Three Key Themes Every Forex Trader Should Watch

11/22/2010 11:18 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Three main themes have dominated the market’s focus this past week and are likely to continue to garner attention moving forward. Markets have been fixated on the continuing debate surrounding QE2, Ireland’s debt concerns, and tightening in China, the world’s second largest economy. Several politicians and international officials have been publicly criticizing the Fed’s asset purchase program and calling for a halt of quantitative easing, citing inflation concerns and debasement of the US dollar, however, the Fed maintains its goal of price stability and full employment. US inflation data released this week reinforced the $600 billion bond buying plan efforts to fight deflation as October PPI came in much lower than anticipated at +0.4% versus expected +0.8% on the headline and -0.6% vs. expected +0.1% for the core month-over-month (MoM) reading. CPI was also softer than expectations with October CPI MoM at +0.2% (cons. +0.3%) and a core number of 0.0% (cons. +0.1%). Ireland was at the center of European debt concerns as the government has been under pressure to accept an international bailout to help its troubled banking system (including banks that passed EU bank stress tests just a few months ago). After denying acceptance of financial aid—which sent peripheral yields higher and weighed on the euro—the Irish government acknowledged the need for financial assistance and it appears the details are being worked out (more below). EUR/USD dipped to around 1.3450 on heightened debt concerns and has since bounced back to just under 1.3700 near where it began the week. China’s move to tighten weighed on risk sentiment, which was supportive for the US dollar. The PBOC explained that the move was taken “to strengthen liquidity management and appropriately control supplies of money and credit.” While China continues its tightening, investors are going to be more cautious holding onto risky assets and commodities (more below).

A Long Weekend for Ireland

It’s been a long week for Ireland as its debt woes dominated financial markets. However, what we thought would be a quick resolution has turned into a more protracted affair. IMF and EU officials are currently in Dublin to see exactly what type of financial aid Ireland needs. The Irish government is adamant that it will not accept a sovereign bailout and instead will only ask for financial assistance for its beleaguered banking sector. The Irish are also pushing a hard bargain and have pledged not to cut the low corporate tax rate, which is seemingly being protected at all costs by the Irish government. The market seems to be pricing in a neat resolution to Ireland’s problems, and risky assets have rallied. It seems unlikely that bailout package will disappoint. Initial estimates suggest that an aid package could top 80 - 100 billion euro. This is a manageable sum for the European authorities, and Irish ten-year bond yields have fallen sharply this week, declining by 80 basis points to 8.14%. The bigger risk is contagion. Portugal is considered the next peripheral economy at risk. Although its bonds have come off along with Ireland’s, they remain at elevated levels. Markets are concerned that Portugal’s weak economy won’t be able to cope with austerity measures to reign in its deficit, making a bailout all but inevitable unless its growth outlook improves. Whether Portugal will be pushed to the brink any time soon will depend on the markets and if there is euro zone debt fatigue. If there is a neat resolution to the Irish crisis, the markets could shift focus, which may allow the euro to bounce. We believe the single currency may bounce one big figure from its current level to 1.3750 versus the dollar. Above this level, the bulls may find it hard to push the single currency higher.

Can the UK Keep Up the Fast Pace of Growth?

The UK has been an anomaly in financial markets in recent months. Its fast pace of growth in both the second and third quarters of this year were unexpected by the markets. The consensus seemed to be that the harsh austerity measures would cause growth rates in the UK to tumble and inflation to fall from its elevated level (currently consumer prices are rising at a 3.2% annual rate.) But this hasn’t happened...not yet anyway. It’s difficult to try and predict the outlook for the UK economy because there are so many unknowns. We don’t know the exact schedule for all of the public sector spending cuts and we don’t know if the private sector will be able to pick up the slack. But the incoming data for Q4 is giving us an idea of where the bright spots are in the UK economy. Survey data for October suggests that both the manufacturing and services sectors are holding up well, although the construction sector may not boost growth as much in the last three months of the year as it did in the previous two quarters. Another encouraging sign is that retail sales could bounce in the last couple of months of the year as people bring forward purchases prior to the January VAT hike. But on the other hand, housing remains weak. According to data from Rightmove, house prices fell by 3.2% in November, bringing the annual pace of growth to a paltry 1.3%. Also, the public sector finances deteriorated sharply in October. Public sector net borrowing was GBP 9.8 billion, more than the GBP 8.9 billion forecast and the highest figure for an October since 1993. This puts pressure on the UK’s finances to improve in 2011. Next week sees the release of the final reading of Q3 GDP, which is expected to remain unchanged at 0.8%. If this focuses the market’s mind on the more uncertain future for the UK, then we could see the pound come under pressure. Although it touched 1.6000 last week, sterling is vulnerable to fall back to the 1.5820 level, which is the 55-day simple moving average.

NEXT: China's New Tightening Measures, Key Data and Events This Week

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Chinese Tightening Measures Weighing on Risk Appetite

On Friday, the PBOC announced an increase in the reserve requirement ratio (RRR) of 50 bps for all banks, effective November 29. This is in addition to the four prior RRR hikes on the year and brings the average RRR up to 17.5%. In monetary terms, the 50 bp hike is equivalent to the removal of approximately 350 billion yuan from the available loan base and emphasizes the PBOC’s concerns of elevated loan levels (latest net yuan loans release was 588 billion versus expected 450 billion) despite attempts to change lending behavior. Yesterday’s official announcement was accompanied with a statement, unlike the prior announcement, explaining the move as a means to “strengthen liquidity management and appropriately control supplies of money and credit.” Additionally, PBOC governor Zhou emphasized the need for a myriad of measures to effectively curb capital inflows on Thursday, implying the central bank will continue to use RRR hikes along with open market operations to manage liquidity. Considering the PBOC’s resolve to curb lending and anchor inflation expectations, we believe that another RRR hike and another 25 bp hike to the benchmark interest rate are likely to be implemented before year end. Commodity volatility has seen a significant spike over the past two weeks. Gold prices have fluctuated about 7% from highs to lows, oil prices have seen a greater than 9% move, and silver has witnessed a 14% high to low range. Fears arising from the Irish banking crisis and additional tightening steps out of China have dampened commodity demand on heightened global growth concerns, resulting in the recent selloff in commodities. Furthermore, the downside pressure on commodities can partially be attributed to an exaggeration in price appreciation ahead of QE2. However, the focus moving forward will likely remain on China, the world’s largest energy consumer, as further measures to curb growth and inflation seem imminent. That being said, we believe continuing fears of Chinese rate hikes are likely to weigh on the commodity markets in the weeks ahead.

Key Data and Events to Watch This Week

Unites States, Monday: Chicago October Fed national activity index; Tuesday – 3Q (second est.) GDP, personal consumption and GDP price index, October existing home sales, November Richmond Fed manufacturing index, FOMC releases minutes of the November meeting, weekly ABC consumer confidence; Wednesday: weekly MBA mortgage applications, October durable goods orders, October personal income and spending, October PCE, weekly initial jobless and continuing claims, November final University of Michigan confidence, October new homes sales; Thursday: US national holiday, Thanksgiving

By Brian Dolan, chief currency strategist, FOREX.com

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