The Forex Trading Week Ahead

08/01/2011 9:52 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Currency markets will be reacting to the newest developments in the US and European debt deals this week, as well as watching central bank policy decisions in Japan, Australia, and elsewhere.

Uncertainty remained elevated and markets were on edge as debt problems on both sides of the Atlantic dominated headlines. Safe havens such as the Japanese yen (JPY), Swiss franc (CHF), and gold were beneficiaries amid market jitters. The Swiss franc reached new record highs, gaining over 4% this past week against the greenback and roughly 3.73% against the euro (at time of writing).

In Europe, peripheral yields moved higher as the euphoria over the previous week’s EU summit wore off (see below).

The political debate regarding the US debt ceiling and deficit-reduction plans continued forward with a lack of progress and coordination as urgency increased with the approaching August 2 deadline. House Republican John Boehner’s plan was unable to gain enough support to pass through the House to the Senate, prompting him to call off a planned vote on his measure.

In the Senate, Democratic majority leader Harry Reid said he will take action to move to vote on his plan. House majority leader Cantor has said that the Senate plans on being in session over the weekend. Amid the political impasse, the credit rating of the US is threatened as the fiscal position becomes increasingly unhealthy.

While there are many scenarios that can play out, our main view is that the debt ceiling will be raised, at least temporarily averting a US default. This is likely to see a relief rally in the US dollar (USD), which has seen a decline of late. The risk of a credit downgrade looms large, which is likely to see the dollar resume its downtrend should a downgrade or increased expectations of a downgrade occur.

Soft economic data out of the US added to the downward pressure on risk sentiment with dismal GDP figures on Friday. US 1Q GDP saw a significant revision lower to 0.4% (prior 1.9%) and the advance 2Q estimate disappointed, showing that the economy only grew at a pace of 1.3% quarter over quarter annualized (cons. 1.8%).

The weakness in the recovery illustrates how fragile the economy remains and may fuel speculation about additional Fed stimulus. Earlier this month, Fed chairman Ben Bernanke said that the Fed “Remains prepared to respond should economic developments indicate that an adjustment of monetary policy would be appropriate.”

Though growth has been anemic, we believe that deflationary risks would need to be evident to spur additional stimulus from the Fed. Several central banks will be meeting in the week ahead including the European Central Bank (ECB), Bank of England (BOE), Reserve Bank of Australia (RBA), and Bank of Japan (BOJ) with no change in policy expected from all banks.

NEXT: Cracks Appear in New Eurozone Debt Deal

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Cracks Appear in EU Debt Deal

After initially recovering post the EU debt deal announced on July 21, Europe’s peripheral debt markets have come under selling pressure once more. The markets have digested the deal and found it wanting. The biggest bone of contention is the size of the European Financial Stability Facility (EFSF) rescue fund.

The new deal extended the scope of the fund, for example, to help recapitalize the banking sector and purchase bonds in the secondary market, but it didn’t increase its size. EUR 440 billion is considered insufficient and we believe a fund closer to EUR 1 trillion might be enough to stem contagion fears since this sum could cover financial assistance for Spain and Italy.

It’s not just the US that is dealing with politics and a fiscal crisis; Spain is too. At the end of last week, Moody’s, the credit rating agency, announced it was reviewing Spain for a potential downgrade. Its justification was a prolonged high rate of financing as Spanish bonds remain above 6% a week after the EU debt deal was hailed as a success.

Interestingly, it also expressed concern that Spain’s contribution to the second Greek bailout could add extra pressure on its already stretched public finances. Spanish bond yields are close to record highs and the cost to insure Spanish debt against default has surged. Spain is now only 90 basis points away from the crucial 7% threshold in ten-year yields. This was the level when the bond yields of Greece, Ireland, and Portugal started to escalate rapidly, ultimately leading to a default.

Europe’s peripheral debt markets are illiquid and investors are extremely nervous. Even though Moody’s said that it would only downgrade Spain by one notch, events like these are greeted with exaggerated moves. Adding to the pressure on Spanish assets was the announcement from Socialist Prime Minister Zapatero that elections had been called for November; they had originally been planned for March 2012.

The Prime Minister has already declared that he won’t run again, so within five months, Spain will have a new leader. There have been mixed reactions to this. The opposition People’s Party is in the lead in the polls, and it is considered to be more fiscally conservative than its Socialist rivals. Thus, a change in government might not be that bad for the Spanish bond market.

Growth data is also painting a bleak economic picture. The unemployment rate dropped in July but remains at an “eye-wateringly” high 20.89%, and consumer prices remain elevated at 3.1%. This data compared sharply with Germany and reinforces the theme of a two-speed Eurozone economy.

Germany’s retail sales surged at a record monthly rate of 6.3% in July. Consumption has been supported by a tight labor market. German unemployment has fallen for the last 25 months in a row. German bunds continue to attract safe-haven flows and spreads with weaker, southern European states remain close to record highs. Spreads are likely to remain wide for as long as Germany has the growth differential on its side.

The EU deal may have been a feat of political engineering, but it didn’t change the overall bleak picture for growth in much of the weakest European states, which is weighing on credit markets.

You could also argue that there is a two-speed euro trade. EUR/CHF fell to a record low at the end of last week at 1.1300. This is due to 1) continuing fears about the Eurozone sovereign debt crisis, and 2) general risk aversion. The Swissie has been the safe haven of choice in recent weeks and is benefiting from both the European and US debt crises.

However, the single currency has held up well against the dollar as the greenback gets battered in the FX markets, taking the brunt of investors’ frustrations and fears about the debt impasse on Capitol Hill.

NEXT: UK Data Surprise; Central Banks in Focus This Week

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UK Growth Picture Not as Bleak as Expected

The UK’s second-quarter GDP data was a very weak 0.2%, but growth was weighed down by a number of special events over the quarter, including the extra bank holiday for the royal wedding and the aftereffects of the Japanese tsunami.

The Office for National Statistics estimates that it may have weighed on growth to the tune of 0.7%, with the service sector taking the brunt of the disruption. In the aftermath of the news, the pound actually rose. Investors had low expectations for the UK economy and a growth rate of 0.7% is fairly good in the current environment.

However, there are few signs so far that growth is bouncing back after the “special factors” of the second quarter. The CBI survey of business optimism, a forward-looking indicator, fell to its lowest level in two years, and the retail sales CBI survey for July fell to the lowest level in 12 months.

Government spending slowed sharply in Q2, registering zero growth after rising 1.1% in Q1, however, the government is not planning on reducing the pace of its fiscal consolidation program. This leaves the door open for quantitative easing.

Although the latest MPC minutes from the July meeting did not suggest the Committee is planning on another stimulus package anytime soon, if growth does not pick up in the coming months, then it may have to fill the gap left by the public sector spending cuts.

Sterling continues to outperform the dollar, but it remains weak against the swissie and the aussie, both strong currencies. We think the pound may continue to weaken against the safe haven and Pacific currencies, and will remain well supported versus the dollar, which is likely to suffer if the US is left to default in the coming weeks.

Asia/Pacific Region: Rising Inflation and Intervention Risks

The currencies of the major Asia/Pacific economies extended their parabolic ascents this past week. AUD/USD and NZD/USD printed multi-decade highs around 1.1075/1.1080 and 0.8775/0.8780, respectively, and yen strength sent USD/JPY to fresh post-G7 intervention lows just below the 77.00 figure.

While domestic economic considerations have contributed to the rise in Asia/Pacific FX, broad-based USD weakness stemming from US debt limit concerns have exacerbated their respective ascents. As noted earlier, we think US lawmakers will ultimately come to a short-term agreement by the August 2 deadline, which may lift some weight off the USD’s shoulders in the week ahead.

Nevertheless, NZD and AUD strength look set to continue. Consumer prices in Oceania have surprised to the upside. Australian 2Q CPI printed above consensus estimates of +0.7% at +0.9% (q/q) and New Zealand CPI rose +1.0% versus expected +0.8% in 2Q, lifting rate-hike expectations to the upside as well.

The Reserve Bank of New Zealand (RBNZ) held the OCR steady at 2.50% as expected last week, but outlined the need to remove post-disaster stimulus, suggesting rate hikes may be implemented sooner rather than later. On August 2, the RBA is expected to keep the target rate steady at 4.75%, but it may take a more hawkish policy stance as recent consumer prices have sent core inflation to the upper end of its 2%-3% target range.

The BOJ is also on tap this week (Aug. 5) with no change expected to the current 0.10% target rate. However, recent JPY strength has led to heightened intervention rhetoric from Finance Minister Noda and other officials. This has kept market participants on their toes as the closer USD/JPY gets to post-disaster lows, the greater the risk of BOJ/MOF intervention.

Typically, sharp declines in Japanese equities accompanied direct FX intervention. While this is not the case in the current situation, we think further yen strength into the 76.00/77.00 range may force monetary authorities to intervene in efforts to protect Japanese exporters.

By Brian Dolan of Forex.com

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