USD Outlook Still Higher, but Near-Term Correction Possible

03/02/2009 10:38 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The USD extended gains last week, and the overall trend in what now looks to be the sole safe haven paper currency remains bullish as we muddle through the first half of 2009. That said, short-term corrections in what has become a very volatile trading environment are a dime a dozen, and a move lower cannot be ruled out. Technically, the USD index looks to be potentially setting up a double top around the 88 level, though we'd need to see a move below the 100-day simple moving average near 85 to even suggest this pattern is coming to fruition.

The buck will face a big test this week as Treasury secretary Tim Geithner is set to testify on the Treasury's massive budget. This will serve as a reminder to markets that the US will print record budget deficits in excess of $1 trillion for the foreseeable future—something that is likely to weigh on the world's number one reserve currency. Tax hikes in excess of $1 trillion also remain in the back of the minds of many traders, and this punishment of the productive resources of the economy will make any recovery that much less robust. Throwing money at the problem now means a high potential for inflation issues later as well. With inflation expectations now back to the highest level since August, this is not something the Fed can afford to ignore.

The headwinds for the buck are, nonetheless, longer term in nature compared with the issues facing Europe and Japan at the moment. Japan this week just printed its worst trade numbers in at least half a century, a pattern that is likely to get worse. The massive rally in JPY in the second half of 2008, coupled with the decline in global growth, will continue to hamper trade in the region. This suggests the upward trajectory for USD/JPY looks likely to remain intact. Short-term corrections should find support near the 24-25 February 96.40/30 range lows. Below there would open up potential to the 95 area, where we expect longer-term buying interest to emerge. EUR/USD looks poised to trade in a range until more details surface about the euro zone's massive emerging market debt exposure. For now, we would expect weakness to find good support into 1.2550/00 and rallies to be capped into 1.2900/50.

Gold Uptrend Likely to Resume After Profit-Taking Plunge

Gold lost some more of its luster last week as profit taking on longs ahead of month-end elicited a $50 drop in the precious metal towards the $940 area. The critical $935/$930 support zone we highlighted last week was tested briefly intraday, but as of this writing, it looks as if we will close above there. We would not be surprised, however, to see the leg lower continue in the short term if we do manage to settle under that zone. We would then target the 55-day simple moving average at $890 and daily trend line support drawn from the 13-Nov and 15-Jan lows by $875/$870 next.

What makes the case for a short-term leg down so compelling is the fact that there was no perceivable spike in trading volume on the move from $900 to the nearby highs just above $1000, indicating a pretty thin market on the way up there. This compares to a sevenfold jump in volume when gold moved from $800 to $930 on 15-30 of January. The less than stellar participation in the more recent rally suggests the move had little legs.

Fundamentally, gold looks poised to head higher and retest the $1000 area once again. Risk aversion remains extremely elevated as global equities continue to get hammered, and prospects for a quick economic recovery remain dismal. This coupled with the massive budget deficits many world governments have to run for the next 5-10 years makes gold attractive as a reserve currency. The yellow metal has also proven to be a resilient asset class over the last 3-4 decades or so. Since the dismantling of Bretton Woods back in 1971, gold has registered an 8.7% annual return, while US stocks are up about 5.5% per year in that same period. So while any short-term move lower cannot be ruled out, the bias through the balance of 2009 remains higher.

Key Data and Events to Watch This Week

The US economic calendar is bustling with events this week. Monday kicks things off with personal income/spending, core PCE prices, ISM manufacturing, and construction spending. Tuesday has pending home sales and motor vehicle sales on tap. Wednesday sees the ADP employment report, ISM services index, and crude oil inventories. Thursday is also busy with productivity, initial jobless claims, and factory orders, while Friday rounds out the week with the all-important non-farm payrolls (NFP) report and consumer credit. Plenty of Fed speakers are up this week as well, and chairman Bernanke is the highlight on Tuesday. Geithner testifies on the budget Thursday. Look out for the Fed's Beige Book, out on Wednesday, as well.

The euro zone is also quite busy with top-tier data abound. The action kicks off on Sunday though with an EU summit on the economic crisis. The press conferences that follow could provide for some interesting EUR price action at the Sunday open. Monday has euro zone PMI manufacturing and the euro zone consumer price estimate, which is expected to grind lower still. Tuesday is light with only German wholesale prices, while Wednesday brings euro zone PMI services. Thursday closes out the week with euro zone GDP, French employment, French producer prices, and German retail sales. The ECB rate announcement is up on Thursday as well, and the bank is expected to cut rates by -50 bps to 1.5%. More importantly, Trichet's press conference will be closely watched for signs of further economic weakness in the euro zone to come.

It is an important week in the UK as well. The data kick off on Monday with PMI manufacturing, consumer credit, and mortgage approvals. Wednesday has nationwide consumer confidence on deck, and Thursday sees the PMI services index. Friday is light with producer prices and mortgage equity withdrawal numbers. The BOE is poised to cut rates on Thursday by an anticipated -50 bps to a new record low of 0.50%. The statement is expected to highlight continued economic weakness along with diminishing inflation risks. More dovish than expected rhetoric out of the BOE here should see GBP head markedly lower.

Japan has an extremely light week ahead. Labor earnings and vehicle sales are up on Monday and capital spending is on tap Wednesday. In other words, look for moves in USD/JPY to be more dollar-driven than anything.

Canada is on the light side, but all of the events are top-tier. Monday kicks things off with monthly and quarterly GDP. Thursday closes out the week for data with building permits and the key Ivey PMI report. The Bank of Canada is scheduled to decide on rates on Tuesday, and the market is looking for a -50 bps reduction to 1.0%. The fact is that the Canadian economy continues to catch up to the weakness in the US at a rapid pace, and thus, we are not surprised that their rates are finally now nearly commensurate with the Fed.

It is very busy down under for a change, but all of the action is in Australia. The performance of manufacturing index and new home sales are up on Sunday. Tuesday has the current account and retail sales due up. Wednesday sees GDP, while Thursday closes out the week with the trade balance and building approvals. The RBA is due to decide on rates on Tuesday and the outlook is for a -25 bps reduction to 3.0%. With the commodity picture worsening and global growth decelerating further, we would not be surprised to see a sharper than anticipated cut.

By Brian Dolan of

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