Key Forex Themes for This Week

03/21/2011 9:53 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

The conflict in Libya, currency intervention and the crisis in Japan, and euro zone debt problems continue to drive FX markets. Here are key technical levels and what to watch for in the week ahead.

The past few weeks have seen events unfold at a furious pace, sometimes making it difficult to keep up with developments, which is exacerbated by heightened market volatility. During such times, it’s important to stay focused on the big picture, which we currently see as an ongoing global recovery, which is generally positive for risk assets such as stocks and commodities. In precious metals and oil, we prefer to be buyers on dips. In particular, we would note that UN-sanctioned military action against Libya has the potential to see precious metals and oil prices spike higher.

Libya’s Gaddafi tried attempting to forestall attacks on his military infrastructure by proclaiming a cease fire, but the Western and Gulf regional nations didn’t buy it and began to damage his air defenses. Gaddafi’s response is unpredictable, but there is potential for him to lash out at regional Gulf nations, potentially threatening further oil supply disruptions.

In gold prices, we would note a potential bull flag consolidation pattern, where a break above $1422-$1423/oz. could signal a fresh wave higher, possibly taking out the key $1440-$1450/oz. resistance zone and targeting higher to $1500 or more.

In FX, the key is the divergence between monetary policies of the major central banks, with the Fed maintaining extraordinary measures and most others generally removing accommodation, with the ECB in the lead at the moment. In this environment, the USD is likely to remain weak, in our view, and we prefer to be sellers on bounces. There had been some speculation that events in Japan could cause the ECB to postpone its threatened April rate hike, but comments on Friday from president Trichet suggest he is intent on pushing rates higher. EUR/USD appears set to challenge the Nov. highs around 1.4280 and ultimately appears destined for gains to the 1.4450/1.4500 area. Of course, there is always potential for global events to deteriorate in further unexpected ways, potentially triggering a wave of safe-haven USD buying at some point, but we would look at that as an opportunity to re-sell the greenback. EUR/USD immediate upside potential remains while above 1.4000/1.4050.

Concerted Intervention in JPY Is for Real

The G7 stepped in to the currency markets for the first time in over a decade on Friday, with the Bank of Japan (BOJ) leading the wave of JPY selling and sending USD/JPY higher to 82.00 before settling back just below 81.00. Importantly, we would note that other central banks bought their local currencies and sold JPY, amplifying the intervention’s impact to the JPY crosses like AUD/JPY and CAD/JPY. Though the amounts bought by other central banks were reportedly small, we think the G7 is serious about preventing the JPY from strengthening again and that follow-up rounds of intervention are virtually guaranteed. The ministry of finance (MOF) and BOJ appear intent on seeing the JPY weaken back to pre-earthquake levels around the 83.00 USD/JPY area. A price move above that level has the potential to spur algorithm-based trading systems to reverse from long to short JPY positions, potentially triggering gains to the psychologically significant recent highs around 84.00/85.00 and higher. In the aftermath of the tragedy in Japan, we expect the JPY to weaken in the months ahead on economic fundamentals as the Japanese economy struggles, the BOJ adopts additional easing measures, and government borrowing for reconstruction undermines faith in the currency. We think the 79.00/80.00 area will be defended from here out, and that dips in USD/JPY and other JPY crosses represent buying opportunities.

NEXT: Germany Throws New Wrench in Sovereign Debt Crisis

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Germany Throws a Spanner in Europe’s Works

There is a chance that Germany could scupper a long-term solution to the sovereign debt crisis. The Lower House of the German parliament approved a motion last Thursday that will ensure that the German Parliament remains closely informed about the decisions made by the EU regarding a permanent solution to the sovereign debt crisis and the creation of a permanent crisis resolution mechanism (ESM), which is due to be in place by 2013.

This has added another layer of complexity to the creation of the ESM, which is crucial to ensure that markets remain confident that the EU authorities have the situation under control. Public opposition to Germany’s involvement in the bailouts of weaker euro zone states has hardened the stance of some politicians in Berlin towards the ESM negotiations.

Events in Germany make the future effectiveness of the fund far from certain. We are worried that last weekend’s surprisingly advanced discussions might not reflect the end result of the upcoming summit later this week and the markets could be looking for too much from the EU authorities.

Germany’s Lower House ruled out the issuance of joint bonds by the euro zone, and crucially, it also opposed the guaranteed debt purchase program for bailed-out nations in the primary debt markets. This was the key message that cheered the markets after last week’s EU summit. In our opinion, this is a major step back on the road to finding a long-term solution to the debt crisis. Although it hasn’t been reflected in the FX markets, it has the potential to derail the euro’s progress further ahead. If the summit disappoints, then we could see EUR/USD return to the bottom of its recent range towards 1.3800. It would also weigh on peripheral bond yields and may cause 1) further discussions about a restructuring of Greek and Irish debt; 2) sovereign debt downgrades from credit rating agencies for the weaker euro zone states; and 3) a bailout for Portugal.

Key Technical Levels to Watch in the Week Ahead

USD/JPY: A wild ride in FX land last week saw a number of significant technical levels completely obliterated. The main focus has been on USD/JPY and other yen crosses as the crisis in Japan has led to a surge in volatility. USD/JPY made record lows around 76.45/76.50 on fears of deteriorating nuclear reactor conditions and technically driven price action. However, yen strength reversed on Friday to trade back above the 80.00 figure as coordinated central bank intervention absorbed repatriation flows. However, gains in USD/JPY stalled into triangle consolidation support (now resistance) around the 81.50/81.75 zone, which looks to be a key resistance moving forward. Above the 82.00 figure sees additional resistance from the daily Ichimoku cloud base (82.40), suggesting the ride higher on the back of direct intervention may not be a smooth one.

USD Index: The USD index looks set to post a weekly close below primary trend line support extended from the March 2008 lows at 70.69, suggesting further USD weakness may be in store. Daily Ichimoku clouds signaled a downside technical bias when the Tenkan line crossed the Kijun line from above to below after falling below the cloud base in late February. The breakdown level around 76.25 may now serve as key resistance, and 75.60/70.65 (Nov. 4, 2010 lows) looks to be immediate support ahead of the psychologically and technically significant 75.00 pivot.

EUR/USD: The bearish technical picture in the USD index is most ominous for the greenback against the euro, which also breached a key technical resistance level this past week. EUR/USD broke above the 1.4050 prior highs (also trend line resistance from the Dec. 2009 highs at 1.5140/1.5145), which may serve as near-term support on EUR weakness. The next meaningful resistance is likely to be found into the long-term trend line from the record 1.6035/40 highs around the 1.4275/00 zone. The trend line also converges with the Nov. 2010 highs at 1.4280/1.4285. A weekly close above may signal a potential upside breakout from the 2008 primary downtrend.

GBP/USD: The sterling has managed to mount a decent recovery against the buck after falling back from the 1.6340 level in the beginning of March. Moving forward, 1.6340 is likely to remain a key technical level considering upside stalled into it on multiple occasions since March 1. Adding to its technical significance is the possible convergence of trend line resistance extended from the 2.1160/2.1165 record highs. Whether these technical resistance levels converge or not will depend on the rate of upside acceleration in GBP/USD. A choppy move higher would see the levels converge, while a steeper ascent may see the trend line come in closer to the 1.6400 figure. Near-term support may be found into the converging 55-, 100-, and 200-hour simple moving averages (SMAs) around 1.6100, also the midpoint of the broken short-term rectangle consolidation pattern seen on hourly charts. However, the pair’s ascent above rectangle tops suggests a measured move objective of 200 pips towards the 1.6400 figure and a potential attempt to break above its 2008 primary downtrend.

By Brian Dolan, chief currency strategist, FOREX.com

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