The Forex Trading Week Ahead

07/11/2011 10:04 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Currency markets will be driven this week by the newest developments in the Eurozone debt crisis, rate hikes from the ECB and China, and important technical levels in play for a number of major pairs.

The Eurozone crisis is at a critical phase. After Portugal’s debt was downgraded to junk status last week, Italian and Spanish bonds started to come under pressure, along with Irish and Greek debt. So it looks like contagion is spilling over to Europe’s core.

Italy is the biggest concern right now. It is the third largest economy in the Eurozone, but its debt-to-GDP ratio is 120%. Its ten-year bond yields are also approaching an important level, and could break out of their long-term range above 5.4%. Once Portugal, Greece, and Ireland’s bond yields hit 6%, they accelerated quickly, culminating in bailouts from the European Union (EU)/European Central Bank (ECB) and International Monetary Fund (IMF).

Spanish bond yields also rose sharply last week, and if Italy and Spain both get into financial difficulties at the same time, it may become a case of "Two big to bail"—and the start of Europe’s Lehman Bros. moment.

Pressures in Europe’s core economies come the week before the results of the third round of stress tests are scheduled to be released on July 15. We have already heard that Italian banks have passed these tests, but the markets are more interested in Spain, whose domestic caja banks remain poorly capitalized.

The tests are already attracting criticism after the original stress scenarios were changed only a month ago. Investors will be watching out for firstly whether the tests are credible and if they assume a default of a Eurozone nation, most likely Greece, but possibly Portugal and Ireland to follow. Next, investors want to know how large the capital shortfalls are, especially in Spain, where the final bill may fall on the government, aggravating Spain’s public finances.

This may dent sentiment towards the Eurozone this week, but we are wary of being too bearish on EUR/USD. The ECB raised interest rates for the second time last week, and although ECB president Trichet said he expected growth to slow in the second half of the year, he rammed home the point that interest rates remain "accommodative," using the word twice in his opening paragraph.

NEXT: China Hikes Rates; More Hikes to Come

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So the ECB remains closer to hiking rates than the US, especially after the dismal June jobs report. This should protect EUR/USD above 1.4000. Likewise, the Bank of England kept rates on hold for a 28th month last week, which is weighing on sterling.

We prefer to short EUR/CHF. The swissie is a traditional safe-haven currency and tends to be bought during flare-ups of the Eurozone debt crisis. It had a stellar run against the single currency this year, but we think there is more to come, and any strength in EUR/CHF will be used as an opportunity to sell. Below 1.2060—the 21-day moving average—we look for a break below 1.1900 before testing 1.1830—the lows reached at the end of last month.

China Hikes Rates; More to Come with Inflation Still Elevated

Earlier this week, the People’s Bank of China (PBoC) hiked benchmark rates by 25 basis points (bps) to 6.56% and 3.50% for the one-year lending rate and deposit rate, respectively. This marked the third increase this year and fifth hike to the benchmark rates in the current tightening cycle, which began in October 2010.

The PBoC has used a combination of tools (reserve requirement ratio, policy rates, and gradual currency appreciation) to help limit inflation pressures, however, inflation remains stubbornly high with year-over-year CPI currently at 5.5% (a 34-month high). Following the release of May CPI, which rose to 5.5% from the previous 5.2%, the PBoC announced the sixth reserve requirement ratio (RRR) hike for 2011.

Interestingly, the RRR has been increased once each month so far for this year, and it would not be surprising to see an additional hike to the RRR in July. June CPI, which was released this past weekend, was expected to show an increase to 6.2%. As policymakers are focused on taming inflation, this will be a key indicator for the week ahead.

After this week’s rate increase, PBoC adviser Xia Bin said the increase is "not enough," indicating more tightening is likely to follow. This is in line with our view that rates need to be raised further to correct negative real rates, as well as to anchor inflation expectations.

China will see a slew of data in the week ahead, which includes the June trade balance, industrial production, retail sales, CPI, and most importantly, 2Q GDP figures. While the June trade surplus is expected to expand, Wednesday’s release of second-quarter growth is forecasted to moderate to 9.3% from the prior 9.7%.

A slowdown in Chinese growth is likely to see risk sentiment decline, as China has been a major contributor to global growth as the world’s second-largest economy. In FX markets, the Australian dollar (AUD) has been most sensitive to developments in China due to the close ties between the two nations and is likely to respond to surprises in Chinese data.

NEXT: Important Technical Levels to Watch This Week

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Important Technical Levels to Watch This Week

This past week has caught both bulls and bears alike off guard. On Thursday, "risk" caught a bid on the back of a strong ADP number (+157K vs. expectations of +70K), however, a mere 24 hours later, this optimism was completely undone by the much-worse-than-expected June employment figures (NFP +18K vs. consensus +105K and unemployment rate 9.2% vs. consensus 9.1%). Even May’s NFP figure was revised lower to +25K from +54K. With that said, we’ve seen mixed results across different risk barometers.

EUR/USD: After failing up against the 50-day simple moving average (SMA) around 1.4370/1.4380 and then closing beneath the 100-day SMA for the first time since February, the euro’s technical outlook has once again shifted back to the downside. Furthermore, Friday's bearish engulfing candlestick is an ominous sign as we go forward.

However, all is not lost, as the single currency is still within the triangular consolidation pattern that began at the beginning of May and currently sees the support level come in around 1.4150/1.4160. Should this give way this week, the next credible levels to watch are the psychological significant 1.40 level and then the 200-day SMA around 1.3905/1.3910. Only a break above 1.4580, the prior high, would change our bias.

AUD/JPY: Earlier Friday it reached trend line resistance around 87.80 (connect April 11 and April 28 highs) and then came off hard after the NFP announcement. Moreover, the daily RSI was rebuffed around the 60-65 level (typically, RSI tops out around 60-65 in a downtrend and bottoms around 40-45 in an uptrend), therefore, we still tend to favor further downside.

Additionally, it too has formed a daily bearish engulfing candlestick. The 55-day SMA has provided support all week long and currently resides at 86.30/86.35, however, should this level give way this week, it could see back towards the June lows around 84.00/84.10. A break back above 88.00 would negate this view.

NEXT: Latest Outlook for EUR/CHF, S&P 500, and Crude Oil

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EUR/CHF: This pair continues to be one of our favorite risk-aversion plays in the currency market, especially if you are looking to avoid exposure to the US dollar (USD). Earlier last week, it too was rebuffed by the 50-day SMA around 1.2350 (also was prior June highs) and has just collapsed since. This pair has seen perhaps the most impressive of the bearish engulfing candlestick of the day, easily surpassing yesterday’s open around 1.2020 to the downside. It now seems it’s not a matter of if, but rather when the June low around 1.1800/1.1810 gets tested and we look to this week’s EU finance ministers meeting and EU stress tests as potential triggers to the downside. Only a move above 1.2400 would alter our negative bias.

S&P 500: It appears last week’s upward momentum has been halted, as Friday's US economic data proves that things may not be as rosy thought. Last week, the S&P formed a doji, which conveys a sense of indecision between buyers and sellers.

Should the equity market see a sharp selloff this week and close below the prior week’s mid-point (1305), the three-week pattern would be called an evening doji star, a very bearish technical formation. On the downside, we highlight the technically significant 1317/1318 level, as it represents the 50- and 100-day SMAs, as well as the 38.2% retracement of the move higher from the June 16 low.

We have also identified a longer-term Elliot Wave count beginning from the July 2010 low. This suggests we are currently in wave 5 and the upside may not be as high as some analysts suggest. Wave 5 would equal wave 1 around 1377, however, an alternative count could see this as a truncated 5th wave, which mean Friday's high of 1356 is as high as the S&P is going to reach for a while.

Even if it pokes to fresh highs for the year, we still believe this is a better opportunity to sell into longer term, rather than chasing it higher.

Crude Oil (WTI): After bouncing off $90 nearly two weeks ago, crude oil has had quite a run, however, it looks like the 50-day SMA around $99 and the psychologically significant $100 level were just too much for black gold to overcome.

The poor economic data suggests demand for oil (and its byproducts) could diminish going forward. A break below the 200-day SMA around 93.50 sometime this week could see oil re-test the June lows below $90 and possibly even extend into the mid-80’s, which sees the 2011 lows and 61.8% retracement (using the May 2010 low and May 2011 high). A break above $105 is needed to alter this view.

By Brian Dolan, chief currency strategist, FOREX.com

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