The Forex Trading Week Ahead

02/06/2012 10:12 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Following upbeat data from a number of major economies last week, look for policy announcements from three central banks to drive action in world currency markets in the week ahead.

The past week ended with a string of better-than-expected data releases from key major economies, suggesting the global recovery may avoid a more worrisome downturn. Mostly better-than-expected PMI’s from Europe, the UK, China, and the US were supplemented on Friday by a much stronger-than-expected US employment report.

We’re cautiously optimistic that the better US jobs report is a valid signal that the US recovery is improving, but we’re also aware that January employment numbers are especially volatile due to seasonal factors, and subject to major revision.

The decline in the unemployment rate in the January report, in particular, is also suspect due to the inclusion of new population data from the 2010 census. The best way to interpret the data is as though the unemployment rate was already at 8.3% in December as opposed to having declined in January.

The series of more upbeat data allowed the current “risk-on” rally to extend further, but with a few notable twists. Of special note is that markets continue to differentiate between currencies based on the prospects for respective central banks to further expand their balance sheets (quantitative easing, or QE). We saw this last week following the Fed’s lower-for-longer rate pledge and Bernanke’s mention that QE3 remains an option, which sent the greenback lower across the board.

See related: What Is a “Risk-on” Trade?

Following Friday’s jobs report, which we think delays (at the minimum) potential for a QE3 program, the USD rebounded against EUR and GBP, but lost ground to other major currencies like AUD, CAD, and NZD. The key there is that EUR and GBP, whose central banks are expected to continue asset purchases/balance sheet expansion, also lost ground to AUD, CAD, and NZD, whose central banks are not expected to initiate QE.

Gold prices also declined sharply on Friday, revealing the yellow metal’s strong relationship with the likelihood of Fed QE3.

We expect this dynamic to continue to influence near-term trading conditions, and incoming data will remain an important driver. Next week doesn’t see too much in the way of top-tier data for the majors, but what does come out could have a larger impact than normal (e.g. Australian retail sales, German factory orders/industrial production, Canadian Ivey PMI, and UK industrial production).

Still Waiting on a Greek Debt Deal

Another week comes and goes with no final deal in place to secure Greece’s next round of bailout funds. EU officials’ comments continue to suggest that a deal is nearly complete, with the final sticking point being the amount of public sector participation in debt losses, meaning how much of a loss national governments and the ECB will have to swallow. Assuming a satisfactory deal is reached on the Greek debt swap, what then?

We would expect a final flurry of risk-positive movement as fears of an imminent Greek default are quashed, but we think such a moment may also represent a near-term peak in the current risk rally. If a deal is reached, we think it will likely be the high point in terms of good news in the Eurozone debt crisis.

Markets are likely to conclude that even with a Greek debt deal, Greek debt levels are still unsustainable in the long run. And this also assumes there is no messy rebellion by some Greek debt holders and CDS are not triggered.

Moreover, despite better-than-expected January Eurozone PMIs, the outlook is still for further weakness in Eurozone growth in the months ahead, which will likely come back to undermine European debt markets yet again.

While there has been some marked improvement in Italian, Spanish, and Portuguese bonds in the last week, we’ll be looking to how much of the decline in yields was due to ECB purchases. The ECB will announce the total amount of bond buys made in the last week on Monday at 9:30 ET/14:30 GMT. If they were forced to step up purchases significantly over recent weeks, the nascent calm in European debt markets may not last.

In EUR/USD, we continue to watch the recent 1.3000/1.3250 area as a consolidation range, with a break signaling the next directional move.

Central Bank Decisions on Tap

This week sees interest rate and policy decisions from the Reserve Bank of Australia (RBA), Bank of England (BOE), and ECB. The RBA is first up on Tuesday afternoon local (Sydney) time, and markets are expecting a 25-basis-point (bp) rate cut from 4.25% to 4.00%.

There is some minor risk of a larger 50-bp cut, as the RBA does not expect banks to pass on to customers the full 25 bps if it only cuts by that much. There is also a small risk that the RBA stays on hold, potentially in light of recently more upbeat global data and the calming in the Eurozone debt crisis. Regardless, AUD is not trading on interest rate dynamics at the moment, so we would look to the overall risk environment to gauge AUD’s outlook.

The BOE is up on Thursday morning, and they are expected to hold the benchmark rate steady at 0.50%, but also to initiate a third round of asset purchases. Markets are mostly expecting a smaller round of GBP 50 billion, with a minority expecting another round of GBP 75 billion.

In light of some surprising strength in recent UK data, we think the risk is that the BOE does nothing at this meeting, which could see GBP strengthen briefly. Sterling also appears to be defying QE speculation in recent days, and GBP/USD is nearer to its recent highs. However, we would note cable is having difficulty extending gains beyond 1.5900, and we are watching for a daily close below the 1.5765 daily cloud top to suggest a potential failure and the start of a reversal lower.

See also: Trading with Ichimoku Clouds

The ECB is also up on Thursday, but is expected to keep policy on hold. ECB President Mario Draghi is likely to point to slightly better PMI’s as a further sign that the 4Q was potentially the nadir for the Eurozone, but will also certainly note that downside risks remain. Overall, we don’t think the ECB meeting/press briefing will drive EUR, but that the Greek outcome and risk sentiment will be more important.

By Brian Dolan, chief currency strategist,

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