USD Strength May Be Setting up for a Reversal

01/26/2009 10:24 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The past week saw the USD gain further ground against other major currencies (except for the JPY), but the key, I think, is that the greenback had great difficulty maintaining those gains. The same was true for the JPY crosses, which experienced pronounced selling on most days, only to stage equally dramatic rebounds before each day's end. The two developments are closely related in that increased risk aversion typically leads to USD safe-haven buying alongside JPY cross (carry trades) selling. The moves in FX closely resemble stock market developments, where heavy selling early in the week (risk aversion) proved unsustainable and key technical levels were regained by week's end. In last week's report, I suggested that renewed risk aversion might quickly vanish and this past week's price movements suggest to me that such a reversal may develop this week.

The fundamental environment certainly warrants risk aversion, with grim data and deteriorating outlooks the rule, but upcoming developments may yet inspire a recovery in sentiment. A sentiment bounce should not be confused with any reality-based improvement in the outlook, but rather simply taken as a turn in investor positioning. The key events I'm watching are the progress of the US fiscal stimulus package and the impending second round of TARP capital allocations. As prospects for their passage/implementation increase, both have the potential to fortify investor sentiment. President Obama has called for weekend meetings to address the second round of TARP allocations, and there is widespread talk that a deal on a so-called "bad bank" might also emerge. (The bad bank is modeled on the Resolution Trust Corporation (RTC), which was used to take over failing S&L's in the 1990's and dispose of their assets in an orderly fashion.) Between the two, concerns over the demise of the US banking sector may quickly recede, prompting a potentially significant rebound in beaten-down sentiment and share prices. For the USD in particular, a likely bleak FOMC statement on Wednesday, and worse than expected US 4Q GDP report on Friday, may accentuate USD weakness.

Technically, the multiple extreme reversals in non-JPY dollar pairs suggest the market is hammering out a bottom in GBP/USD, EUR/USD, AUD/USD, and a top in USD/CAD. In EUR/USD, a daily close above the 1.3050/3100 area would suggest scope for a rebound back to 1.3500/50 area. The USD index also posted a significant long-legged doji on daily candles, suggesting a downside reversal, and a daily close below 85.00 points to weakness back to the 83.00 area initially. JPY crosses also saw sharp rebounds, leaving behind multiple “hammers” and “tweezer bottoms,” which suggest a rebound after a decline.

Intervention Risks Increase in GBP, JPY and CHF

In addition to sizable intra-day volatility, this past week was notable for increased chatter over intervention, with no fewer than three separate currencies being mentioned. A G7 source indicated that GBP weakness will be a subject of discussion at the February 14 G7 meeting in Rome, though he stopped short of saying the pound will be singled out for mention in the communique. Still, that GBP weakness has appeared on the G7 radar screen suggests that the risks of being short Sterling at 25-year lows have increased dramatically. Given heavy short positioning, there is significant potential for a short squeeze, and a daily close back above 1.4000 will be a likely signal of a recovery toward 1.44/45 initially.

On Tuesday this past week, Swiss National Bank (SNB) VP Hildebrand flatly threatened intervention by selling unlimited amounts of CHF to prevent a further appreciation of the Swiss franc. The SNB's focus is primarily on the EUR/CHF rate given the strong trade flows between Switzerland and the rest of Europe, and I would caution against buying USD/CHF to act on the view of a weaker CHF, and instead focus solely on EUR/CHF. Please see the weekly strategy for my trading outlook for potential gains in EUR/CHF.

Lastly, persistent talk of Japanese intervention to stem JPY gains peaked with the BOJ (Bank of Japan) reportedly “checking rates” on Friday morning in NY. Checking rates is the middle step after verbal intervention, which the MOF delivered in December, and before actual market intervention, which would likely see the BOJ buy USD/JPY and possibly JPY crosses as well. Again, the risks of being short USD/JPY and JPY crosses at such low levels in the face of potential intervention have dramatically increased. I would also note a double bottom at 87.10/20 as a potential reversal pattern. The 89.50/90.00 area stands out as the key resistance level, and a daily close above there may see gains back to the 94/95 area.

FOMC and RBNZ Rate Meetings This Week


The Federal Open Market Committee (FOMC) is scheduled to meet this week, and while there is little they can do on the interest rate front, the press statement due up at 1915 GMT on Wednesday will be important. In the December meeting, the Fed cut the target rate to a range of 0.00-0.25%, and therefore, has all but run out of bullets on this end. The statement will probably be very similar to the last communique where the Fed noted how they will continue to "support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level." The risk is that they announce a commitment to purchase long-term Treasury securities outright in an effort to bring rates down across the yield curve. This sort of measure would likely see risk appetite increase in the near term, as yields would probably fall hard, resulting in an improvement in the outlook for US housing via potentially lower mortgage rates. In FX, this would translate into higher EUR and JPY crosses across the board. However, any positive reaction will likely diminish as the reality sinks in that demand for housing is likely to remain soft no matter how low rates move.

The Reserve Bank of New Zealand will release their interest rate decision on Wednesday at 2000 GMT, and is expected to cut by -100 basis points to 4.0%—the lowest rate on record. The consensus is nearly unanimous with only one prominent bank looking for a more aggressive -150 bps adjustment. In either case, the RBNZ is poised to act aggressively. The continued deterioration in the global economy has weighed on New Zealand trade and recent economic data of late surely warrant action. The NZIER business optimism survey plunged to a dismal -64 in 4Q from a prior -19 print, matching 34-year lows. Inflation, meanwhile, continues to grind lower and was running at a 3.4% annual rate in 4Q, a marked deceleration from the 5.1% pace the previous quarter. The reaction in NZD will depend on the magnitude of the cut and sentiment of the accompanying press statement. More aggressive action should see initial knee-jerk selling of the currency. However, if this is accompanied by a more upbeat statement that more aggressive cuts will pave the way for speedy recovery, the move lower will likely reverse in short order.

Trade in Japan Weakens Further as Intervention Rumors Swirl

Rumors that the Bank of Japan could be looking to intervene in the currency market in an attempt to weaken the yen swirled around the markets as we headed into the weekend. The bleak Japan trade data we got this week looks to have intensified the calls for action, as exporters continue to suffer the double whammy of a strong currency and recessionary global economy. The international trade balance deteriorated to -¥320.7B in December, down from -¥223.4B the prior month.

The important thing to consider is that we've never seen this large of a divergence between weak Japanese trade and overall yen strength. Indeed, over the last year, the yen has rallied nearly 17% against the US dollar, while the one-year rolling average trade balance is at the lowest since data became available in 1986. This leads one to believe that intervention could indeed be waiting in the wings. Coupled with what is likely to be continued USD demand in the face of a sharp global economic slowdown. We would expect a markedly higher USD/JPY as we muddle through 2009.

While the BOJ would preferably intervene into a general market selling of JPY, the risk is that they do so regardless of this. This way, even if they can't elicit weakness in yen, they will at least prevent it from strengthening further. They were unable to do this over the latter half of 2008—despite the precipitous drop in the trade position—because the global unwind in carry trades (as stocks got decimated) was overwhelming and put a massive bid under yen. Thus the BOJ would have gotten crushed if they tried to fight that move. But now it seems that the carry has all but unwound, as major market players have cut equity positions in size, so the risk of continued yen strength from this factor looks almost non-existent.

Key Data and Events to Watch This Week


The US data calendar is relatively busy this week, and the highlight is the FOMC meeting on Wednesday (more on this above). Other action kicks off on Monday with the index of leading economic indicators and existing home sales due up. Tuesday has the Case-Shiller home price index and consumer confidence. Thursday has some top-tier data with durable goods, jobless claims, and new home sales on deck. Friday rounds out the week with 4Q GDP (expected to be dismal), the Chicago PMI, and the University of Michigan consumer sentiment index.

The calendar in the euro zone is a little less hectic. The EZ current account and German IFO business surveys start off the week on Tuesday. Wednesday is busy with French consumer confidence, German GfK consumer confidence, and German consumer prices. On Thursday, we get EZ consumer and business confidence surveys along with German employment numbers. Friday closes things out with the EZ CPI estimate, EZ employment and French producer prices.

In the UK, it looks like a pretty light week ahead. Monday starts things off with home loan data. Thursday sees the next major report with Nationwide home prices due up, while Friday has GfK consumer confidence and consumer credit on tap. Also look for the Bank of England's Blanchflower, a dove who voted for 100 bps easing at the last MPC, scheduled to speak on Thursday.

Japan's calendar, on the other hand, is jam-packed. The action doesn't start until Wednesday, when we get small business confidence and retail trade. Thursday is extremely busy with PMI manufacturing, employment, household spending, consumer prices, and industrial production. Friday sees housing starts and construction orders.

The action in Canada is nearly non-existent. Tuesday has the 2009-2010 budget projections, while Thursday sees industrial product prices. Friday closes out the week with the November GDP release.

Last but not least, it is uncharacteristically busy down under. Monday has New Zealand credit card spending on deck. The action picks up on Tuesday with Australian business confidence, producer prices, and the leading economic index. On Wednesday, we get the RBNZ rate decision (more on this above), NZ trade balance and AU consumer prices. Thursday has NZ building permits, while Friday rounds out the week with AU private sector credit.

By Brian Dolan of

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