The Forex Trading Week Ahead

05/23/2011 10:50 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

New debt problems in Greece and Spain, Japan’s now-official recession, and a weakening Canadian dollar are among this week’s major themes for currency traders to monitor closely.

This past week saw most major asset markets and currencies essentially consolidate around recent lows following the selloff in the first half of May. Incoming data, however, continues to suggest increasing sluggishness in the major economies.

In the US, housing data weakened further, both the Philadelphia and Empire manufacturing indexes declined, industrial production flattened, and the index of leading indicators dropped for the first time in ten months.

In Europe, in addition to the ongoing peripheral debt saga (see below), the ZEW outlook survey of investors and analysts declined more than expected for Germany and the euro zone as a whole, while on Friday, the Bundesbank warned that German growth would likely moderate after the strong surge at the start of the year. Japanese Q1 GDP also declined by more than expected, and Q2 prospects are not much better (read on for more).

Overall, between weakening data in major economies, deteriorating debt conditions in Europe, the debt cap debate in the US, and the looming termination of QE2, we think the environment continues to lean toward risk aversion, and we would expect commodities, stocks, and JPY crosses to resume their declines, likely propelling the USD higher in the process.

Looking at this week’s data calendar, there aren’t any reports that on their own seem sufficient to provoke a surge in risk aversion, so we would anticipate either a steady drip of weaker data to eventually see recent lows tested, with a break below serving as confirmation, or another week of choppy consolidation.

Spanish elections over the weekend could provide a spark of euro-specific negativity (see below), and the steady drip of Greek travails could also take a further toll.

There is a G8 meeting at the end of this week, but at the moment, currencies do not appear to be high on the agenda.

On the charts, we will be watching to see if the US dollar index can break into its daily cloud, which it tested several times this past week. The base of the cloud drops to 75.55 to start the week, and declines to below 75.00 later in the week (price last at 75.47).

EUR/USD has dropped inside its cloud, with the cloud top rising to between 1.4263 and 1.4359 as a source of resistance this week. The base of the cloud is mostly steady between 1.3975 and 1.4039 as a support/potential breakdown area, again highlighting the significance of the 1.4000/1.4050 area overall.

We prefer to use remaining strength in the JPY crosses as a selling opportunity in anticipation of heightened risk aversion.

NEXT: Greek Problems Get Worse Before Getting Better

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Greek Problems Get Worse Before Getting Better

The second wave of the Greek debt crisis seems to be focused on the technicalities of default. This time last year, the EU authorities together with the European Central Bank (ECB) and the International Monetary Fund (IMF) were trying to find a stop-gap solution to the Greek financial crisis. Now the hard work begins as the EU authorities (in particular the ECB) try to wean the Greek financial system off temporary liquidity support.

To complicate matters, Greece isn’t playing ball. Its tax collection record is still dismal and its deficit cutting hasn’t happened fast enough to convince the EU authorities to give them more money.

German officials have spoken out about Greece’s shortfalls and it was slapped on the wrist by the IMF last week. This pushed Athens to announce a wave of privatizations of state assets, but that wasn’t enough to stop Fitch, the credit rating agency, from cutting its long-term credit rating to B+. Fitch justified its actions by saying that the risk of default had dramatically increased and that any re-profiling of debt is another form of default.

This caused a flurry of risk aversion in the markets; however, this is likely to be short-lived. The market has come to expect a second bailout/default from Greece.

What is much more troublesome is the ECB’s recent rhetoric. It is steadfastly against a debt restructuring for any member states, which is what the EU authorities are pushing for. The reason for this is twofold: Firstly, it believes that a default would cause contagion to other more systemically important nations in the euro zone, like Spain. Secondly, since last year, the ECB has been accepting lower-grade collateral in return for its loans, which means that it is sitting on billions in peripheral debt.

ECB member Jens Weidman said that the Bank may no longer accept Greek bonds as collateral if there is an arranged default for Athens. This would in essence shut off Greek banks from the capital markets, causing them to collapse and potentially triggering a global financial crisis, resulting in the 200-pip drop in EUR/USD at the end of this past week.

The ECB is talking tough and has a right to voice its concerns, but we believe it will be sidelined and EU authorities will ultimately determine the solution to the debt crisis. The ECB’s mandate is to promote financial market stability, and unleashing chaos into the markets by effectively forcing Greece into bankruptcy would be a clear violation of this mandate.

The bad news for euro bulls is that the Greek situation is likely to get worse. An IMF audit into how well it is adhering to the conditions of its first bailout is due to be released next month, which has the potential to dent investor sentiment even further.

NEXT: The Euro Hinges on Spain

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The Euro Hinges on Spain

It is becoming a bit of a habit for investors to start selling the euro in the lead-up to the European close on a Friday afternoon. The single currency was weak across the board, as we ended last week and EUR/USD dropped nearly 200 points on the back of the Greek story described above.

However, the euro still looks supported above 1.4000 against the dollar. That’s nearly 20% stronger than it was this time last year during the peak of the Greek crisis.

Today, FX traders are treating the Greek crisis as manageable; however, any deterioration in Spain’s financial situation could trigger a similar decline.

This weekend is pivotal for the single currency. Local elections in Spain are expected to hand the ruling Socialist party a hefty defeat across the municipalities. This is problematic on two fronts. Firstly, if the opposition Peoples’ Party (PP) does as well as expected, then it may call for the resignation of the government. Bond markets hate political uncertainty, and this would cause Spain’s borrowing costs to spike.

The second issue is that new local administrations are unlikely to waste any time in unveiling hidden debts or financial irregularities by the former leaders. This may push up Spain’s official debt position, thus derailing its fiscal consolidation program that is so vital to maintaining investor confidence. Right now, reports suggest that these “hidden” debts could amount to EUR 30 billion.

Spain is the canary in the coal mine. It is the fourth-largest economy in the euro zone, and so far, its bonds have largely escaped the same selling pressure as Greece, Ireland, and Portugal. However, the aftermath of these elections could cause all that to change.

If bond yields soar, this would mean that Spain is another step closer to a bailout, the size of which may exceed the size of the Greek, Irish, and Portuguese bailouts combined. German taxpayers are unlikely to cough up these kinds of sums, and that could bring the whole euro zone project to its knees.

This isn’t our central scenario, and there is one thing that may keep Spain out of the firing line for the time being: Its public debt levels are fairly low, totaling around 45% of GDP. Private sector indebtedness is the problem in Spain, fueled by cheap loans from the now-beleaguered domestic Caja lenders and a huge housing bubble.

But Spain still has the power to spook FX markets. If fears grow about the Iberian nation, then it is likely to trigger safe-haven flows to the dollar, weighing on the single currency even more. 1.4150 is holding as support, but below 1.4235—the top of the Ichimoku cloud—the single currency looks vulnerable. The 1.4000 level is a key psychological level, and below here the next major support level is 1.3880.

NEXT: Japan’s Economy Still in a “Very Severe” State

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Japan’s Economy Still in a “Very Severe” State

Japan released its preliminary Q1 GDP figures earlier last week, which confirmed that the nation’s economy fell back into recession. The data showed a quarterly contraction of -0.9%, which was worse than the expected -0.5%, and the prior quarter was revised significantly lower to -0.8% from -0.3%.

Prior to the release of the data, Bank of Japan governor Masaaki Shirakawa said that the nation’s economy has been in a “very severe” state since the March 11 earthquake. This comes as no surprise, as economic activity fell sharply following the devastating earthquake, as evidenced by negative growth and declining consumer confidence.

Japan’s April trade balance is scheduled for release on Wednesday and is expected to show the country’s first trade deficit in two years due to a significant drop in exports and small advance in imports.

Also due this week is April retail sales, which are likely to fall further as recent confidence indicators have continued to deteriorate.

As the world’s third-largest economy, the downturn in Japan is an impediment to the global recovery. It will likely be some time before the economy can turn around and begin to claw its way out of the recession, and as such, we would expect the yen to come under pressure.

Safe-haven flows have benefited the yen, however, acknowledgement by policymakers of the severe state of the economy and expectations of additional extraordinary measures to stabilize the economic conditions are likely to limit further yen gains.

In USD/JPY, the 80.00 level is the key pivot to the downside, which is around the 61.8% retracement of the rally from the March lows to April highs, in addition to being a key psychological level.

The key levels to the upside are the top of the daily Ichimoku cloud and 200-day simple moving average (SMA), which can be found in the 82.55/82.75 area. A sustained break above here may see upside towards the 84.50 pivot area ahead of the 85.50 prior highs, while a drop through the 80 figure may see a further decline.

The Loonie May See Weakness Ahead

On Friday, the Canadian dollar (CAD) weakened on the back of Canadian CPI and retail sales figures. April Consumer Price Index remained unchanged from last month at +3.3% year-over-year (y/y), however, this was below economists’ expectations of a rise to +3.4%.

Additionally, the March retail sales figures came in at 0.0% month-over-month (m/m), which was much weaker than the consensus of +0.9% and +0.5% in February. Taken together, this eliminates any chance of a Bank of Canada (BOC) rate hike on May 31, and presumably for the July 19 decision as well.

Furthermore, provided that inflation expectations continue to stay well anchored, it is unlikely that headline inflation will be able to persist above the target range for much longer.

Given that the world economy is beginning to show signs of slowing and the Federal Reserve is about to end QE2, the fundamental outlook for higher commodity prices has abated. This suggests the impact of higher energy prices on headline inflation and its indirect pass-through effects on core inflation may begin to deteriorate in the second half of 2011.

Consequently, it seems the BoC’s decision to keep its policy rate unchanged at 1.00% has been correct. As such, we believe the market will begin to price in the realization that rates aren’t going anywhere anytime soon, and this could weigh on the loonie going forward.

Technically, the USD/CAD has been confined in a downward-sloping channel since September 2010, and the Relative Strength Index (RSI) has confirmed the move lower throughout. Additionally, the 100-day SMA has roughly coincided with the top of the trend channel, and earlier, the pair tested both of these key technical levels (which is the second time over the past week) and has so far been rebuffed.

The 0.9765/0.9775 level also encompasses the 61.8% Fibonacci retracement of the move lower from the middle of March to the beginning of May. Should commodities—especially crude oil—continue to remain under pressure, this would be bullish for USD/CAD, and we would expect the aforementioned resistance level to give way to an eventual test of the 200-day SMA and the March 15 high, which are both just below parity.

By Brian Dolan, chief currency strategist, FOREX.com

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