USD at Critical Juncture

11/16/2009 11:11 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The risk rally extended gains this past week as optimism over the global recovery beat out concerns that rising unemployment may lead to continued sluggishness. The USD, meanwhile, finished out roughly in the middle of the week's range after testing near to its recent lows against the EUR and other currencies. The optimists took heart from G20 nations vowing to maintain stimulus efforts until a more solid recovery was underway, while the USD took a drubbing after the IMF told us what we already know: That the USD is being used as a funding currency. Unfortunately for the bulls, the G20's pledge was largely hollow, as fiscal stimulus efforts in many countries are mostly winding down and initiatives to extend them seem fiscally unavailable. The early-week rally in risky assets faltered mid-week, but managed to stage a minor comeback on Friday. In the process, recent highs in the S&P 500 were briefly surpassed, but they held on a weekly closing basis. Similarly in FX, recent USD lows were tested and recent highs in other currencies were tested and briefly surpassed in some cases, only to see the USD recover into the end of the week.

The price moves set the stage for a potential double top formation to develop in several key asset markets if risk assets see a further pullback next week. In the S&P 500, the October high of 1101 was briefly surpassed this past week, but prices finished out below it for the day and week. Also of note is a major daily trend line from the all-time highs at 1507 way back in October 2007, which comes in at 1103 as critical daily close resistance. In EUR/USD, the 1.5060/65 October high was not breached and the subsequent pullback highlights that level as critical resistance. USD/CHF similarly made a double bottom at 1.0030/35. AUD/USD also looks to be making a double top in the 0.9330/50 area, though the upside looks more viable in Aussie. We may not yet know whether risk appetites will retreat next week, but we certainly know what price levels will signal another leg higher in the risky assets, down for the USD. We will be closely watching the levels outlined above for daily close breaks (5 pm EST is the daily close) as a signal that the risk rally is extending, and the USD is taking another dip lower. Until then, and in light of the cacophony of USD bearishness, extreme short-USD positioning, and what we think is still an overextended stock market rally, we prefer to be USD buyers on dips (against all but the JPY), using the levels above as relatively low-risk stop-out/reverse levels.

US Retail Sales on the Radar Versus EUR in the Approach to November MPC

The US retail sales report is due up on Monday and will be closely watched by the market. Consensus is that headline sales will increase by 0.9% in the month of October, but most of this is expected to come from the autos component. The auto sector witnessed a statistical rebound following the bleak September read that was a result of the cash for clunkers hangover. Ex auto retail sales are forecast to print a more modest 0.4% increase. Economists have had a difficult time pinning down this release in 2009, missing the actual result by 0.6 percentage points on average. Thus the risk that we see a negative print is not trivial.

More importantly, however, will be what the components do when we exclude the auto, gasoline, and building materials components. This core number is what feeds directly into GDP and will dictate what kind of handoff we get for 4Q growth from this 70% chunk of the economy known as consumer spending. The bulls had better hope we see a strong print because all of the anecdotal evidence thus far suggests that the holiday shopping season will be a dud. Most recently, the University of Michigan consumer sentiment index shed some light on this front. The forward-looking economic outlook component plunged to 63.7 from 68.6 last month and 73.5 in September. This component leads consumer spending and implies some caution is warranted on the retail front.

The recent trend higher in energy prices is also a concern. Indeed, the jump in long-term inflation expectations to 3.1% from 2.9% this week suggests that the 8% jump in retail gasoline prices since the beginning of last month is beginning to bite. Our research indicates that every penny increase in pump prices subtracts about $1.2 billion at an annual rate from consumer pocketbooks. So the recent swing higher equates to a whopping -$24 billion drag on the economy.

The recent intermarket correlations are likely to remain intact and thus a weaker number should see equity prices falter and the US dollar strengthen, and vice versa. The risk looks a bit asymmetrical, however, as a better number would not necessarily paint a rosy picture for consumer spending going forward, thus limiting the upside for stocks and the downside for the US dollar.

MORE: BoE Meeting May Impact Pound, Key Data This Week


MPC Minutes Could Bring Clarity to the Issue of BoE QE

The market is skeptical as to whether the UK economy will be able to match the BoE's optimistic 4% growth forecast for 2011 contained in the BoE November quarterly inflation report. In spite of the Bank's healthy forecasts for growth, the accompanying rhetoric supplied by Governor King was clearly dovish with the Governor warning that inflation was more likely to be below than above the 2% inflation target in two years and that output is unlikely to return to pre-crisis levels for some time. On the subject of quantitative easing, King appeared relatively supportive of the plan, stating that the policy will ultimately stimulate spending and that he has an open mind on QE going forward. This was a rebuff to the view that in deference to the lack of response in M4 from Q4, the BoE will likely phase out QE by February. The upcoming release of the minutes of the November MPC meeting will shine further light on the position of the whole committee with respect to QE. The addition to QE announced this month will stretch until February; any sign that the committee may increase the scale of QE again in February can be expected to weigh on the pound.

Cable Continues to Find Buyers on Dips

In spite of the dovish tone of Governor King and a moderately better tone of the USD, cable has recovered from the week's lows. Cable has continued to run into good buying on dips, which strengthens the USD1.6520 technical support and the view that a moderately bullish tone in cable still persists. Given the softer tone in EUR/USD, the firm tone in cable has pushed EUR/GBP back to just above the 0.8900/10 support area. A break below EUR/GBP0.8900/10 may see back to the 0.8850/70 area, though the inability of the UK economy to pull out of recession in Q3 and the ability of the euro zone to register an expansion of +0.6% q/q in Q3 suggests that a sterling recovery versus the EUR could be short-lived.

Key Data and Events to Watch This Week

The calendar in the United States heats up following a very slow week. Retail sales (more on this above), the NY empire manufacturing index, and business inventories kick it off on Monday. Producer prices, international capital flows, industrial production, and the NAHB (homebuilder confidence) survey make for a busy Tuesday. Consumer prices, housing starts/permits, and the usual oil inventory stockpiles data are due Wednesday. Thursday rounds out the week with initial jobless claims, leading indicators, and the Philadelphia Fed manufacturing index. There are also plenty of Fed speakers on the agenda and Fed Chairman Bernanke is the highlight of these on Monday.

We have a little less data in the euro zone. Consumer prices are up on Monday, while the trade balance is scheduled for Tuesday. German producer prices close things out on Friday. There are a ton of ECB speakers as well and ECB President Trichet is on tap Thursday and Friday.

The UK is modestly busy. Home price data kicks it off on Monday, while consumer prices are on deck Tuesday. The Bank of England minutes will be closely watched on Wednesday for any talk regarding quantitative easing and the extension thereof. Mortgage approvals, public sector credit, and the all-important retail sales report are up Thursday.

Japan has some top-tier events lined up. Gross domestic product starts the week off on Sunday, while Monday has the tertiary industry index. Machine tool orders are on deck Wednesday. The all-industry index, leading index, and department store sales make for a busy Thursday, while the BOJ rate decision (likely a non-event) ends the week on Friday.

Canada is characteristically on the light side. Manufacturing sales get things going on Monday, while Wednesday has the consumer price indices. International capital flows and the index of leading economic indicators close things out on Thursday.

It is not very busy down under. Australia has the RBA minutes on Tuesday, the Westpac leading index on Wednesday, and wage data on Thursday. In New Zealand, meanwhile, we'll see the performance of services index on Sunday along with producer prices and credit card spending on Friday.

By Brian Dolan, chief currency strategist,

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