Risk Is at a Tipping Point for Currency Traders

01/25/2010 10:40 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

In last week's update, we cautioned that risk was in retreat, and that more downside was likely to develop. This past week saw risky assets (stocks, commodities, and JPY crosses) slide further as new Chinese lending restrictions undermined the outlook for the global recovery generally, and for commodities especially. Softer ZEW surveys and European debt concerns centered on Greece continued to drag on the EUR, and there were some signs of deficit contagion spreading to other nations as well (see more below). Mixed 4Q corporate earnings reports were already weighing on stock market sentiment when late last week, US President Obama announced plans to rein in banks' trading operations and overall size. The plans sparked fears of capital flight from the US and led to steep losses on individual banks' shares and pressured broader markets further. On Friday, concerns over the fate of “Helicopter Ben” Bernanke's re-confirmation to a second term as Fed chairman appeared to add to market fears. (Bernanke is viewed as a friend to markets.) The USD has broadly benefitted, but the real FX movers in the current risk selloff have been the JPY crosses, which we expect to continue to be the primary reflectors of risk sentiment. We are skeptical about the fallout on the USD from the Obama bank plans, but we can't completely ignore it either.

This week brings us into month-end, along with some important data releases/events, and we expect the usual volatility to emerge. However, prices in many markets have fallen to some important psychological and technical levels, and we are increasingly cautious on the prospects for further downside in risk after this past week's losses. From the fundamental side, markets may very well have overreacted to many of the recent developments. For example, China is cutting lending precisely because its economy is growing so strongly and inflationary pressures are building—hardly a reason to doubt the strength of the global recovery. The Greek deficit concerns have been with us for a while and will not be resolved anytime soon, but its impact on the EUR appears to be somewhat overdone, given the low prospect of EMU breaking up. The Obama bank plans are also potentially a source of exaggerated negativity, given that the details have not been disclosed, and the entire proposal needs to go through Congress, where it could be substantially modified or even rejected. Lastly, Bernanke's re-nomination appears subject to a populist backlash, but the negative stock market reaction to his being rejected may lead senators to reconsider.

In terms of prices, The US dollar index appears to have failed at the 200-day MA at 78.51, and has printed a double doji. The failure and price pattern would suggest the potential for a US dollar reversal lower, which would fit with the “capital flight out of the US” scenario, or a sudden rebound in commodities. Similarly, EUR/USD made a short-term double bottom just above the psychologically significant 1.4000 level, while GBP/USD has held up well above the 1.6000 level. On Friday, EUR/JPY managed to hold above the 127.00 recent lows despite further declines in stocks and commodities, while GBP/JPY has held above the cloud bottom at 144.75. USD/JPY is the rogue here, and it could be vulnerable to a downside shakeout if USD negativity heats up; 89.30-80 is key support. Gold prices printed a hammer on Friday (a bullish reversal signal after a decline) and based out above the key 1075/1080 support zone. Similarly, oil prices (WTI/USD) are holding above the bottom of the cloud at 73.90 into Friday's close. To be sure, momentum favors a further extension of the risk selloff, but we can also easily imagine a significant rethink of the current panic and for bargain hunters to emerge and for risk to bounce sharply. Daily closes below the key support levels outlined above will convince us that another leg down is unfolding, but until then, we remain cautious. Risk is at a tipping point—things will either stabilize and recover, or another sharp downdraft is in store. Monday will likely be the defining day to resolve that outlook.

NEXT: This Week's Fed Meeting Could Move the Markets

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Fed Meeting Could Prove Market Moving, for a Change

The Federal Reserve is due to announce its latest interest rate decision on Wednesday at 1415ET. The market is once again unanimous in expecting no change to the ultra low 0.00%-0.25% interest rate band. Thus, the statement will be the main focus for traders. We expect little to change in terms of the economic outlook, and at best, the Fed will likely mark-to-market the gradual improvement in employment (that latest pop in initial jobless claims notwithstanding). Inflation is likely to be of little concern as well, given that expectations for price increases at the consumer level remain anchored. The area that will garner the most interest is their language on rates going forward and the potential for any tweaks in their effort to end their 1.25 trillion MBS purchase program.

Special focus will be given to whether the Fed leaves in the line that current conditions are "likely to warrant exceptionally low levels of the federal funds rate for an extended period." Some Fed officials have recently commented that perhaps this language should be changed. Should the Fed alter this to a more "hawkish" stance (more willingness to raise rates sooner rather than later), we would expect the US dollar to outperform the majors. This would also likely elicit a retreat in equity markets as the removal of the proverbial "punchbowl" would be viewed as a stock negative. Thus, the yen crosses (especially EUR/JPY, GBP/JPY, CAD/JPY, AUD/JPY) would likely come under intense pressure.

The Fed could balance this by showing a willingness to extend their MBS (mortgage-backed securities) purchase program beyond the current March deadline. Of interest is a recent US Treasury survey currently making the rounds at the major Wall Street bond dealers that asks what the potential impact to the MBS market would be from the Fed's exit. These results are not expected to be discussed until the day after the Fed meeting, but we would have to think that the FOMC would be privy to the survey before then.

Given that the Fed absorbed almost 100% of the MBS issuance since beginning their program, it is quite difficult to ascertain what the real demand for this paper looks like. Some believe that the Fed exit will elicit an immediate 50-100 basis points backup in mortgage rates. Given already-weak demand on the residential real estate front, this would only worsen the outlook for US housing. Any extension to the plan, however, would also mean that more "money printing" is in the offing and this would ultimately scare off some of the US dollar bulls. Bottom line is that this could prove one of the more eventful Fed statements we have seen in a long while.

Greece Bond Sale Could Be a Test for EUR

News from the Greek debt office that the government intends to sell a minimum of EUR 3 billion five- or ten-year bonds via a syndicate of banks has resulted in further widening in Greek bond yield spreads. More details on the sale are possible in the coming week. While Greek debt has cheapened significantly this month, there are considerable concerns in the market that the government will be hard pressed to garner sufficient demand for its bonds. Not only have spreads over bonds ballooned, but credit default swaps on Greek government debt have risen to record levels. Perhaps more worrying has been the rise in credit default swaps on government debt on countries such as France, Belgium, and the US in response to the perception that government stimulus to prevent economic depression last year has switched risk from the private sector to public sectors. While sovereign default risk is arguably still modest, the forthcoming Greek bond sale may be seen as a litmus test for demand for debt for other countries suffering from excessive deficits. With the Portuguese budget due to be presented to parliament on January 26, and given Spain's need to balance the need for fiscal restraint against an unemployment rate which could reach 20% this year, the EUR is likely to remain in the firing line.

MORE: Key Data and Events to Watch This Week

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IFO May Confirm or Dispel Fears That Pace of German Recovery Has Lessened

The release of the German IFO survey will likely be a welcome diversion to euro zone budget issues. This comes against worrying that the pace of the German recovery slowed significantly during Q4 and into Q1. While the market expects a moderate rise in the overall index, no change is foreseen in the current assessment component.

GDP Data Set to Confirm UK Finally Shook off Recession in Q4

UK Q4 GDP data is likely to confirm that the economy finally pulled itself out of recession at the tail end of last year. The market is expecting to see growth of 0.4% q/q, up from the -0.2% q/q contraction that was registered in Q3. Sterling will be sensitive to any strong divergence from this median. In view of the better tone of the pound over the past couple of weeks, the pound will be particularly vulnerable to a poor number. In view of the disappointing soft +0.3% m/m UK December retail sales data, UK GfK consumer confidence and the CBI distributive trades survey will also be keenly watched. Weaker data will reinforce the view that the BoE is unlikely to bring forward rate hikes and could sap the recent firmer tone of the pound. In view of the clouds hanging over the EUR, a negative sterling view may be better expressed in cable (GBP/USD). A break below GBP/USD 1.6050 could see lower towards USD 1.6000 next.

Key Data and Events to Watch This Week

The US calendar heats up next week and starts with existing home sales on Monday. The Case-Shiller home price index and consumer confidence are up on Tuesday, while Wednesday brings new home sales and the usual weekly oil inventory numbers. The Fed also concludes its interest rate meeting on Wednesday afternoon (more on this above). Thursday is a touch busier with the Chicago Fed National Activity index, durable goods and jobless claims. Friday rounds out the week with the Chicago PMI and the University of Michigan consumer sentiment index.

It is pretty eventful in the euro zone as well. German consumer confidence starts things off on Monday and is followed by the EZ current account and the German IFO business climate indicator on Tuesday. French consumer confidence, French employment, and German CPI make for a pretty busy Wednesday. Thursday brings EZ consumer confidence and German employment, while EZ employment closes things out on Friday.

The UK has a light but significant data week ahead. 4Q GDP and home loan data are up on Tuesday, followed by the CBI distributive trades (retail sales) at midnight GMT. GfK consumer confidence wraps things up on Friday.

Japan is relatively busy and kicks off the week in earnest with the BOJ rate meeting on Tuesday. That day also brings small business confidence and international trade. Retail sales are the highlight on Wednesday, while employment and consumer prices are due Thursday. Industrial production closes out the week on Friday.

Canada has an ultra-light week and the only noteworthy piece of data is monthly GDP on Friday.

It is an important week down under. New Zealand has credit card spending on Tuesday, the RBNZ rate decision on Wednesday, and international trade on Thursday. Australia sees producer prices on Monday, consumer prices and the economic leading index on Wednesday, and private sector credit growth on Friday.

By Brian Dolan, chief currency strategist, FOREX.com

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