both input and output produce prices - the currency could rally in response.

Other notable releases include UK jobless claims, which are projected to have risen for the 18th straight month in August, this time by 25,000. Adding to this potentially disappointing result, the ILO unemployment rate could rise to 8.0 percent, the highest since November 1996, from 7.8 percent, which would not bode particularly well for the consumption outlook. This point may be highlighted by the UK retail sales report, which is only forecasted to rise by 0.1 percent. This indicator only tends to be market-moving upon large surprises, though, and a reading in line with expectations shouldn’t shake up trade too much. Finally, public sector net borrowing is expected to rise by another 17.6 billion pounds, which will only add to evidence that the nation’s fiscal health is rapidly deteriorating and suggesting that risks are growing for a downgrade to the UK’s AAA credit rating.



Written by David Rodriguez, John Kicklighter, Terri Belkas, Ilya Spivak, John Rivera and David Song, Currency Analysts
Article Source - Forex Weekly Trading Forecast - 09.14.09