The Forex Trading Week Ahead

05/14/2012 9:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Upcoming forecasts from the Bank of England, three key Eurozone developments, and central bank policy in the US and Japan are among the items likely to move world currency markets this week, writes Brian Dolan.

The Bank of England (BOE) kept rates on hold when it concluded its May meeting last week; it also allowed the asset purchase program to come to an end. Since the UK slipped back into recession in Q1 2012 and the growth figures at the start of the second quarter have continued to look weak, the decision to hold interest rates was mostly down to the sticky outlook for inflation. The attention now turns to this Wednesday’s Inflation Report.

The focus will be on the Bank’s growth and inflation forecasts. The growth forecasts are likely to be revised lower. Even if the Bank believes that the underlying strength of the UK economy is stronger than the official figures suggest, it is likely to revise down its growth forecast as it had expected the economy to expand by 0.5% in Q1, when in fact, it contracted by 0.2%. Thus, we could see a slight reduction in the Bank’s 3% GDP forecast for 2013.

The bigger risk, in our view, is for inflation. The BOE had expected inflation to fall sharply in the first few months of the year, when in fact it has remained fairly static between 3.4% and 3.6%. The Bank’s central forecast from its February Inflation Report was for a rate around 3% by this stage of the year.

The February report said that it expected “inflation to decline sharply in the near term, as the impact of past increases in VAT and petrol prices drop out of the twelve-month comparison.” While inflation has undoubtedly fallen, it hasn’t fallen as “sharply” as the Bank had forecast. However, we doubt that the Bank will adjust its inflation forecast too much as the strength of the pound will be taken into account since this could dampen import price pressures going forward.

So in the immediate term, we believe the focus will be on the downward revision to growth, however, we expect the report to reaffirm the sticky inflation problem in the UK, which may stop the Bank from re-starting its QE program.

A major driver of FX markets at the moment is relative interest rate differentials. Thus, if it looks like the UK is going to remain on hold, we may see the pound continue to outperform in the ugly contest between the pound, the euro, and the dollar.

An Inflation Report that is deemed “hawkish” by the market could see another leg lower in EUR/GBP. A weekly close around the 0.8015/0.8020 mark is significant as it is the 100% retracement from the July 2011 high when this pair was trading just above 0.90. GBP/USD also looks well supported above 1.6060, however, we are more wary of potential strength in this pair due to 1) the sharp rejection of 1.6300 (a key resistance level) last month; and 2) the safe-haven status of the dollar could keep the greenback in demand, especially if the Eurozone debt crisis remains at fever pitch.

See also: Safe Havens That Replace Gold and Bonds

NEXT: 3 Critical Items to Watch in the Eurozone

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Is This the Beginning of the End for the Eurozone?

As we start a new week, there are three things that could impact the Eurozone debt crisis: 1) the political situation in Greece; 2) the Spanish banking sector; and 3) growth.

Looking first at Greece, at the end of last week, the country was still leaderless. Rumors throughout Friday suggested at one stage that a moderate coalition may be formed, but this was later rebuffed. Thus, it looks increasingly likely that Greece will need to go back to the polls in the near future.

While Greece’s immediate financing needs have been dealt with, the longer-term picture is more uncertain as the EU and IMF seem unwilling to allow Greece to move its strict austerity targets in return for bailout cash. So it all hinges on the Greek people and who they select to lead the country through this fiscal disaster.

But their decision could have much wider implications for the currency bloc. The rating agency Fitch said on Friday that all euro-area countries would face the risk of a credit downgrade if Greece exits the currency bloc. Fitch said that a Greek exit would “break a fundamental tenet” of the Eurozone, which was designed to be a permanent political structure. However, it didn’t say that a Greek exit would be all bad, as in a benign situation, Greece could provide the catalyst for closer fiscal and political unity, something that many people believe are the missing links in the currency union.

Still, Greece remains a wild card, and while investors can’t make up their minds if a Greek exit is good or bad for risk assets, euro-based assets are likely to remain vulnerable to further dips in investor sentiment.

Contagion from Greece is a huge risk for Spain, which is trying to deal with its troubled banking sector. On Friday, it announced some drastic reforms to try to draw a line under the real estate bubble that burst with horrific consequences for Spain’s lenders.

Firstly, Madrid nationalized Bankia, next, it announced two independent auditing firms have been charged with evaluating the banking sector’s true exposure to domestic real estate in an attempt to make things completely transparent. The government will also force its banks to set aside EUR 30 billion of funds against property loan losses. Non-performing loans will also be put in a “bad bank,” allowing them to be sold off at “market prices.”

The Spanish government has (finally) opted to hear the worst news. It wants to know the true extent of losses, and by creating a separate entity for non-performing loans, it wants to try and get rid of these assets quickly and efficiently, allowing the banking sector to wipe the slate clean.

The risk is two-fold: firstly, it means that banks are likely to suffer large losses on the non-performing loans, especially if they are being sold off at “market” prices. Secondly, the government said it would lend banks money if they did not have enough funds to cover their loan-loss provisions. This would be a loan, but it could still hurt Spain’s public finances and thus weigh on its credit rating.

Banks have 15 days to submit plans on how they will meet the reform targets, so expect volatility in Spain’s bond and equity markets over the next few weeks as the results of the bank reviews trickle out to the market.

The third issue is growth. This week, we will get Q1 GDP data and CPI data. If the contraction in the economy is greater than the 0.2% expected then the disappointment may weigh on the euro.

However, there were some encouraging signs from Germany last week that may boost growth in the currency bloc. Officials in Berlin hinted they may be willing to allow inflation to increase, especially wage growth throughout Germany to try and help “re-balance” the Eurozone’s economy. This may open the way to rate cuts from the ECB in the coming months, which could help boost peripheral bond markets in the short-term.

We need to hear more about this, but if Germany is softening its stance towards inflation, this is a major shift in the currency bloc and would help to deal with the key structural issues that have so far been neglected during this crisis.

European stocks were sold heavily last week; however, the pace of decline slowed as we headed into the weekend. The Spanish index, which has been hit particularly hard in recent weeks, recovered after falling sharply during the banking reform announcement on Friday. This suggests that the market has welcomed the moves by Spain and would rather see complete transparency of the state of Spain’s problems even if they are worse than expected. Spanish banks recovered on Friday afternoon along with the overall European equity indices.

The euro was trading just below the key 1.2950 level versus the dollar at the close of the European markets on Friday. This is below a key resistance level and suggests there may be further losses in the coming days. However, if Greece can form a moderate coalition government then we may expect a relief rally in the short term. We continue to see EUR/USD moving lower, but we think it will be an incremental decline rather than a prolonged downtrend.

NEXT: Federal Reserve, Bank of Japan Policies in Focus

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Fed Officials Reluctant to Signal More Easing

Demand for safety as European politics raises uncertainty has resulted in lower US Treasury yields and a stronger buck. Despite softer US data, Fed officials have indicated their reluctance to engage in further QE. This past week, Dallas Fed President Fisher reiterated that he would not support new quantitative easing, and Minneapolis Fed President Kocherlakota maintained his hawkish stance, saying that the bank may need to cut stimulus in six to nine months. Lacker reinforced his reasons for dissenting on the language to keep rates low through 2014 and Pianalto expressed her optimistic outlook for economic growth this year.

Taken together, recent comments from Fed officials indicate that the bar is relatively higher for another round of QE, as conditions would have to deteriorate significantly before such action would be warranted.

With dampened hopes for additional easing, yields have responded more to risk aversion. In an environment where QE3 speculation is high, we tend to see lower Treasury yields, higher equities, and a weaker dollar.

What has been observed recently is an environment that appears to be driven more by risk sentiment with lower Treasury yields, lower equities, and a stronger dollar. As such, we anticipate sentiment to continue to be a main factor driving the USD in the week ahead with a bias for a stronger dollar.

On the data front, US CPI numbers are scheduled for release on Tuesday and are expected to show above-target inflation, which supports the view that the Fed will not engage in further stimulus.

Technical analysis is constructive for the dollar, as the dollar index is trading above the 80.00 level and the daily Ichimoku cloud. The index also broke above a medium-term bear channel, which began in mid-December, suggesting continued upside.

The channel can be seen by connecting the highs of January, March, and April and bringing a parallel line to down to connect the lows of Dec. 21, early Feb., and late Feb. The top of the channel is currently around the 100-day simple moving average, which is at about 79.60, and the convergence of the daily cloud top, base, Tenkan, and Kijun lines is around the 79.40/79.60 level, which is likely to be a pivotal area. While the zone holds as support, we would expect further upside potential in the dollar.

Broader Risk Environment Outweighs Japanese Rhetoric

The Japanese yen has been a strong performer this week despite recent measures by the Bank of Japan (BOJ) to ease further, as well as increased rhetoric from government officials stating Japan’s readiness to act on the currency if needed.

Action by the BOJ to increase asset purchases in longer-dated maturities did little to stem JPY gains. USD/JPY broke below the 80.00 figure and price action has been contained within the weekly Ichimoku cloud that sees the top and base at about 80.44 and 78.11, respectively.

The yield differential between US Treasuries and Japanese government bonds has moved in favor of a lower USD/JPY, and increased risk aversion with renewed political uncertainty in Europe have resulted in yen gains. Broader market sentiment has been a main driver of the JPY and may continue to outweigh domestic policy.

Japanese finance minister Jun Azumi said earlier last week that Japan is closely watching for speculative yen moves and that the yen rise may be partly caused by EU politics. He also stated that Japan is ready to act immediately on the yen if needed. The rhetoric did not deter JPY longs, as yen strength resumes.

We have seen this in the past with comments from the BOJ, reiterating their commitment to powerful easing. The market is indicating that it does not see officials as a credible threat, and even recent interventions and central bank activity in the past has failed to have a lasting impact.

We expect the yen to be range bound as it consolidates within its weekly cloud and given relatively light data flow in the week ahead. Of note, Q1 GDP figures are scheduled for release on Thursday and are expected to show that the economy grew +0.9% quarter over quarter from the prior -0.2% contraction.

Rhetoric from officials has been uninspiring, as they have reiterated prior comments without strong action to back them. Therefore, unless there is a distinct shift in tone, we expect the market to continue to shrug off the usual comments.

By Brian Dolan, chief currency strategist, FOREX.com

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