The Forex Trading Week Ahead

06/14/2010 10:59 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Most major markets saw some stabilization in the past week, but recent range highs have contained most of the gains. JPY crosses and commodity currencies led the charge higher after a raft of data releases at the end of the week rejuvenated the view that the global recovery was continuing. We remain extremely cautious on the prospects for further gains in risky assets (stock, commodities, JPY crosses, and commodity currencies) going forward, as the weight of looming fiscal austerity measures, high levels of unemployment, and struggling consumer demand (seen in the latest US retail sales decline), is more likely to undermine rather than support the global recovery. As such, we prefer to remain sellers of risk assets on strength. Another way of looking at it is that this past week's price action has simply “closed the gap,” or re-tested the prior week's breakdown levels, which have held. This suggests consolidation, rather than a correction higher, in risk.

In terms of specific price levels to monitor, EUR/USD has critical resistance in the 1.2150/1.2200 area, and the 1.1800/50 area is critical support. The US dollar index is also worth watching as key, five-year-old trend line resistance was tested this week at 88.50, but has held for the time being. In stocks, the S&P 500 is biased lower while below the 1105/10 level and the 1035/1040 area is the support to watch. AUD/JPY as a proxy for other JPY crosses (and 90% positively correlated to the S&P 500) faces resistance from recent range highs at 78.00/79.00 and selling in that area is the focus of our weekly strategy, looking for a drop back to the 72.00/74.00 area. WTI crude oil prices are also facing key resistance in the 75.50/76.50 area. Gold prices were once again turned back from the 1250 level, leaving a more prominent potential double top pattern, but need to see below the 1195/1200 area to generate any downside momentum.

USD/JPY proved extremely sticky on the downside this past week, and we think this may be a sign of a shift in recent trading patterns after the new Japanese government has indicated it may take action to stem JPY strength. The pattern of the last few months was for USD/JPY to be quickly sold on disappointing economic data/news and bought on positive surprises, as JPY crosses remained the primary risk barometer. If the downside is now limited by fears of official support, we may see more pronounced risk reactions in the non-JPY dollar pairs, e.g. AUD/USD will move more sharply in response to market news/data, keeping AUD/JPY intact as an expression of risk sentiment.

Sterling Hit by Production Data

Sterling took a hit on the release of the much-worse-than-expected UK April manufacturing production data. This dropped by -0.4% m/m, compared with a median expectation of +0.4% m/m with reduced production of cars taking its toll. The data will fuel fears that the economy may fall back into recession once the government starts its massive fiscal tightening program; expected to kick off after the June 22 budget. Also of concern for UK markets has been the publication of the BoE's quarterly survey of inflation expectations. The survey predicts that inflation will be 3.3% y/y in a year's time, well above the target of 2.0% y/y. While UK inflation is presently well above target at 3.7% y/y, the BoE is firmly of the view that excess capacity in the economy will drive the inflation rate lower. However, an increase in inflation expectations risks driving wage deals higher, and this will make the BoE uncomfortable. The June 15 release of UK CPI release is expected to bring a moderation in the headline number back to 3.5% y/y. At present, it seems unlikely that the BoE will hike rates until well into 2011. However, a strong number here will intensify fears that the BoE may have to bring forward a rate hike. Combined with the anticipated fiscal tightening, this would have very poor implications for growth, and this may restrict the pound's upside potential on a rate hike. Cable has retraced half of Friday's gains, pushing down below USD1.4640. EUR/GBP has broken back above the 200-hour SMA at 0.8290, suggesting the scope for further near-term gains. However, the downtrend remains intact on the daily charts, suggesting the up move may be corrective in nature.

Tension in the Euro Zone Comes Off the Boil

The acknowledgement this week by ECB President Trichet that the economic environment is "of high uncertainty" was followed by a pledge that three-month tenders will be extended through September. Clearly, keeping liquidity levels ample remains a high priority for the ECB. That said, tensions in the euro zone have come off the boil, for the time being at least. The decent demand seen in the Spanish three-year bond auction followed a smooth result for the Portuguese bond sale and will have brought a sigh of relief from EU officials. It was not without cost, however. The 2.1 bid/cover ratio in the Spanish auction was won with a rise in the average yield to 3.317%, up from 2.007% in April. Even so, the fact that there is still appetite for Spanish and Portuguese debt on the open market reduces the likelihood of sovereign default, as well as providing an endorsement from investors on the budgetary commitments of the Spanish and Portuguese governments and on the exceptional measures taken by the ECB and EU policy makers. While this was a positive step forward, the war is a long way from being won. Budget deficits still have to be crushed, and whether or not the electorates have the stomach for budgetary reform has yet to be thoroughly tested. Medium-term, the EUR is likely to maintain its downward bias.

World Cup, Futures/Options Expirations May Affect Trading Conditions

The World Cup has begun and trading rooms the world over have caught football fever. If past experience repeats, trading activity may become more languid over the next few weeks, especially in the European and NY afternoons, as traders focus on the matches and less on risk taking. In essence, many people won't be trading as much unless they're forced to by news or price movements themselves. If so, market movements may become more volatile and persistent (meaning less two-way price action), as the normal countervailing interest fails to materialize. As well, this week sees a series of US futures and options contract expirations (quadruple witching), which may also adversely impact liquidity and heighten volatility. Finally, we are heading into summer and seasonal doldrums may also become apparent.

By Brian Dolan, chief currency strategist,

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