The Forex Trading Week Ahead

05/21/2012 9:45 am EST

Focus: FOREX

The political situation in Greece, growing concerns about Spanish debt, and central bank policies in Japan and the UK are among the hot topics currency traders will be watching this week, write Kathleen Brooks and Eric Viloria, CMT, of FOREX.com.

It was a pivotal week for the Eurozone after Greece announced that it was heading back to the polls after the top three parities failed to form a coalition government. So now Greece is leaderless; there is a caretaker government in place, but it won’t be able to enforce the austerity required to get the next tranche of bailout funds necessary for Greece to avoid running out of money in July.

So as time runs out for Greece, the European authorities have been clear: the upcoming election is a referendum on euro membership. Either vote for pro-bailout parties and stay in the currency bloc, or don’t and leave.

The EU authorities seem willing to sacrifice ECB losses from its Greek sovereign debt holdings (to the tune of EUR 104 billion) if Athens does not toe the austerity line. But while the EU authorities are not giving up ground when it comes to Greece, there is a chance that the weekend’s G8 summit in the US could lead to German Chancellor Merkel softening her stance on austerity and being more pro-growth. This is not due to Greece (which we think the EU is now willing to cut loose), but rather because of Spain.

Last week, we got a taste of what Eurozone contagion may look like. After the Greek President said that Greek banks had seen deposits withdrawn at a quicker pace post the election result, news came that Bankia, a troubled Spanish lender, was also witnessing a jump in deposit withdrawals.

Spanish savers can see what is going on in Athens, thus, it is easy to understand why they would want to withdraw their money to the safety of a secure Swiss vault. Greek banks’ balance sheets were essentially decimated when Athens negotiated the private sector debt swap. The four biggest banks had a combined loss of nearly EUR 30 billion. That is roughly equivalent to the loss faced by Citigroup at the peak of the financial crisis in 2009; however ,Greece’s economy is the equivalent of 0.3% of the US economy, which puts things into perspective.

In Spain the problem is even more complex. Recapitalizing the banks could push Spain towards a bailout. Yet, Spanish banks hold sovereign debt, so if Spain was to undergo a private sector debt haircut a la Greece, the banks would require even more support from European officials as the value of Spanish sovereign debt plummeted.

If Spain requires the same treatment as Greece, that is effectively the end of the Eurozone as we know it. The only way to pull the Iberian nation back from the edge is by boosting growth. A plan to boost investment through the European Investment Bank may help growth levels recover and reduce pressure on the labour market. Thus, if Merkel agrees to slow down the pace of austerity at the same time as boosting investment in Europe’s periphery, we could see a relief rally in the markets this week. As we have said in the past, politicians move slower than the markets, so any sign that politicians are moving in the right direction could help to boost market sentiment.

Growth will also be in focus this week as preliminary PMI data for May is released. It is expected to increase slightly, but remain in contraction territory. After Q1 GDP remained flat, the markets now expect growth to dip in Q2, but the key thing is how deep the contraction will be.

The euro managed to recover slightly at the end of last week after dipping below 1.2650 at one stage. The key support level to watch is 1.2624, the January low. Below here, there isn’t much support before 1.20.

Although the situation is grave in the Eurozone, the volatility in the options market is not as high as it was in November. This suggests that the markets may be expecting the politicians and the ECB to step in if things get critical. Thus, any signs from Merkel that she is willing to re-assess her stance on austerity could be greeted with a relief rally in EUR/USD. The 1.2860/1.2870 level is a key resistance zone and the location of the 200-hour moving average.

Can the US Dollar Extend its Rally?

Since the beginning of May, the dollar index has seen a sharp rise from the May 1 lows of around 78.60 to test near multi-year highs last seen on January 13 around 81.75. The buck has gained amid demand for safety as concerns surrounding Greece’s future in the euro and contagion fears have escalated. The rally may be running out of steam for now, as negative external factors stemming from the Eurozone haven been largely priced in, and as domestic concerns keep the prospect of additional Fed stimulus in sight.

While safe-haven flows resulting from external uncertainties have benefitted the dollar, domestic concerns cannot be ignored as the FOMC minutes released earlier last week reminded markets that the Fed remains open to the idea of further monetary easing. The minutes noted that the recovery would have to falter in order for more stimulus to be warranted.

Though our base scenario is for no additional QE, this past week’s data showed a slight deterioration in economic activity. Inflation slowed with the yearly change in headline CPI falling to +2.3% in April, retail sales softened, weekly jobless claims showed no sign of improvement, and the Philadelphia Fed index showed contraction for the first time since Sept. 2011.

In the week ahead, new and existing home sales, regional Fed manufacturing reports, and durable goods orders are scheduled for release, and any significant disappointments may cause markets to increase speculation on additional Fed measures.

Technically, the dollar is approaching significant levels against many of the majors, which suggests that it may find resistance as dollar longs look to book profits. EUR/USD has slowed its decline ahead of the 2012 lows, which may act as support in the near term, and USD/JPY continues to face resistance around the top of its weekly Ichimoku cloud. The ascent in the dollar index has decelerated and looks to be stalling around the 81.75 level. Daily candlesticks are showing long top wicks, indicating the market’s reluctance to push the buck higher at this time.

NEXT: Central Bank Policies in Focus

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Bank of Japan May Extend Maturity of its Bond Buys

The Bank of Japan (BoJ) will meet on May 23 to announce policy, and we expect the Bank to keep policy on hold with a small tweak to the maturity of its purchases. With a net ¥5T increase in total purchases at last month’s meeting, we think that it is too soon before the Bank expands the amount of bond buys.

The BoJ has been buying Japanese government bonds (JGBs) as part of its asset-purchase program â€"a monetary policy tool designed to fight deflation. The program began in October 2010, and earlier last week, the Bank saw its first shortfall in its bond buys since the start of the program, as it was unable to reach its target of ¥600B in JGB purchases. The Bank received only ¥480.5B offers in short-term JGB’s as there was an insufficient supply. With the Bank facing difficulties implementing its operations, we think it may need to adjust its approach by increasing the maturity of its purchases.

Currently, the Bank is only purchasing short-term debt with a maximum maturity of up to three years. The Bank announced the extension from a maximum of two to three years at the last policy meeting, and in our view, it is likely to extend the maturity at this week’s meeting. The impact will likely be muted, however, as the Japanese government yield curve is already very flat. Two-year yields are currently at about ten basis points (bps) and ten-year yields are around 83 bps.

With expectations of strong action from the BoJ low, the yen is likely to remain firm as traders avoid risky assets. This past week, the JPY outperformed the G10 currencies as risk aversion saw flows into safe havens. We expect the yen to remain range-bound against the dollar as it consolidates within the weekly Ichimoku cloud that sees the top and base around 80.45 and 78.00, respectively.

The risk is for potential intervention, which finance minister Azumi has been hinting at for some time. As we have previously noted, actions taken by Japanese officials have not had a lasting impact and have been relatively ineffective in sustained yen weakness.

Pricing in More QE from the Bank of England

The pound was one of the worst performers out of the G10 last week after the Inflation Report from the Bank of England (BOE) was perceived as being dovish. Although the Bank revised up its forecast for inflation this year, it also revised its growth forecast lower after the contraction in the economy in the first quarter. But since the Bank sets policy with a two-year time frame, its longer-term inflation forecast was more important. It expects inflation to undershoot its 2% target in the next two years, which suggests the Bank will keep the door open to more QE.

So why didn’t the BOE do more QE at its meeting earlier this month, when the last round of asset purchases was completed? Outgoing MPC member Adam Posen (he leaves in August) explained that his decision to stop voting for more QE last month was down to the stickiness of inflation, however, although he said there was a chance that growth data could be revised higher, he said that he would be reviewing his vote for QE going forward.

This highlights some of the difficulties faced by the BOE. The economy could do with more stimulus, yet household incomes are constrained by rising prices, especially for food and energy. Thus, the recent decline in the oil price (Brent crude has fallen nearly $18 since March) could give the monetary policy committee (MPC) much-needed room to add more stimulus later this year.

It’s a big week for economic data in the UK. Inflation and retail sales are the highlight, and the BOE minutes are unlikely to deviate too much from the Inflation Report. CPI data is expected to decline to 3.1% from 3.5% in March. This is a sharp fall, but remains above the Bank’s 2% target. If inflation is stronger than expected, then the prospect of more QE is likely to get pushed back. However, if it is lower, this could boost the chances of more QE, especially if the growth outlook remains weak and if the Eurozone debt crisis (which the Bank said was the biggest threat to the UK economy) takes another turn for the worst. Retail sales are expected to fall by 0.7% in April, although some of this decline could be due to the early timing of Easter.

See also: The Biggest Threat to the US Recovery

Last week, the pound broke its inverse relationship with Gilt yields. In the past few months, it has strengthened as Gilt yields have fallen, leading the pound to be called a “safe haven.” However, earlier last week, the pound fell alongside bond yields, and also couldn’t manage to keep EUR/GBP below 0.8000.

Since monetary policy has been a key driver of the forex markets in recent months, a more dovish MPC is likely to weigh on the pound. We think the pound is vulnerable, especially against the yen and the Aussie dollar. Weak inflation data could push GBP/USD below 1.60 after it found support at this level last week.

EUR/GBP also managed to recover, however, although we think the euro may consolidate here, we believe it could grind lower in the longer term and re-test the air below 0.8000.

See related: GBP Trade That’s Best in Risk-on Markets

GBP/USD is harder to predict. Because the dollar is a safe haven, this cross is vulnerable to selling pressure when the markets are in risk-off mode. As we mention above, the markets may be ripe for a pullback, and any dollar weakness could help GBP/USD to recover. However, we tend to think that 1.60 is likely to cap any gains in the current environment of heightened tension in the currency bloc. 1.5700 may act as good support.

By Kathleen Brooks and Eric Viloria, CMT, of FOREX.com

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