Why the FX Risk Rebound Won’t Last

01/23/2012 10:15 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

A number of factors including Euro debt, equity and commodity market risk, and this week’s FOMC meeting are likely to cause a “risk relapse” in world currency markets, predicts FOREX.com’s Brian Dolan.

Risk sentiment stabilized in the past week as several European debt auctions saw lower borrowing rates and solid demand. Stocks took heart and rallied, while the US dollar (USD) lost ground and the beleaguered euro (EUR) recovered as extreme short-positions were unwound.

Sentiment was also buoyed by the prospects for a final resolution on the Greek government debt swap. But as of Friday afternoon, a final Greek debt deal has yet to be announced and there is still potential for another impasse.

Even the reported 32 cents/euro pricing agreed to by private creditors represents a much larger haircut than originally agreed, keeping open the risk that some private debt holders will rebel and sue, triggering credit default swaps and potentially exposing new fragility in European banks.

But, it’s only Greece and the amounts involved seem manageable, especially in light of massive European Central Bank (ECB) liquidity injections last December, with another long-term refinancing operation (LTRO) coming up in February.

In the bigger picture, though, I don’t think the ECB liquidity operations alter the fundamental solvency issues plaguing Italy and Spain, in particular. Nor have Eurozone growth prospects improved. Together, those two constraints will keep risk sentiment fragile and headline driven, but for the time being, risk appetite appears in recovery mode.

This week sees additional debt auctions by Germany, France, the Netherlands, Spain, and Italy. Most of the auctions involve short-term debt, as did those from the past week, so results should be similarly risk positive.

More importantly, the Netherlands and Germany will sell 30-year debt on Tuesday and Wednesday, respectively, providing a test of long-term debt demand. As two of the most solid EU countries, the results should be successful, but I’m also reminded of Germany’s failed ten-year auction in late November where bids came up short.

Assuming a favorable Greek debt deal is reached and government auctions are taken up, I think there is further room for risk assets and EUR to recover further. Of course, we’re only a headline away from a quick setback, so I think flexibility will remain critical, especially following the FOMC decision (see next section).

In terms of price action, gains in EUR/USD were quite dramatic, with a bullish engulfing weekly candlestick potentially suggesting a major reversal has taken place. Positioning remains heavily short, so further short covering could fuel more gains if the news environment remains hospitable.

Near-term price levels to keep an eye on are the 1.2830/1.2880 support area in EUR/USD; upside potential remains while above on a daily closing basis, but below suggests a return to recent lows at the minimum. The 1.2980-1.3000 area is the clear upside hurdle, where strength above would target further gains to the 1.3150/1.3250 area, which I think are more favorable levels to re-establish short EUR positions for renewed weakness.

See related: How to Short the Euro with Less Risk

NEXT: Will Fed Disappoint on QE3?


Looking at other currency pairs and other asset markets, I’m struck by the lack of strong confirmation that a significant risk reversal has occurred, potentially suggesting it was only a brief, position-driven move in EUR. Commodities, typically a leader in risk assets, actually lost small ground on the week.

Gains in US equities also seem tentative, as volume has remained weak on the rally since the start of the year. Similarly, commodity currencies (AUD, NZD, CAD), while making minor new highs against the USD, are not storming higher the way one would expect if a major sentiment shift was underway.

All of these factors keep me on high alert for yet another risk relapse, and I’d note what look to be rising wedge patterns in many FX pairs and other markets (AUD/USD is good example), which frequently resolve with sharp breakdowns lower. Pay attention to the lower daily trend lines for a guide.

FOMC Set to Disappoint on QE3

In addition to tentative signs of stabilization in Eurozone credit markets, I think speculation that the Fed may move toward signaling a third round of asset purchases at this Wednesday’s meeting (QE3) is part of the reason behind the risk rebound/USD decline.

While I expect the Fed to deliver on QE3 later in the quarter, I think this week is too soon. On top of recent economic data that suggests the US recovery is strengthening somewhat, lessening the urgency of additional stimulus, the Fed will debut its new policy of releasing members’ forecasts for future rate expectations, along with GDP and inflation projections. I think they’ll want to see how markets react to this new communication tool before they load up their last bullets for QE3.

If markets have indeed priced in greater prospects for a QE3 announcement at this meeting, then no moves toward QE3 could trigger major disappointment and a potentially sharp selloff in risk assets and a rebound in the USD.

SNB Reaffirms EUR/CHF Floor

On Friday the Swiss National Bank (SNB) interim president Thomas Jordan reaffirmed the central bank’s commitment to defending the 1.2000 EUR/CHF floor in a newspaper interview, saying there was no change to monetary policy.

EUR/CHF has come under pressure in recent days as markets had questioned the policy in light of the government’s failure to quickly appoint a new chief for the SNB. Jordan’s comments should leave no doubt that the 1.2000 level will be defended. If the SNB failed to act in support of the level, the SNB’s credibility would be seriously undermined, perhaps irreparably, something no central bank can afford to risk.

I think EUR/CHF longs from current levels just below 1.2100 represent relatively low-risk and potentially high-reward opportunities. However, I would caution that USD/CHF longs are not necessarily the same play, as the SNB is strictly focused on EUR/CHF, even though they may ultimately intervene in USD/CHF.

By Brian Dolan, chief currency strategist, FOREX.com

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