The FX Week Ahead

11/10/2008 10:03 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

More Bad News on the Global Recession

The global growth outlook continues to deteriorate in an accelerating fashion, and it's now evident that growth in the major economies plunged sharply over the last two months. The IMF, in its latest forecast, now foresees recessions for the G7 economies into 2009, with no sign of any recovery until late next year, and possibly not until 2010. US data this week saw the ISM manufacturing and service sector PMI's drop to clearly recessionary levels. Friday's October NFP report, including revisions, revealed that the US economy has lost more than 1.2 million jobs so far this year, with nearly half of those losses coming in the last three months alone. Data and outlooks from the UK and Europe are equally dismal, prompting an aggressive rate cut of 1.5% from the BOE and a more tepid 0.5% from the ECB, with assurances of more to come. Bottom line: The 4Q looks to be a complete debacle for the major economies. Additional interest rate cuts from the Fed, BOE, ECB, and RBA are coming, but with credit constrained by a hobbled banking sector, lower rates are unlikely to stimulate consumer spending any time soon.

With simultaneous downturns in the world's largest economies, there are few apparent trends to anticipate in the currency sphere. Relative growth outlooks will continue to drive near-term FX developments, with markets looking to divine which economy is faring less badly relative to others' weakness. Interest rate expectations have effectively ceased to drive currency values. Rate cuts are now viewed as a currency positive because they represent attempts to stimulate the economy and prevent further weakness. That was one reason GBP actually strengthened immediately following the much larger than forecast BOE rate cut, as did AUD shortly after the RBA also cut more aggressively than expected. Most important in the near term, stock markets appear set to continue to drive overall currency moves, with the primary relationships being a positive link between JPY crosses (e.g. EUR/JPY or AUD/JPY) and stocks (i.e. stocks up, JPY crosses up and vice versa) and an inverse relationship, mostly, between the USD and stocks (i.e. stocks up, dollar down). I still think the USD has a significant risk premium attached to it, meaning some of the dollar's current strength stems from disarray in broader financial markets. If market conditions can stabilize further, I would still expect to see USD strength fade. But stock markets are clearly still fragile, as evidenced by a roughly 10% decline in US shares in anticipation of today's US NFP, followed by a paltry 2.8% rebound after the fact.

FX Consolidates, but a Breakout May Be Looming

Major currencies are finishing the week largely unchanged from week-ago levels, but after undergoing intense short-term volatility. Consolidation ranges have developed in most pairs and in other markets as well. In EUR/USD, a sideways triangle is apparent within a larger potential bear flag channel. The triangle top is at 1.3030 and declining, while the triangle/bear flag bottom is at 1.2660 and rising. A break to the downside would likely signal a resumption of the down move in EUR/USD. A break of the upper end of the triangle would likely see gains to the upper end of the potential bear flag, which is currently at 1.3550, but rising. A break of the triangle is expected sometime before Wednesday (11/12). In USD/JPY, a test above Ichimoku resistance (Kijun line) was short lived, and USD/JPY is now back in between the Tenkan (96.52) and the Kijun (98.54) lines. However, the Tenkan line has begun to turn up and a bullish crossover may come as soon as next week. I look for a daily close over 98.50/60 to trigger additional gains into the 102.50/103.00 area. EUR/JPY has established a wide sideways channel between roughly 131 and 122.50, with similar sideways channels forming in other JPY crosses. Not surprisingly, those JPY cross channels mirror a channel in the S&P 500 that extends from about 850 to 1000. Also worth noting are potential double tops within the rebounds in stocks (1000) and the JPY crosses (EUR/JPY 131.00). The combination of deteriorating fundamental outlooks and the chart patterns observed make me predisposed to further downside volatility in stocks, JPY crosses, and EUR/USD, conceivably from the start of next week.

Some Credit Measures Improve, but Concerns Remain

Credit measures improved overall this week despite a tumultuous US stock market. The TED spread (three-month Libor/three-month T-bill) plunged -60 basis points from last week's levels to 198 bps. The two-year SWAP/two-year T-note meanwhile fell about -12 bps and is sitting near the 110 bps mark. The fact that the TED spread is now below 200 bps (and down more than -265 bps from the nearby highs) and that SWAP spreads are near 100 bps (down -60 bps from the highs) is very encouraging and suggests that the credit freeze in interbank lending is thawing. That said, under normal credit market conditions, both measures should approach 50 bps—so we still have a ways to go.

While the interbank lending market looks to be easing, concerns remain in the corporate credit market. The spread between Baa corporate bonds and US ten-year treasuries remains extremely elevated. While the metric has pulled back modestly in the latest week to about 548 bps, it is up a whopping 94 bps in the last month and barely -20 bps off the nearby 570bps highs. This means companies remain hard pressed to find funding and are forced to offer higher rates of return in exchange. We need to see this metric come back to a more normal 250-300 bps zone before sounding the all clear on this front.

Given that most short-term commercial paper is used to fund everyday needs such as payrolls and bills, this is a bad sign for future employment trends. The US has already shed 1.2 million jobs this year, with more than half of these coming in the last three months alone. Worsening corporate credit markets would put any US economic recovery on hold for quite some time and add upside risk to already bleak estimates for unemployment above 8.5% in 2009.

Key Data and Events to Watch This Week

The US economic calendar is just modestly busy, but has some important data on tap. The action doesn't start until Thursday when we get the trade balance, weekly initial jobless claims, crude oil inventories, and the monthly budget deficit. Friday is big with import prices, consumer confidence, business inventories, and the all-important retail sales report due out. There are also plenty of speaking events lined up and Treasury's Kashkari speaking on the TARP program on Monday is the highlight.

The euro zone sees a ton of top-tier data next week. Monday kicks things off with French industrial production and EZ investor confidence. Tuesday has the EZ and German ZEW surveys, while Wednesday sees EZ industrial production. Thursday is very important as we get German GDP, French consumer prices, and the French consumer account. Friday is even bigger with German consumer prices, French employment, French GDP, EZ consumer prices, and EZ GDP. There are also various ECB speakers on tap, with Trichet on Monday, and Weber on Thursday as the main events.

Japan's week looks a little busier than usual. Sunday evening starts things off with machine orders, while Monday has the trade balance and current account lined up. Wednesday has consumer confidence and domestic CGPI due out. Thursday rounds out the week with industrial production and machine tool orders. The BOJ's Nakamura is due to speak on Thursday as well.

The UK has a pretty light week ahead. Monday gets the ball rolling with producer prices. Tuesday has the BRC retail sales monitor, trade balance, and home prices all on tap. Wednesday closes out the week with the key employment report. Be sure to look out for the Bank of England Quarterly Inflation Report on Wednesday also.

Canada has a light week lined up as well. Housing starts and home prices kick off the action on Monday. International trade is due on Thursday, and manufacturing shipments and motor vehicle sales are up on Friday.

Last but not least, it is a relatively busy week down under. Monday has Australian home loans and investment lending, along with New Zealand producer prices. Tuesday sees Australian business confidence, while Wednesday has Australian consumer confidence along with New Zealand business PMI and retail sales. Thursday closes out the week with Australian consumer inflation expectations and average weekly wages. Also watch out for the Australian Reserve Bank Quarterly Monetary Policy Statement on Monday, and the New Zealand Reserve Bank Financial Stability Report on Tuesday.

By Brian Dolan of

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