Consolidation Setting in, but Continue to Favor USD

08/25/2008 12:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The USD made fresh new highs early in this past week, but was unable to sustain the gains, and now a consolidation phase appears to be setting in. The economic fundamentals largely supported those moves, with European data coming in steadier than expected and US data presenting worrisome elevated jobless claims, weaker housing, and a larger than expected drop in the index of leading indicators (mainly due to the drop in building permits). We know the US housing sector remains mired in weakness and that the new home segment is the weakest of this weak sector, so there should be no surprises. The jury is still out on the reliability of weekly jobless data due to extensions to unemployment eligibility passed in early July, but we also already know that the US labor market was soft, just not as bad as in prior downturns on a population adjusted basis.

Net-net, the US outlook continues to point toward likely stabilization while growth outlooks elsewhere continue to erode. We will get some important forward looking data out of Europe next week (IFO, GFK and EC sentiment gauges) which is likely to augur further weakness ahead. We'll also get some backward looking US data (first revision to Q2 GDP) and a slew of housing reports. On balance, the data should continue to offer optimism on the US outlook, though with a somber tinge of uncertainty remaining. Jake Oubina provides a more in-depth update on this theme below. These are the types of environments that frequently lead to periods of consolidation, but the unfolding big picture continues to favor the USD resuming its abrupt reversal higher.

Technically, EUR/USD looks to have formed a bear flag channel, a countertrend consolidation pattern, with the base at 1.4730/40 and rising, and the top at 1.4930/40 and rising. A drop below the base of the channel suggests the down move is resuming, with a measured move objective of about 300 pips to target 1.4430/50. Thursday's pullback in the USD saw daily closes below the Ichimoku Tenkan lines (the fastest indicator in the system) for many USD pairs (AUD/USD and EUR/USD finished above), suggesting the USD upward move was potentially reversing. Friday's price movements, however, completely reversed the USD pullback, and the USD closed back above the Tenkan lines (EUR/USD and AUD/USD below) signaling the USD upside was back in play. Weekly candlesticks in EUR/USD show a long tail to the upside, signifying rejection of attempts to rally. Also, EUR/USD came close but could not touch the 55-week moving average at 1.4919. GBP/USD posted a bear engulfing pattern on Thursday and Friday and the obvious breakdown level in GBP/USD is at 1.8500. Weekly USD/JPY has a similar long tail to the downside, signaling rejection of attempts to sell it lower and the upside breakout level is at 110.50/60. Strength above there is likely to see a rapid follow-through to near 112.00.

Commodity Rebound Is a Bounce to Sell on

Closely linked to the goings on for the USD are developments in commodities. In case you have not been following the chicken-and-egg trading patterns between gold, oil, and the USD, it's easy to be confused by which is leading which at any given moment. Oil traders point to USD gains as a reason to sell oil, while FX traders point to oil dips as a reason to buy USD. Gold traders are watching both FX and oil, and we're all watching gold as well, but keep in mind that commodities started this whole move lower and the USD has mostly followed. Still, that is not to say the USD cannot also break out and wear the yellow jersey (Tour de France) for a day or two. The pullback in the USD on Thursday was presaged by a bounce in commodities on Wednesday and follow-through gains on Thursday. Oil led the way by closing above its Tenkan line on Wednesday evening, but then it ran into the next Ichimoku resistance line (Kijun) which sent oil plunging back down to close below its Tenkan line. Those sharp whipsaws are further evidence that we are in a bear market for commodities and a new bull phase for the USD.

In case you have been following the debate about whether commodity price increases have been driven by demand or speculation, I would suggest oil price gains into the $80/bbl area represented fundamental demand increases, but that most of the gains since then have been driven by speculation. Over the last several weeks, it has become commonplace to see 3-5%+ daily ranges in oil and other commodities, with oil gaining 5% on Thursday and then losing nearly 6% on Friday. Prices don't fluctuate like that when it's just supply/demand driving the boat. The other element to keep in mind when looking at commodities and the USD is that global growth is slowing, and this is a trend that is likely to continue. Fundamentally, slower global growth will reduce commodity demand and bring prices down. That brings us back to an answer to the chicken-and-egg question-it doesn't really matter which is leading-just keep looking for suitable levels to sell commodities on bounces and to buy USD on dips. A daily close in WTI oil below its 200-day moving average at 110.69 should see quick follow-on drop through the psychologically significant 110.00 level and target weakness toward $100 initially.

Status check: The US vs. the Rest

Our developing theme that economies abroad continue to worsen while US fundamentals show signs of stabilization rang true once again this past week. This is part and parcel of our fundamentally bullish USD view. Timely data out of the Euro zone showed economic sentiment and business activity continued on a downward path, while indicators in the US suggest this economy is merely treading water. The German ZEW survey of economic sentiment rose a touch in August, but the Q3 average remains at a horrible -59.7 from -44.8 in Q2, when the German economy printed a negative GDP. The Euro zone equivalent is averaging -59.7 in Q3 as well from a -47.0 read last quarter. Meanwhile, PMI manufacturing surveys came in below the expansionary 50 level in August. French PMI fell to 45.1 from 47.1, German PMI dipped to 49.9 from 50.9, and the Euro zone measure came in at a paltry 47.5 for the month. These relatively timely indicators all suggest a Euro zone economy that is in the dumps.

US data was pretty much in line with an economy just chugging along, albeit at a low pace. Housing remains weak as suggested by the steady but low 16 print in the National Association of Home Builders index and lackluster housing starts numbers, which declined to 965K from 1084K in July-though much of this was a correction from the prior month's read, which was distorted and propped up by a change in New York City's zoning laws. The overall trend for housing starts over the past six months has been relatively steady and suggests a bottom is in the offing. The US job market continued to look stagnant, with initial claims running at 432K in the latest week, a touch lower than the 445K print previously. The jobs data have not deteriorated of late though and claims still remain well below the 500-510K "recession" threshold. So while the deterioration in the Euro zone is palpable, US data was pretty much steady as she goes.

The weakness abroad not only will help the relative attractiveness of US investments and the US dollar, but also looks poised to stop the commodity bull market in its tracks. Consider that US demand destruction helped tip oil prices from an all-time high near $147 towards just below the $115 mark currently. Further slowing in the growth of overseas economies would have a detrimental impact on many other extended commodity prices as well. We believe this slowing is for real, and as such, modest rallies in commodities are likely to prove to be just blips within the larger move lower. The end of the commodity bull-run would benefit the USD quite a bit on the follow as the inflation hedges come off (i.e. lower gold prices) and the buck is given a psychologically important boost.

Key Data and Events to Watch Next Week

The US economic calendar is bustling next week with a number of top-tier indicators on deck. The week kicks off Monday with existing home sales. Tuesday is a busy one, as we'll see consumer confidence, new home sales, and the minutes of the August 5 FOMC meeting. Wednesday has durable goods, along with a speech on inflation from Atlanta Fed President Lockhart. Thursday sees the usual weekly initial jobless claims and the preliminary Q2 GDP numbers, which are expected to see a substantial upward revision. Friday ends the week on a busy note, with personal income/spending, core PCE, Chicago PMI, and University of Michigan confidence all due up.

The Euro zone calendar is also very busy, and kicks off on Tuesday with German GDP, German GfK consumer confidence, French housing starts, and German IFO surveys. On Wednesday, only German import prices are due up. This will be followed by German employment stats and a speech by German finance minister Steinbrueck, both on Thursday. Euro zone unemployment, Euro zone CPI estimate, Euro zone confidence surveys, and German CPI will round out the week on Friday.

Japan is relatively light next week. It starts off with employment data, consumer prices, industrial production, and retail trade on Thursday. Housing starts and small business confidence close out the week on Friday. Other notable events include speeches from BOJ governor Shirakawa on Monday, and BOJ board member Suda on Thursday.

Not much going on in the UK either. Notable data include BBA home loans on Tuesday, and nationwide home prices, GfK consumer prices, and the CBI distributive trades report (a retail sales survey) on Thursday.

Canada is also very light, and kicks off with the current account data on Thursday. Industrial product prices and the monthly GDP report round out the week on Friday. Recall that last time around, Canadian GDP surprised to the downside. We would expect that a similar outcome would see sharp losses in CAD.

Last but not least, it is modestly busy down under. New Zealand has trade balance data scheduled for Monday. Tuesday sees RBNZ inflation expectations, followed by business confidence on Wednesday. Thursday has Australian leading indicators and New Zealand building permits on tap. Friday rounds out the week with Australian private sector credit and new home sales.

By Brian Dolan and Jacob Oubina of

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