The Pendulum of Forex Sentiment Keeps Swinging

02/02/2009 11:10 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The main driver in FX overall remains investor sentiment, with stock market movements as the primary barometer of risk appetites. When stocks are up and sentiment is positive, the USD, the JPY, and gold are typically sold, and when shares start falling, the USD, JPY, and gold are all bought. The rally in shares that started this past week was echoed in EUR/USD strength and JPY cross strength, but sentiment quickly turned on the surfeit of bad news, whether it was weak earnings, dismal data, or dire prognostications. The positive wave of sentiment was largely based on prospects for the US fiscal stimulus plan and the potential creation of a 'bad bank" to absorb toxic bank assets, but the optimism quickly faded as hopes for a quick fix to the US and global downturns proved unsustainable. However, hope springs eternal and new US Treasury Secretary Timothy Geithner is working on a comprehensive plan to stabilize the US financial sector, though concrete details have yet to emerge. News reports late Friday suggested that the 'bad bank" plan has been scrapped altogether, leaving the outlook even more uncertain and downbeat than before.

Still, sentiment remains extremely fickle, and the pessimism that returned by week's end may dissipate as quickly as it returned, and traders will need to remain flexible. Overall, markets have remained largely range-bound to start the year, with key stock indexes holding above important technical supports (DJIA 8000 and S&P 800), being mirrored by ranges in forex (EUR/USD 1.33-1.28; USD/JPY 92-88; and the USD index 83-87). At the moment, however, the sentiment pendulum is clearly on the risk aversion side, and this looks set to keep the USD supported in the near term and JPY crosses under pressure. The monthly USD index is sitting just below the Ichimoku cloud, potentially setting up a major reversal of the long downtrend in the USD. The USD index is above the cloud on weekly and daily Ichimoku charts and within striking distance of trend line resistance at 86.60 from last November's highs at 88.46. In short, we are either very near a top in the USD, or set to see a new phase of risk aversion and a safe haven surge into the USD.

Concerns Mounting About the Fate of the EUR

The flip side of strength in the USD is weakness in the EUR, and there appears to be growing momentum to more aggressively test the downside of the European single currency. At the top of the noise list is uncertainty over the very survivability of the EUR, which legendary currency speculator George Soros suggested was in danger unless European leaders joined in a global plan to address lost capital. While I do not share those concerns, there is nothing to prevent a speculative assault on the EUR in the near term. More solidly grounded concerns are the fiscal strains on individual EZ countries, most notably Spain and Greece, with Ireland becoming the latest Euro nation to have its AAA credit rating placed on review for a possible downgrade. The ECB is still seen as being behind the curve in providing interest rate relief, perhaps dooming the EZ economy to a longer, deeper recession. Similarly, EZ fiscal stimulus packages are seen as less aggressive relative to US initiatives.

The EUR is also being pressured by developments in other currencies in Europe. The Russian ruble is under intense pressure over the faltering outlook, which exposes European banks and firms to significant risks. The Russian central bank recently declared that the USD/RUB rate would not be allowed to move past a maximum corridor between 36.00-41.00. Markets quickly pushed the rate higher from 33 to just shy of 36 at the end of the week, setting up a major showdown this week. When it intervenes to support the ruble by selling USD, the Russian central bank typically sells EUR to obtain the needed USD. Separately, Swiss National Bank president Roth completely contradicted earlier comments by the SNB's VP Hildebrand, effectively removing the threat of intervention to weaken CHF and triggering a sharp sell-off in EUR/CHF. Heavy EUR/GBP selling is also putting pressure on the EUR, as an increasing number of analysts now view the pound as undervalued and think that more aggressive UK government action will result in a shallower UK recession.

Technically, EUR/USD is finishing out the week just above the key lows at 1.2760/70 for the entire move down from 1.4720. EUR/USD is below all key moving averages and below the Ichimoku cloud and related lines. Weakness below 1.2750 may see a cascade of EUR/USD selling that quickly re-tests the lows seen last year at 1.2340/50. Strength over 1.3050/80 is needed to suggest a bottom. In EUR/CHF, price is below all key daily moving averages, and below the cloud, meaning that a test of trend line support at 1.4740/50 looks to be in store. In EUR/GBP, price has fallen into the cloud from above, and weakness below the 0.8825/30 lows of January may signal a test of the bottom of the cloud at about 0.8750, with a daily close below there suggesting further weakness. The risks for EUR are clearly skewed lower, and the recent pattern has been for London/European markets to start the week with a test of vulnerable price levels, so be on guard for a potentially quick descent in EUR.

Outlook for RBA, BOE and ECB Rate Meetings This Week


The Reserve Bank of Australia is expected to cut its overnight interest rate by -100 bps to 3.25% on Wednesday at 0130GMT. The consensus is a bit contentious with some strategists/economists looking for a less aggressive -75 bps reduction. We think the bank will choose the more aggressive path. The economy continues to slow as anemic global growth puts a crimp on trade and commodity prices. Indeed, the index of leading economic indicators plunged -1.0% in November after a -0.2% read the prior month, and this suggests things will only get worse from here. Meanwhile, inflation continues to wind down with consumer prices falling -0.3% in 4Q and slowing the annual run rate to just 3.7% from 5.0% prior. So the continued deterioration in economic fundamentals, coupled with the deceleration in inflation leaves the bank in a position to be quite aggressive on rate cuts. The reaction from AUD from the larger cut is likely to be a negative one, as such a large cut is probably not fully priced into the market. The fact that many participants expect a lesser reduction is testament to this.

The Bank of England is up next on Thursday at 12:00 GMT. The market is looking for the bank to reduce the key rate by -50 bps to a new low of just 1%. The forecasts are quite divergent, with some looking for no change in rates and others expecting a much steeper -100 bps reduction. We think consensus is just about right at -50 bps. While many bank members have recently alluded to the possibility of a 0% interest rate somewhere down the line, we believe the bank would prefer to give itself some flexibility here and not do too much too soon. The press statement will also be important, as discussion of more measures to address the economic problems and even some talk on the recent GBP weakness could emerge. Indeed, BOE member Blanchflower gave the pound some positive lip service just this week by saying that the currency is "undervalued." We would expect that more of this talk could put a short-term bid under GBP. Any rally, however, would likely be short-lived as members cannot escape the reality that the economy continues to worsen as the months go by.

Last but not least, the ECB is expected to leave rates on hold at 2% on Thursday at 12:45 GMT. Indeed, ECB president Trichet said outright that the next important meeting for rates will be in March, so the idea that the bank will not move on rates looks pretty well baked in the cake. While the rate decision itself is expected to be a snooze, the press conference could offer some interesting nuggets and should elicit some price action in EUR. Trichet will no doubt continue to provide a bleak assessment for the economy and financial markets, while his rhetoric on inflation will probably be a touch softer. With EZ consumer price estimates for January falling to a much lower than expected 1.1% annual rate from 1.6% the prior month, the ECB will be hard-pressed to pound the table on inflation. One important topic that could emerge is the recent comments from some market participants regarding the potential for euro disintegration. Chatter from a prominent investor this week sent EUR sharply lower, and we would expect Trichet will get at least one question on this. The reaction in EUR is likely to pick up in the question and answer portion of the press conference, as the statement itself will probably be pretty much in line with what we have heard from ECB officials in the last few weeks. Look for harsh comments on the euro zone economy, coupled with any sign that the ECB is willing and ready to cut rates further as a catalyst to send EUR lower.

Key Data and Events to Watch This Week

The US economic calendar is chock full of top tier data this week, and the action kicks off with personal income/spending, ISM manufacturing, and construction spending on Monday. Pending home sales and motor vehicle sales are due on Tuesday, while Wednesday sees ADP employment and the ISM service index. Thursday has productivity, unit labor costs, jobless claims, and factory orders on tap. Friday rounds out the week with the ultra-important employment report and consumer credit numbers. Also, watch for the release of the Fed's Senior Loan Officer Survey, which should be out next week as well.

The euro zone has an even more important week upcoming. Monday starts things off with key PMI manufacturing reports for the euro zone. German retail sales and euro zone producer prices are scheduled for Tuesday, while Wednesday has euro zone PMI services and retail sales on tap. The ECB rate decision and press conference will be the main highlight on Thursday, and we will also see German factory orders that day. Friday has the French trade balance and German industrial production.

The UK is a touch slower this week, and manufacturing PMI starts things off on Monday. Tuesday sees construction PMI, while Wednesday has consumer confidence and the services PMI due up. Thursday is important, with the Bank of England expected to cut rates by -50 bps to a new record low of 1%. The statement will be critical in terms of assessing the future path of rates and any other potential measures to stimulate the UK economy. Friday follows this up with producer prices and industrial production.

The calendar in Japan is pretty devoid of any economic events. Tuesday has labor earnings on tap, while Friday sees the leading and coincident economic indices. Also, watch for a speech by BOJ board member Atsushi Mizuno on Thursday.

Canada is also extremely light, and the action doesn't start until Thursday when we get building permits and the Ivey purchasing managers index. Friday closes out the week with the all-important employment report.

On the flipside, it is uncharacteristically busy down under. Sunday has Australian AiG performance of manufacturing index, Australian new home sales, New Zealand labor costs, and New Zealand hourly earnings. Monday sees Australian home prices. Tuesday is key with the RBA expected to cut rates by -100 bps to 3.25%. We also get the Australian trade balance that day. Thursday is also busy with New Zealand employment, Australian retail sales, and Australian building approvals. Last but not least, watch for the RBA's quarterly monetary policy statement on Friday.

By Brian Dolan of

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