Sentiment Improves and the USD Softens

03/16/2009 10:11 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

In last week's report, I suggested that market pessimism had become extreme and that any improvement in sentiment, as seen in stock market performance, would likely hurt the USD as its safe-haven allure diminished. After a final plunge in shares to start the week, investors took heart from comments from leading US banks that they had returned to profitability in the first two months of the year. US shares subsequently led a global equity market rebound and the USD fell against most other major currencies. Financial shares led the way higher, and this seems natural given the source of the news, but it's also important for the durability of the bounce. Regardless of accuracy, markets appear to believe that a resurrection in the banking sector is a prerequisite for a rejuvenation of the broader stock market and overall economic outlook.

But before we get carried away with the good news from the mouths of bank CEO's (haven't we seen this movie before?), it's important to keep in mind that this is a consumer-led recession, and a global one at that. And there, the news is more mixed. Consumers remain in retrenchment mode, though there are some tentative signs of stabilization in US retail sales and consumer sentiment. But key impediments to a broader consumption recovery remain, namely ongoing job cuts and falling home prices, not to mention further deterioration overseas.

Even the upbeat bank news is subject to interpretation. The "return to profitability" cited by bank CEO's does not take into account expected additional write downs of toxic debt holdings, which may swamp any profit from current operating revenues. However, therein lies the answer to the overarching pessimism that has weighed on the financial sector. Investors have been overly focused on banks' bad assets (the zombie bank concern) and have largely ignored traditional banking revenues that may essentially offset future write offs. The net result may be flat bank profitability for several more quarters, but not insolvency for key institutions. Additionally, US Treasury commitments to re-capitalize systemically important banks further remove the prospect of nationalization. On balance, the rebound in the banking sector looks to have traction, and this bodes well for broader market sentiment in the weeks ahead.

In terms of FX trading strategies over the next few weeks, essentially into mid-April when 1Q earnings reports will dominate markets again, further stock market gains are likely to keep pressure on the USD in general, and provide further support for JPY crosses. But just as sentiment remains exceptionally fragile, the USD decline is likely to move in fits and starts. I look to use USD gains as a selling opportunity near recent range highs (buying in particular, GBP/USD, AUD/USD, NZD/USD on dips, selling USD/CAD on rallies), but I also strongly urge taking profits on USD weakness. I do not expect an especially forceful trend to develop given the high state of uncertainty, so I expect plenty of opportunities to exploit USD bounces for shorter-term positions.

Last week, I cautioned that gold longs were in jeopardy, and I'll highlight that risk again for the week ahead (need over $950/oz to negate), and I'd also add a cautionary note about EUR longs now. Euro zone deterioration is likely to surface as a major focus over the next few months, likely in contrast to stabilization in the US and UK, and this makes me reluctant to own EUR. In addition to the outcome of the G20, which may show the euro zone in weak light (more below), this week sees the March German ZEW investor sentiment index, and expectations are for another sharp drop. I'll be looking for selling opportunities on the EUR crosses, especially in EUR/AUD and EUR/GBP, and would avoid buying the EUR to express a short USD view.

SNB Steps in on the CHF

On Thursday last week, the Swiss National Bank surprised markets by aggressively intervening to sell the CHF against other currencies, with most of the intervention focused on buying EUR/CHF. I highlighted the risks of SNB intervention at the beginning of February, but subsequent official comments downplayed those prospects and I took my eye off the ball, for which I'm now kicking myself. EUR/CHF moved from 1.4850 to 1.5400 in the 36 hours post-intervention, nearly completing the expected move up to 1.5500. Going forward, I would expect the SNB to step in should EUR/CHF fall below 1.5000 again, suggesting buying EUR/CHF on weakness below 1.52. I would caution traders against selling the CHF against the USD, however, as the SNB is not concerned with USD/CHF levels or the potential for the USD to keep softening if sentiment continues to improve. The SNB is focused on preventing CHF strength against EUR, and that's where we should focus too. SNB board member Jordan is speaking on Thursday, and he may provide us with greater context in which to trade.

Japanese Financial Year-End Flows and JPY

The end of March will see the close of the Japanese financial year, and this period typically sees JPY repatriation flows (JPY buying) accelerate only to then vanish in April. This year, however, anecdotal information suggests Japanese asset managers and hedgers accelerated their JPY repatriation/buying in 4Q 2008 and look to have finished up by mid-February. However, I cannot exclude another surge in the JPY on final year-end flows, but my overall bias remains to position for a weaker JPY in the months ahead. I look to use USD/JPY weakness into the 94-96 area to establish longs (stop below 92) for an eventual move to 102-105, and potentially much higher. The risk is that we do not see additional JPY strength and move directly lower, which could also be a function of further stock market gains driving JPY crosses higher. But as we have seen on several occasions in the last two weeks, sharp drops in USD/JPY do happen, and we need to be prepared to exploit those opportunities.

Policy Events That Could Impact Markets|pagebreak|

1) G-20 Meeting Could Boost Risk Trades

The G-20 will be first up in terms of important policy events as we kick off the new week. Most of what will be discussed has been pretty well advertised. The US basically wants a globally coordinated fiscal stimulus to bring the world economy out of one of the steepest funks in history-estimated in some circles to be as bad as a -1% decline in global growth this year. The Europeans ostensibly would like to focus more on regulation and discuss ways in which countries could work together to synchronize financial regulation efforts going forward. So much of the meeting is expected to be a squabble between these two sides. One thing that could emerge is the recently proposed $500 billion addition to the IMF fund, tripling the amount available to help countries under duress. US Treasury secretary Geithner has been most vocal about adding these funds to the IMF, and if he gets his way over the weekend, this could elicit yet another rally in risk trades. This should see recent gains in JPY crosses extend.

2) OPEC mulls more production cuts

The OPEC meeting follows on Sunday and will also be closely watched. While members continue to follow through (for the most part) on their promise to cut at least four million barrels a day in production, the minimal reaction in oil prices thus far has them contemplating further reductions. The fact is that demand has also waned, and thus the cuts in supply have done little to support prices. In terms of the OPEC members themselves, Venezuela commented very recently that the market remains oversupplied and that the target floor price for oil should the around the $70 mark. In recent past, however, Venezuela has failed to "walk the walk" when it comes to actually meeting production decline quotas.

Expect more of the same from a lot of the weaker OPEC members this time around as the need for cash flow in a crumbling global economy outweighs the desire to artificially support prices. So while a short-term blip on the back of more saber rattling is likely, the overall supply/demand imbalance is likely to continue to keep prices under pressure. Oil remains in an overall range, with resistance into the $47-$50 area. Here lurk the December pivot to the collapse into nearby lows, the 100-day simple moving average, and the psychologically important $50 level. To the downside, we have immediate trend line support by $43, a short-term pivot near $40-$39, and the nearby lows into the $35-$33 area.

3) More of the same from the FOMC

The Federal Reserve will gather this week for a two-day meeting on 17-18 March. The subsequent press statement is expected to show more of the same. The Fed has done all it can on the rates front, and the target will remain the 0.00% to 0.25% range. They will continue to highlight the downside risks to economic growth and the potential for a deflationary backdrop. Consumer spending will probably be noted as leveling out, though the Fed likely does not want to go out on a limb and say that it is "stabilizing"- we all remember what happened when they said the same about the housing market back in January 2007.

The statement that the Fed will continue to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability" will remain the crux of the communique as the Fed makes an effort to roll out the TALF program the following day, which is targeted at $1 trillion to ease credit markets. Market reaction is likely to be minimal if the statement comes out as expected. The markets will closely watch for any news on the TALF with greater interest. Failure to implement the program (which has already been delayed multiple times) could elicit a decline in confidence and risk trades could take a hit.

Key Data and Events to Watch This Week

The US economic calendar is modestly busy this week, and it kicks off Monday with NY Empire manufacturing, international capital flows, industrial production, and the NAHB homebuilder index. Tuesday has producer prices and housing starts/permits lined up. On Wednesday, we'll see consumer prices, crude oil inventories, and the Fed's press statement following the two-day meeting (more on this above). Thursday rounds out the week with initial jobless claims, the index of leading economic indicators, and the Philly Fed manufacturing index.

It is very light in the euro zone. Monday starts off the week with euro zone consumer prices on tap. The German ZEW economic survey is the highlight on Tuesday. Euro zone industrial production and German producer prices close out the week Friday. Also look out for a speech by ECB President Trichet on European integration on Monday and a summit of EU leaders on Thursday.

For the UK, it is also pretty uneventful. Home prices are up on Monday and employment is on deck Wednesday. The CBI industrial trends report is due up on Friday. Also noteworthy are the Bank of England quarterly bulletin on Monday and the BOE meeting minutes on Wednesday.

It is a similar story in Japan. The tertiary industry index starts things off on Monday and is followed by machine tool orders on Tuesday. The BOJ rate meeting is on Wednesday and is likely to be a non-event. Wednesday also has the leading economic index and all industry activity index due. Friday ends the week with department store sales.

Canada is a bit busier than usual. Manufacturing shipments and labor productivity kick it off on Tuesday. Wholesale sales are on deck Wednesday, while consumer prices and international capital flows are up Thursday. Look for the all-important retail sales report on Friday.

It is a relatively average week down under. Sunday gets things underway with the New Zealand performance of services index and New Zealand manufacturing activity. The RBA meeting minutes are up on Tuesday along with the Australian leading index. Thursday has Australian foreign exchange transactions and Australian preliminary import data. New Zealand credit card spending rounds out the week on Friday.

By Brian Dolan, chief currency strategist,

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