Forex Trading Ideas for the Week Ahead

10/03/2011 9:50 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Risk continues to be high in the currency markets, and with new Eurozone rescue plans and central bank announcements upcoming, potential short plays are setting up for a number of major currency pairs.

September and the third quarter ended with many major markets closing around recent lows for the current decline. Perhaps most disheartening from a technical perspective is that most risk assets spent the early part of the week attempting to rebound, only to fail, leaving behind ominous price patterns.

The CRB commodity index actually closed at new lows for the decline and below the 300 level for the first time since November 2010. The S&P 500 tested higher early in the week, but was soundly rejected from the base of the daily Ichimoku cloud around 1195 and finished out near where it started, but with a very long tail above, suggesting more downside to come.

In FX, risk aversion clearly remains evident. The US dollar index made its highest close for the current US dollar (USD) rally, despite heavy long-USD positioning, according to futures data. USD strength was mirrored by extreme weakness in the high-beta/commodity currencies like the Australian dollar (AUD), New Zealand dollar (NZD), and Canadian dollar (CAD), which all closed at new lows for the current decline.

EUR/USD finished out just a few pips above its recent 1.3360/1.3370 lows after being rejected several times from attempts to surpass 1.3700. Last week, we noted that risk sentiment had taken a nosedive, and after this past week, it would seem that we’ve only experienced a very weak attempt at correction.

We’re expecting October to start off on weak footing with a number of significant event risks throughout the week, culminating with the September US jobs report on Friday. In the meantime, we’ll be closely watching the lows in equities and major USD pairs, but indications from the FX realm are that further downside is a question of when, not if.

Critical Week Ahead for Eurozone Debt Crisis

The euro (EUR) suffered even though the news out of Europe was about the best that could be expected. Votes to approve the July enlargement of the European Financial Stability Facility (EFSF) cleared the most difficult hurdles after Finland and Germany voted to approve the package. The key issue now for Eurozone policymakers is how to increase the effective firepower of the EFSF to something around EUR 2 billion to contend with potential market disruptions to Spain and Italy.

So far, the signals have been mixed, but German Financial Minister Schaeuble suggested using leverage to increase the EFSF was out of the question, as it would endanger Germany’s AAA credit rating. Still, there are reportedly a number of different plans circulating within EU capitals to increase the effective size of the EFSF, and markets continue to cling to hope that something will materialize soon.

The more it looks like EUR 440 billion is all they’ll get, the sooner bond markets are likely to resume dumping Spanish and Italian debt. There are a number of key meetings of Eurozone finance ministers on Monday and Tuesday this week where concrete proposals are desperately desired, and if nothing materializes, it may start the "risk-off" ball rolling again sooner rather than later.

See related: “Risk-off” Trade Is Back on

One bright spot may be at the ECOFIN meeting on Tuesday where ministers are expected to approve the sixth installment of Greek aid from the bailout package. Troika auditors are still working to determine whether Athens has made sufficient progress/commitments to justify the next dose of aid, without which Greece will run out of funds by October 14.

Our expectation is that the Greek aid will be approved, however grudgingly, as the risk of a disorderly default is simply too great. If approval is given as we expect, we may see another relief rally in the single currency and potentially risk markets in general, but we would also look to fade that rally again.

Deteriorating economic outlooks for the Eurozone and other major developed economies are the real source of investor malaise, with the debt crisis acting as a proximate source of angst.

NEXT: Central Bank Decisions: RBA, ECB, and BOE


Central Bank Decisions: RBA, ECB, and BOE

A number of major central banks are meeting this week, and while we and the market expect them all to make no policy changes, there is no shortage of risks for a surprise. The Reserve Bank of Australia (RBA) is first up on Tuesday afternoon local Sydney time, and the Bank is expected to hold the OCR steady at 4.75%.

Recent RBA minutes suggested market expectations of imminent rate cuts were misplaced, diminishing the prospects for a cut at Tuesday’s meeting. Still, the risks lie in that direction on the global outlook, but we also think the RBA could take a more hawkish tone in its statement, attempting to reinforce the message from the minutes. We would hope such a statement materializes, as it could provide a nice opportunity to short AUD/USD from better levels.

On Thursday, we have the Bank of England (BOE) and the European Central Bank (ECB). The BOE is expected to hold rates steady at 0.50% and refrain from announcing new asset purchases. However, there is a decently high risk the Bank may announce an increase to its asset purchases (QE), likely on the order of GBP 50 billion.

While not entirely unexpected, it would still likely send GBP lower, as markets express alarm over the sense of urgency displayed by the BOE, suggesting more is wrong with the UK economy than meets the eye. No QE announcement could see GBP rally for a period, but we would also view that as an opportunity to short.

The ECB follows up later that morning and is also expected to hold rates steady, but announce additional liquidity measures to the banking sector. The ECB is expected to re-establish 12-month term loans, a practice it dropped at the end of 2009. There has been more than a little speculation the ECB would enact a 25- to 50-basis-point emergency rate cut at this meeting, but since it’s Trichet’s last meeting as President of the ECB, we don’t think he’ll exit on a note of panic.

Along with the surge in September Eurozone CPI to 3% reported this week, we think the ECB will hold steady. The ECB’s economic outlook in its statement, however, is likely to highlight downside risks to growth again, keeping the overall outlook for rate cuts down the road and adding to pressure on the EUR. A steady decision may see the EUR pop a bit, as those betting on a cut run to cover, but again, we would look to fade any such rally.

By Brian Dolan, chief currency strategist,

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