The Forex Trading Week Ahead

05/24/2010 10:47 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Last week, we suggested that EUR/USD might base out in the 1.2150/2200 area and then begin a correction higher and that Elliott Wave projection proved spot on. Market short covering, spurred on by rumors of intervention (actual in the case of the SNB in EUR/CHF), sparked the move higher, but there's more to it than that. Despite the cacophony of doomsayers predicting the demise of the EUR and an end to the global recovery, markets actually got what they have been demanding for the last several weeks: Passage of the peripheral EU rescue package by Germany and others and a commitment to defend the EUR. A sovereign debt default by Greece, Portugal, or Spain has effectively been forestalled for the next several years, buying those nations time to get their fiscal houses in order. That they will experience economic pain and further social unrest in that time is certain, but the immediate crisis seems to have passed. As to the threat of European debt problems cutting short the global recovery, there too, fear seems to have gotten the better of reason. Europe was never expected to contribute greatly to the global economic recovery. Meanwhile, growth continues solidly in emerging Asia, and the North American recovery is gaining momentum, a few data disappointments (weekly claims and LEI) notwithstanding. In short, if one believes the immediate EUR crisis was behind the decline in global stocks and other risk assets, then it stands to reason that a stabilization and rebound in the EUR should augur well for risk sentiment in general.

In terms of price action suggesting a near-term EUR base, in addition to reaching a key Elliott Wave projection at 1.2150/2200, EUR/USD made a double bottom at 1.2150 amid feverish volatility. The measured move objective for that pattern suggests a correction to the 1.2750/2800 area at the minimum. (The 38.2% Fibonacci retracement of the most recent EUR decline from 1.3680 is at 1.2730, highlighting that area as well.) Lastly, this past week is the first weekly increase in six weeks, and on a weekly closing basis, EUR/USD held above the October 2008 1.2330 blow-off lows. Our longer-term view still looks for a lower EUR, but we now expect a correction higher that may prove surprisingly forceful given the amount of short EUR positioning. We'll look for the EUR/USD to recover higher while the 1.2300/50 area holds and target gains back to that 1.2750/2800 area. Above that level may see an even larger short squeeze into the 1.31/32 area, where we will look to establish strategic, longer-term short positions.

GMO Week Sees Excessive Risky Asset Declines

Last week, we also suggested that risk assets (JPY crosses, AUD, and CAD) had been knocked down to more attractive levels and looked like buying opportunities, but that view was obliterated by what can only be described as a "Get Me Out" market capitulation. Nowhere is this more evident than in the massive short squeeze in several no-brain trades of the past year, like short EUR/AUD or short EUR/CAD. It's also seen in US Treasury yields dropping to recent range lows (3.15/20% in ten-year US Treasuries). Those ten-year yields also posted a prominent hammer on the daily candles to end the week, a potential indicator of a reversal higher. (By the way, whatever happened to the bond vigilantes and concerns over US deficits? How long until market concerns refocus on US indebtedness again?) While it remains risky to buy into a panicked market, we think recent risky asset declines have become excessive and are ripe for a correction. Rather than wading in with two-fisted buying, however, we'll stick to one-handed buying on remaining weakness for now until we see further signs of a change in direction. In particular, we would look at buying AUD/USD in the 81.00/50 area (0.8107 is 38.2% retracement of the 0.6000-0.9400 advance) and selling USD/CAD in the 1.0700/50 area (weekly cloud bottom is at 1.0752). JPY crosses also look attractive again, and if we see US yields begin to back up, we'll be more confident about risk buying.

In terms of risk sentiment stabilizing, economic data this week will be more important than usual as a few data bright spots could quickly swing sentiment back around to the view that the global recovery is continuing and that Europe, in particular, might not be the immediate basket case it has been made out to be. We'll be watching US durable goods orders and consumer confidence and euro zone industrial new orders closely.

NEXT: What to Watch for in the EUR This Week

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Medium-Term Bias for EUR Still Lower, Short Covering May Support Near Term

The extreme levels of volatility in the market are obvious signs of heightened anxiety. There are now signs that the market has overreacted to the uncertainties stemming from the fiscal crisis in the euro zone, and while fairly choppy conditions may persist for some time, short covering could continue to take the EUR higher in the short term.

Fundamentally policy makers in the euro zone continue to face a lot of uncertainties. The decision by the German Bundestag to endorse Germany's EUR 148 billion contribution to the European Stability Fund was no real surprise. That said, the fact that 195 Bundestag members (of 622) abstained and 73 voted against is a measure of the displeasure that many Germans feel about their perceived position as the “bankroller” of Europe. Chancellor Merkel indicated earlier in the week that Germany would not be prepared to keep paying to support less-prudent EMU partners. She also indicated that sovereign insolvency should be studied. This suggests that Germany may request that the EMU's Stability Pact should be extended to include such provisions. Clearly, there are a lot of political hurdles to be negotiated before doubts about the future of the EUR unwind.

While short covering may chase EUR/USD higher in the short term, the medium-term trend in the EUR is likely to remain bias lower, consistent with the relatively soft outlook for growth and interest rate differentials in the euro zone relative to the US. Weaker-than-expected German PMI data for May (at 58.3 for the manufacturing component down from 61.5 in April) and the softer expectations component of the May IFO (down to 103.7 from 104.0 in April) provide further signs that the fiscal crisis in the euro zone is impacting confidence in the real economy. By contrast, the Fed has revised higher its outlook for US growth to 3.45% in 2010; market forecasts for euro zone growth are closer to 1.1%. Medium term, EUR/USD can move below its 1.18 long-term average towards 1.10 and potentially lower.

Queen's Speech Expected to Give Some Guidance on UK Budget Reform

The Queen's speech in the coming week will set out the agenda of the new UK government. It is expected to give some guidelines as to the proposed GBP 6 billion in government savings this year and is likely to underpin the coalition's commitment towards budgetary reform. That said, the markets will have to wait until June 22 for details as to where the government intends to make most changes to spending and revenue. Hints from ministers that the UK's fiscal position may be even worse than previously indicated have undermined the pound. The break above the 21-day SMA in EUR/GBP is a bearish technical signal for the pound. Looking forward, sterling can be expected to find support versus the EUR if the government makes progress on fiscal reform. Key support for EUR/GBP is last year's low at 0.8400.

By Brian Dolan, chief currency strategist, FOREX.com

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