USD Reversal Lower May Be Unfolding

12/15/2008 10:02 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Last week, I suggested that market sentiment was subtly improving, as stock markets shrugged off weak data and plodded on to modest gains. I viewed the emerging stabilization in shares as an indication that safe-haven demand for USD was diminishing and that the greenback was likely to weaken, with JPY crosses set to benefit. This past week's price action delivered just such USD weakness and JPY cross strength, and I look for additional USD weakness in coming weeks. However, it's important to note that the weakness in the USD was primarily concentrated against the EUR, and less so against other major currencies, such as AUD, NZD, and GBP, which makes some of the USD weakness suspect.

But the fundamental basis for a weaker USD remains (stabilizing stock markets, diminishing repatriation flows, moderating risk aversion), and that suggests that other currencies (AUD/USD, NZD/USD, GBP/USD) are likely to play catch-up next week. Importantly, traders should note that USD weakness against the JPY seems less likely if risk appetites continue to improve, so I would expect to see more pronounced JPY weakness across the board in coming weeks. Friday's announcement from the White House that it will support the use of TARP funds to aid struggling US automakers (see more below) is yet another positive (in the sense it's not negative) for sentiment, but is negative for JPY. Inter-market relationships will continue to drive FX, and I'll be watching both stocks and oil for indications of how much more the USD can fall.

Key Price Levels to Watch

Because the economic environment remains exceptionally weak, and market sentiment extremely fragile, a sudden shift to a weaker USD is by no means a done deal. Many significant technical levels are currently in play across a variety of markets, and I will be closely watching the following price points as mileposts to gauge the extent of USD weakness.

EUR/USD: Parabolic rally over 1.30/31 ran into major daily trend line resistance from the 1.60 highs at 1.3420 on Friday. That trend line falls to 1.3400 by Monday, so a daily close above 1.3400 sees potential higher to the 1.3600 area initially. EUR/USD is currently trading inside the Ichimoku cloud, and the top of the cloud comes in at 1.3598. Critical support is well below at 1.2950/80, but short-term support at 1.3250 keeps the immediate bias higher.

USD/JPY: Massive spike reversal higher from just above 88 likely signals a significant bottom for USD/JPY. Confidence will build on sustained strength over 92.30/50, opening the way to more significant trend line resistance at 93.50, which defines the decline from 106. The Ichimoku Tenkan line (fast moving average) is now at 91.22 and a daily close above will be an early warning sign of a likely advance.

GBP/USD: Cable drifted over major daily trend line resistance at 1.4870/80 and is currently trading above the Ichimoku Tenkan line at 1.4795. A daily close over 1.5178 Kijun line signals further gains are likely, with potential to the bottom of the cloud at 1.57/1.58 initially (the base of the cloud is at 1.6295 today, but falls sharply to 1.5736 by next Friday).

EUR/JPY: Tested above the Kijun line at 122.16 and trend line resistance at 122.30, but set to close below. However, spike reversal from 117.80 keeps the focus higher. Look for a daily close over 122.50 to target 125.50/126.00 initially, then 130/131 highs from October.

S&P 500: Major markets continue to take the lead from stocks, so watching share prices is as important as watching FX prices, especially for USD/JPY and JPY cross traders. The Tenkan line (868) has crossed above the Kijun line (846), generating a weak buy signal, but an inverted head and shoulders pattern continues to be viable while prices are above 810/815. Strength over 920 opens the door to the neckline around 1000/1010, a break of which would target back to 1250, which now seems surreally distant.

NYMEX crude oil: USD weakness is likely to fuel commodity strength, and vice versa, so it's important to watch oil as a proxy for commodities. Oil closed today right on trend line resistance at 46.69, which drops to 45.76 on Monday, but is set to close above the Tenkan line at 45.37, shifting the bias higher. Potential is now to gain and test the Kijun line above at 53.03 (falling).

Automaker Bailout to Dictate USD/JPY Price Action

The failure to pass the bailout package for the US automakers in the Senate sparked massive global selling of risk early Friday. The reaction in USD/JPY was a case in point. The pair plunged from a 91.45 Thursday close to a Friday low of 88.10/20 on the news that the plan had come apart at the seams. Since then, both the US Treasury and the Bush administration have offered to give support to the automakers despite the decision in Congress. The White House promptly released a statement early in NY, saying "A precipitous collapse of this industry would have a severe impact on our economy, and it would be irresponsible to further weaken and destabilize our economy at this time." While the ultimate economic severity of the impact is arguable, the market reaction to such a failure of the automakers is not. Consequently, USD/JPY is back to trading near the 91.00/50 zone on news that the Treasury will come to the rescue. So it is clear that the resolution of this issue has ramifications for the currency pair.

If the automakers receive the $14 billion handout, and with this are able to make it through the end of January, then they will be set up for the Obama administration to open up the taxpayers' wallets and tap some of the remaining $350 billion TARP money in an effort to keep the manufacturers out of bankruptcy for the foreseeable future. So the here and now resolution would be a bridge to further funding later, and as such is critical. The price action in USD/JPY will once again be dependent on the outcome here, and we expect a positive resolution should usher in a 200-300 pip rally in the pair. Failure to come up with some sort of bridge loan would likely see USD/JPY retest the overnight lows near term. The reversal on this type of move lower would also likely be fast and furious, however, as USD/JPY would be once again entering intervention terrain.  

The US Federal Reserve will decide on interest rates this upcoming Tuesday at 1415ET/1915GMT, and the market expectation is that they will cut rates -50 basis points to a meager 0.50% target. While this seems significant on the face of it, in reality, the effective Fed Funds rate (the overnight rate which is eventually negotiated between banks) is already trading well below that level. Indeed, the effective rate has averaged just 0.16% for the month of December thus far—well below the current 1.00% target. Thus, further reductions in the target rate (even all the way to 0%) are likely to elicit muted market reactions.

The press statement will as such be more valuable here. While the Fed is expected to remain of the opinion that the US economy is getting worse at a more rapid rate and that inflation is no longer a worry, the focus will be on whether they note any new upcoming initiatives to support financial markets. One of the measures that has been thrown around is the direct purchase of US Treasury securities by the Fed. This would result in a lowering of interest rates across the curve as the Fed would ultimately pay above market for these securities (and higher prices mean lower yields for bonds). While this looks to be a low-probability event in our view, such an announcement would likely trigger a rally in risk assets. In FX land, this means JPY crosses are likely to catch a bid.

Key Data and Events to Watch This week

The US economic calendar is pretty busy this week, and the highlight is the FOMC rate decision on Tuesday (more on this above). Prior to this, we'll get NY Empire manufacturing, US capital flows, industrial production, and the homebuilder index on Monday. Tuesday also sees consumer prices and housing starts. The current account and crude oil inventories are on tap for Wednesday. Thursday rounds out the week with jobless claims, the Philly Fed manufacturing index, and the index of leading economic indicators.

It looks even busier in the euro zone. The action kicks off on Tuesday with French consumer prices, PMI service and manufacturing indexes for the euro zone, and euro zone employment. Wednesday sees consumer prices for Germany and the euro zone. Thursday has the German IFO business climate survey and the euro zone trade balance on deck. Friday closes out the week with the French business confidence indicator.

Things are a touch quieter in the UK, and home prices start it off on Monday. Tuesday has consumer prices lined up, while Wednesday sees the employment numbers along with the Bank of England meeting minutes. Thursday is important with retail sales on deck. Friday closes it out with GfK consumer confidence and total business investment data.

Japan is characteristically quiet next week. Sunday has the Tankan manufacturing and services indexes due up, while Monday sees the key Tertiary industry index. On Wednesday, we get the leading economic index, while Thursday has department store sales and machine tool orders lined up. Last but not least, the Bank of Japan will decide on rates on Friday, and they are expected to leave the target unchanged at 0.30%—a likely non-event.

Canada's calendar is on the light side as well, but has important top-tier data due up nonetheless. Tuesday has manufacturing shipments, while Wednesday sees wholesale sales. Thursday is the busiest day, with international security transactions, economic leading indicators, and the all-important retail sales report on tap. Consumer prices round out the week on Friday.

The action down under is on the modest side. Sunday kicks it off with New Zealand manufacturing activity. Tuesday sees the RBA meeting minutes and the Australian leading economic index. Australian new home sales are up on Wednesday, and Thursday has New Zealand business confidence and Australian industrial trends lined up. Finally, we get New Zealand credit card spending on Friday.

By Brian Dolan of

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