The Forex Risk Rally Is Done!

11/02/2009 10:48 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Last week's lead bullet point was that the risk rally had stalled, for the moment. Lacking any solid technical indications of a reversal, we could only highlight potential for an upcoming correction in risk assets. This week, however, we have no such hesitation and a plethora of technical evidence that a multi-week top in the risk rally has been made. Ultimately, this should be USD supportive, given recent high correlations and excessive USD short positioning. However, the real driver of USD weakness is near-zero US rates, which will not be changing anytime soon. In light of that, the USD recovery should not be in a straight line, but rather fraught with continued choppiness. As a result, we will look to buy the USD on dips in the weeks ahead against all but the JPY. The JPY remains the primary funding currency, and barring a collapse in US rates in the weeks ahead, this should remain the case. As such, we will also look to re-sell JPY crosses (EUR/JPY, AUD/JPY, GBP/JPY, etc) on any rebounds, and the JPY cross decline is likely to be the most pronounced FX outcome of any risk unwind. Lastly, the outlook for gold remains somewhat confused, given the various forces at work. But our preference is to be sellers while it holds below the 1070/75 area, and we will become more bearishly convinced on a daily close below the 1025/27 level, targeting a move lower to 970/980 initially.

The USD may also benefit from a G20 gathering in Scotland at the end of next week. Market reports suggest European officials, in particular, will press the US to take a firmer tone in defense of the USD, basically asking the US to put some teeth in its much maligned "strong dollar policy." Short of threatening market intervention, it is difficult to envision US officials moving beyond verbal intervention to support the greenback. That does leave open the potential for disappointment coming back to haunt the USD. But a chorus of support from the G20 and intensified US rhetoric, coupled with an overall short dollar position exodus, may be enough to lend the USD additional support.

Fed Speculation Is Misguided

There has been increasing speculation in the market that the FOMC will drop the "extended period" language from their policy statement next Wednesday afternoon. That view was spurred by comments from an advisor to the NY Fed that he could "imagine" the Fed dropping the commitment. We do not expect the Fed to alter that language. Recent FOMC member comments and the minutes of the last meeting suggest a majority of Fed officials are increasingly concerned about the trajectory of the economy as stimulus efforts wind down. The retention of that commitment may provide a brief USD setback and perhaps a respite to stock markets, but we think the overall somber tone of the Fed's outlook will keep that short-lived. More intriguing is the prospect that the Fed will single out the beleaguered USD for comment. Traditionally the purview of Treasury, this Fed spoke out in support of the USD last year as it was near its weakest. The Fed may mention USD weakness as a potential headwind to economic recovery, as it may spawn inflation and undermine consumption. If the Fed speaks out on the USD, it would also signal the rest of the G20, and the ECB in particular, that Washington "gets it" and will be more forceful in defending the dollar. If the Fed statement mentions the word "dollar," we would expect a significant boost for the buck.

Earnings Still Little to Write Home About

With 65% of S&P 500 companies now having reported, the 3Q earnings season continues to look considerably worse. Bottom line earnings (EPS) are indeed beating by 13% on aggregate, but this is down from a 16% surprise one week ago. Meanwhile, sales figures have worsened materially. Last week, aggregate sales figures were about in line with overly conservative estimates. The additional 150 companies or so that reported this week helped ratchet that number down to a -1% surprise. As the sample size grows, it is becoming clearer that EPS was once again driven by massive cost cutting, mainly on the employment front. Organic growth remains non-existent and the consistent +500K prints in the weekly initial jobless claims figures suggest it is still a ways away.

Earnings expectations ultimately drive stock prices and we believe the market is now realizing that perhaps the forecasts in the quarters ahead are overly optimistic. With the S&P 500 trading at a price/earnings multiple well above 20, this makes the case for a short-term top in the equity space even more compelling. The downside pressure in the S&P is alive and well while it trades below the 1050 level and a drop below 1035/1030 suggests a test of the 100-day moving average near 1000 next. Given the US dollar's extremely robust correlation with stocks this year-at better than -90%-we would expect the greenback to continue to benefit from this unwind in risk appetite.

MORE: Changes Coming to ECB Policy, Key Data/Events This Week


ECB Could Be on the Point of Reigning in Enhanced Policy Measures

Bundesbank chief Weber has suggested that the ECB may not continue with its 12-month auctions next year, though one more has been scheduled for 2009. The addition of liquidity at the short end has been the mainstay of the ECB's enhanced policy responses to the financial crisis. QE has been small. At the most recent auction for 12-month funds, demand was well below expectations. The ECB took the view that this indicated that the improved health of financial institutions meant reduced dependence on the ECB for liquidity. If ECB president Trichet confirms on August 5 that the 12-month auctions will be withdrawn by next year, this is the tone that he is likely to take. The absence of any inflationary pressure in  euro zone CPI suggests that the ECB's refinance rate will be maintained at its 1% low for many months yet, suggesting impact on the EUR should be limited.

Key Data and Events to Watch This Week

The calendar in the United States is very busy. Monday kicks it off with ISM manufacturing, pending home sales, and construction spending. Factory orders and vehicle sales are due Tuesday, while Wednesday brings the ADP employment change, ISM services, crude oil inventories, and the FOMC press release (more on this above). Productivity and the usual jobless claims are up Thursday and Friday rounds out the week with the all-important NFP report, wholesale inventories, and consumer credit.

The euro zone is a touch lighter, but has important releases due out nonetheless. Monday starts with EZ PMI manufacturing and we then wait until Wednesday to get PMI services and EZ producer prices. Thursday brings EZ retail sales and the ECB rate meeting, while Friday has the French trade balance and German factory orders.

It is an important week for the UK as well. The Hometrack housing survey and PMI manufacturing are up on Monday. Wednesday has nationwide consumer confidence and the PMI services index on tap, while industrial production and the Bank of England rate meeting are scheduled for Thursday. The week ends with producer prices on Friday.

Japan has an extremely light week ahead. The Bank of Japan meeting minutes on Thursday and the employment report on Friday are the only noteworthy releases.

Canada is also very light. Building permits and the Ivey PMI index are scheduled for Thursday, while Friday sees the all-important employment report.

The calendar down under is on the busy side. The action kicks off Sunday with Aussie performance of manufacturing. New Zealand hourly earnings are due Monday, while the RBA rate meeting is the highlight on Tuesday. The New Zealand employment report is on tap Wednesday along with Aussie retail sales and building permits. Thursday closes things out with Aussie trade numbers.

By Brian Dolan, chief currency strategist,

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