Currency Markets to Remain Beholden to the Risk Trade

11/23/2009 11:01 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The moves this past week should convince anyone who had any doubt that the correlation between equity markets and currencies remains alive and well. It was a rollercoaster, with EUR/USD oscillating between 1.4800 support and 1.5000 resistance for the better part of the week. The S&P 500, meanwhile, continued to find interest on either side of the pivotal 1100 level. It seems that EUR/USD 1.50 and the S&P 1100 go hand in hand as both remain extremely challenging technical and psychological levels. Indeed, both have only closed above those crucial levels three times this year-euro in October and stocks just this week. It should not surprise anyone that the correlation between these two since the beginning of the second half of 2009 has been a stellar 92%. Don't look for much to change on this front anytime soon.

In this vein, we look for any reversal in the risk trade to elicit a significant turn lower in euro. The fact that stocks could not pull off any sustained rally this week despite what was better-than-expected data should be concerning for the bulls. US retail sales early in the week were strong at the core level, with the control number (ex autos, gasoline, and building materials) increasing by 0.5% in October on the heels of similar increases the prior two months. But equities did not rally in earnest that day until Fed chairman Bernanke left no doubt that rates were not going up anytime soon. Even more surprising was the -1.3% collapse in equities witnessed on Thursday. That day saw a steady initial jobless claims read of 505K and a much better Philly Fed manufacturing index (which was even stronger in the details). The fact that the market cannot seem to rally on good news makes us think that the risk of a short-term correction is more likely than not.

The data over the next few months is likely to be disappointing to say the least, most importantly on the holiday shopping front. Sales will be followed closely as memories of the disaster of last year still lurk. The anecdotal evidence suggests that the season will be a dud. The percentage of consumers planning to spend less this year is a whopping 56% versus just about 40% ahead of the 2008 season. Meanwhile, consumer economic outlooks (a leading indicator of spending) have rolled over in recent months. The University of Michigan consumer outlook index is once again plumbing the depths at 63.7 in November after hitting a nearby high of 73.5 just two months ago. Weak holiday sales coupled with an unemployment rate that has 11% in the crosshairs could be the nail in the coffin for the current rally. If past is prescient, we could see EUR/USD closer to the 1.45 handle sooner rather than later.

Bullion's Bull Run Still Intact Versus EUR in the Approach to November MPC

Gold looks poised for a weekly gain of more than 2% as we write, having tested the air above $1150 well before we anticipated. This would be the third consecutive weekly gain and the seasonal trends suggest the run could very well continue into year end. We wrote a few weeks ago that the seasonal trend in gold would put $1150 within striking distance by the end of December. This level has been tested well before our expected horizon and should the recent gains be sustained, the precious metal could be sitting near the $1300 mark as we close out 2009. Looking back at the last 20 years shows that the November and December months have been extremely kind to gold. We maintain that the upside is firmly in focus for now.

One of the concerns is that the gold trade has become extremely one-sided. Indeed, the net speculative contract position is currently sitting at a long 272K. This is just a hair below the record 281K set back in October when gold was taking out the $1000 level in earnest. The last time the long position in gold was this one-sided was back in July 2008 and the eventual unwind saw the price plunge -24% over the ensuing three months. That sort of correction this time around would put us somewhere in the realm of $870 per ounce. This is merely a risk to keep on the radar and not our base-case scenario.

Our optimism in terms of the durability of this rally comes from the fact that corrections in gold have been limited even on days of considerable US dollar strength. For example, the US dollar index jumped more than 0.6% on Tuesday and gold actually managed to rally 0.2%. It seems that the precious metal has not only become a referendum on the weak US dollar, but a hedge against all fiat currencies. This has been most evident in the decision by India to purchase 200 metric tons of gold from the IMF in order to diversify their reserves. The IMF had announced plans to sell a total of 400 metric tons and speculation is rife that China will be in the bid for the remaining 200 tons. This could be the catalyst that sends gold right through the $1200 area.

The technical picture for gold remains bullish for now as well. Important support rests at the $1130 area, and we have seen much buying interest ahead of that zone, namely from Middle Eastern names this week. A daily close below there should open up potential for a move back to the critical $1100 level next. However, the bias remains higher while above there, and we are now looking for a daily close above the $1150 level to pave the way for a test of the daily uptrend line from the October 2008 and February 2009 highs, which comes in at $1163. Clear that hurdle and we should be staring at $1200 in short order.

MORE: GBP Takes a Pounding, Key Data to Watch This Week


Sterling Takes a Hammering; Focus on 3Q GDP and Public Finances

Sterling took a hammering in the tail end of the week. Cable plummeted through the previous week's low, while EUR/GBP steered comfortably back above the technically important 0.8900/10 area. Cable naturally finds it difficult to appreciate when the market is paring risky positions and buying US dollars. By the end of the week, risk appetite had retrenched, which supported the USD across the board and emphasized the size of the decline in GBP/USD. Whether or not the risk trade will see another flurry before year end remains to be seen, but it will likely take a decent move higher in EUR/USD to push cable back to its recent highs.

One of the key events for UK markets in the week ahead will be the November 25 publication of the updated estimate of 3Q GDP data. Some upward revision to the -0.4% Q/Q initial print is already priced in. Interestingly, while not one economist in the survey for the initial GDP estimate expected a negative number, now not one is expecting a positive number for the revision. The relatively cautious estimates of economists are in spite of much complaining that the ONS was way off the mark with the initial read.

Economists' expectations for an upward revision have been endorsed by the BoE, and this suggests that something more than the -0.3% Q/Q consensus is in the price. This suggests that it may take a number close to flat to bring fresh positive incentive into the pound. While cable will continue to be subjected to changes in appetite for USD, sterling is likely to retain its much undervalued status versus the EUR for some time yet in view of the terrible position of public finances and the expectation that fiscal consolidation will weigh on growth potential next year. Given that the approaching December 9 pre-budget statement will ensure the focus remains on public finances, there is scope for further weakness in GBP versus the EUR towards EUR/GBP 0.9050, and a break would signal potential to 0.9100. Support lies in the EUR/GBP 0.8930 area ahead of 0.8900/10 as well.

Key Data and Events to Watch This Week

The calendar in the United States is pretty eventful despite a holiday-shortened week in observance of Thanksgiving. The typically under-the-radar Chicago Fed national activity index kick tings off on Monday along with existing home sales. The second cut of US 3Q gross domestic product, Case-Shiller home prices, consumer confidence, and the minutes of the FOMC November 4 meeting are due Tuesday. The week closes out on Wednesday with personal income/spending, durable goods, jobless claims, University of Michigan consumer confidence, new home sales, and the weekly crude oil inventory numbers-talk about a busy day!

It is quite busy in the euro zone as well. PMI manufacturing surveys for the region are due on Monday, while Tuesday sees euro zone industrial new orders, French business confidence, French consumer spending, German gross domestic product, and the German IFO business climate indices. The German GfK consumer confidence indicator is up on Wednesday, while German consumer prices are on tap Thursday. The euro zone business climate indicator, euro zone consumer confidence, and German import prices round out the week on Friday.

The UK calendar is on the light side. Loans for home purchases are on deck Tuesday. Gross domestic product is due Wednesday, while the CBI distributive trades report closes things out on Thursday. Look for speeches from the Bank of England's King, Tucker, Fisher, Sentance, and Posen on Tuesday as well.

Japan has an important week for data coming up. The Bank of Japan's monthly report and the international trade numbers are due on Tuesday. Small business confidence and the BoJ policy meeting minutes come to us on Wednesday, while Thursday rounds out the week with employment, consumer prices, and retail sales.

Canada's agenda is characteristically light. Retail sales on Monday and the current account Friday are the only noteworthy releases.

It is rather light down under as well. Australia has new motor vehicle sales and the leading index on Monday. New Zealand sees business confidence and trade on Thursday and inflation expectations on Friday.

By Brian Dolan, chief currency strategist,

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