Forex Risk Rally Stalls and Reverses

05/18/2009 10:32 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The recovery in risky assets (stocks, commodities, JPY crosses/carry trades) has stalled and reversed in relatively short order and our cautious outlook for further gains looks to have been validated. The steady flow of less negative news has given way to the realization that we are now entering a likely extended period of global economic underperformance. The horizon has also become increasingly cloudy, with consumer spending showing signs of ongoing retrenchment, continuing claims still rising (accelerating even), and housing markets still highly vulnerable (see below). The announcement of massive US auto dealership closures and the potential bankruptcy of the top US automaker will only amplify slack in the labor markets, keeping the consumer outlook bleak, and further undermining the outlook for corporate earnings. News that the German economy contracted by a larger than expected -3.8% q/q in the first quarter and that Russia's growth fell -9.5% highlight the depth of the hole that the global economy fell into. About the best that can be said is that we may have found the bottom, but that still leaves a steep climb out before we can expect anything resembling a real recovery.

Risk asset markets have posted strong signals that a significant reversal is underway and we would expect to see further declines in stocks, commodities, and the JPY crosses and a return to USD strength (except against JPY) in the weeks ahead. In currencies, bearish engulfing lines dominate weekly candlestick charts for the JPY crosses, and daily closes below the Kijun lines augur weakness as well. USD/JPY has tested below the base of its daily Ichimoku cloud at 95.02, and a close below may signal weakness toward the 90.00/92.50 area. An unfolding head-and-shoulders pattern in USD/JPY suggests potential back to the 87.50/89.00 area. JPY crosses are also likely to test their clouds next week, and a looming downside crossover of the Tenkan and Kijun lines would generate yet another sell signal. The commodity currencies (AUD and CAD), which led the way higher during the risk rally, appear to be leading the way lower in the retreat. In particular, we will be watching the 0.7334 and the 1.1992 Kijun lines in those pairs versus USD, where a daily close through those levels would argue for a more aggressive decline for the commodity currencies. In EUR/USD, the 1.3400/50 area, highlighted by the 200-day moving average at 1.3420, remains critical support, below which we would expect losses to accelerate. In GBP, the 1.5000/50 area represents a similarly important pivot level, and a decline below would suggest greater downside potential in cable.

Having just called an end to the recent rally in risk sentiment, we are mindful that topping patterns frequently have several false starts. In the current environment, we can't point to any one single news or event catalyst behind the apparent reversal unfolding. We are also aware that prices in USD/JPY, EUR/USD, and GBP/USD are still above key support levels highlighted above. As such, we would be reluctant to chase this move lower in JPY crosses/higher in the USD from current levels. Instead, we would look for opportunities to sell JPY crosses on corrective bounces/buy USD (except against JPY) on pullbacks in anticipation that the risk reversal will continue. The relatively light data calendar this week may offer some additional signs of improvement (see below), potentially offering just such rebounds and allowing for entry at more advantageous price levels. Should further data improvements materialize and risky assets fail to rally materially, we would view that as confirmation that risk appetites have further room to unwind. The coming weeks will likely settle the argument of whether we have been in a genuine risk recovery or simply in a bear market rally, and we think it is the latter.

SNB Steps Back into EUR/CHF

After several volleys of verbal intervention in the past week, which markets increasingly seemed to shrug off, the Swiss National Bank evidently felt compelled to demonstrate its commitment to prevent the CHF from strengthening further against the EUR. On Friday, as EUR/CHF tested near to the 1.5000 level, the SNB intervened and bought EUR/CHF, sending the pair up to nearly 1.5150 in about 30 minutes. The intervention was apparently conducted in such a fashion as to gain maximum exposure and drive out speculative EUR/CHF shorts. We continue to ascribe to the view that the 1.5000 level will be defended and look to buy weakness in EUR/CHF sub-1.5100/50, maintaining a core long position. We would look to take partial profits toward the 1.5250/5300 area (200-day SMA is at 1.5279) and exit the position entirely near 1.5450/1.5500. The deflationary risks in Switzerland are currently increasing, potentially peaking in May/June, and we think this will keep the SNB proactive on reining in CHF strength through that period. We will revisit the deflation outlook at that time. As always, the SNB is strictly focused on EUR/CHF, so selling CHF against other currencies is not part of our strategy. However, in USD/CHF, the 1.1250/1.1300 area is a key resistance level, and strength above it would support the case for a larger USD recovery.

US Housing Still on Shaky Ground

There has been much debate of late as to whether the US housing market has been carving out a bottom in recent months. While we agree that the worst of the declines are likely behind us, we remain cautious about the outlook and maintain that current fundamentals still point to more pain ahead. The employment backdrop can hardly be described as constructive and the recent record 6.56 million in continuing jobless claims should give anyone expecting a housing renaissance some pause.

For all of the so-called positive developments on the home sales front, fully half of the sales over the last few months have been in "distressed properties." Mortgage delinquencies were running at a record 7.9% in 4Q and certainly have risen further in the first months of 2009. Should homeowners under duress (job losses) continue to capitulate, this will only add even more inventory to an already bloated overhang—months' supply was running at a whopping 9.8 in the latest existing home sales report, a four-month high.

In terms of affordability, the good news is that the real monthly mortgage payments (adjusted for inflation) are running about -28% below the average since 1990. For comparison, real payments were about 20% above normal at the peak of the recent housing bubble. Current developments in the interest rate space make it hard to believe that this will last, however. The 30-year Treasury yield has jumped more than 140 basis points from the 2009 lows and this has yet to filter through to 30-year mortgage rates, which are up a modest 13 basis points from the lows. Should mortgages follow Treasuries, we are looking at rates well above 6% in the very near future.

Even if people are ready to dive back into the market, credit availability poses another challenge. Bank lending standards remain near record tight levels and looming problems for banks in the commercial lending and credit card spaces will restrict credit expansion further still. For the credit-worthy borrowers, the fact that home prices are forecast to depreciate beyond the already dismal -20% annual rate is likely unsettling. We wonder how many of these potential buyers sitting on the sidelines want to jump into a depreciating asset in the current economic environment. And how many homebuyers are waiting in the wings exactly? The homeownership rate was running at 67% in 1Q and still well above a "normal" 65%. Where short-term demand will come from is anyone's guess and the demographics (baby boomers getting older) don't exactly argue for any secular pickup either.

The bottom line is that while housing is seemingly stabilizing, many of the factors behind this are not exactly positive (fire sales) or likely to last (low interest rates). In other words, anyone expecting the US housing market to contribute to growth any time soon will probably be disappointed. Data this week in the form of housing starts and the homebuilder sentiment index (NAHB) should continue to depict a US housing market on shaky ground.

MORE: Key Data and Events to Watch This Week |pagebreak|

Euro and UK Data Highlights

On Tuesday, the German ZEW survey is expected to show an increase in expectations regarding future conditions, in line with the April survey. This survey is a gauge of investor sentiment rather than business sentiment and the April survey was already supported by the expectation that the "downward dynamics of the business cycle are bottoming out," suggesting that scope for another significant increase may be muted.

The release of the euro zone PMI data on Thursday is expected to show moderate improvement from the April numbers. Last week's Q1 euro zone GDP data highlighted a worse than expected 2.5% q/q decline in activity in the initial months of the year. However, data such as German factory orders have highlighted an improvement into the second quarter.

Emerging optimism with respect to the UK economy suffered a setback last week on the very dovish projections contained in the BoE's inflation report. Ahead of this, there was some talk that there may be an upward revision to the nasty -1.9% q/q Q1 GDP, based on the better-than-expected March industrial production data. The second estimate will be published on May 22 and the market median stands at 1.9% q/q.

Official April retail sales data will be a key focus for the sterling markets. Both the BRC and the CBI surveys posted strong results for the month. However, both institutes note that the move of the Easter break from March in 2008 to April this year could have provided a temporary boost. The minutes of the BoE May MPC meeting are due out on Wednesday, along with the May industrial trends survey, which will be watched for signs that the downturn in manufacturing is bottoming.

Key Data and Events to Watch This Week

The US economic calendar is relatively light on top-tier data. The homebuilder sentiment index (NAHB) kicks things off on Monday, while housing starts and building permits are due on Tuesday. Treasury secretary Geithner will testify regarding TARP on Wednesday and we will also get the Fed meeting minutes and weekly oil inventories that day. Thursday rounds out the week for data with leading indicators and the Philly Fed manufacturing index.

It is likewise pretty uneventful in the euro zone, but important data loom nonetheless. Monday has the euro zone trade balance lined up. Tuesday sees the euro zone ZEW (economic sentiment) index, euro zone construction output, and the German ZEW index. Wednesday brings German producer prices, while Thursday has euro zone PMI surveys on tap.

In the UK, it is a touch busier than usual. Tuesday starts things off with consumer prices. On Wednesday, we have the Bank of England minutes and the CBI industrial trends report. Thursday is busy with business investment, retail sales, and public sector borrowing. Friday sees the all-important GDP and the index of services.

Japan sees more action than typical as well. Consumer confidence and department store sales get the week started on Monday. Industrial production, machine tool orders, and GDP make for a pretty busy Tuesday. The tertiary industry index is due Wednesday, while Thursday has the Bank of Japan monetary policy meeting (likely another non-event). The leading index closes out the week on Friday.

Not much going on in Canada. The noteworthy data don't start until Wednesday with consumer prices and the leading economic indicators due. Retail sales is the only other notable piece of data on Friday.

The calendar down under is characteristically light. New Zealand performance of services index and producer prices are up on Sunday. The RBA meeting minutes are due Tuesday, while Australian consumer confidence is up on Wednesday. The data week ends Thursday with New Zealand credit card spending and Australia inflation expectations.

By Brian Dolan, chief currency strategist,

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