Weekly Trading Forecast - 01.17.11

Subject: Weekly Trading Forecast - 01.17.11 Sun Jan 16, 2011 12:55 am

By David Rodriguez,
Quantitative Strategist ; John Kicklighter, Currency Strategist ; Ilya
Spivak, Currency Strategist ; David Song, Currency Analyst ; Michael
Wright, Currency Analyst and John Rivera, Currency Analyst
US Dollar Recovery in 2011 at a Tipping Point – DJIA Trend Critical
The US Dollar fell sharply against the Euro on a sudden improvement in
Euro Zone sovereign debt markets, but a sharp late-week reversal
suggests USD bulls have not yet given up the fight. We have long argued
that the month of January is often pivotal in setting the stage for
medium term trends, and the fact that the Euro/US Dollar pair was unable
to close above its earlier highs bodes well for the Greenback. A
relatively empty week of economic event risks leaves volatility
expectations considerably lower through the short-term. Yet traders
should watch whether the US Dollar is able to hold its lows against the
Euro and set the stage for continued reversal through the coming months.

Little foreseeable event risk leaves the Greenback at the whims of
broader market flows and developments in ongoing Euro Zone fiscal
crises. Possible exceptions include mid-week Housing Starts and Existing
Home Sales reports, but it would likely take a substantial surprise in
either direction to force important moves in the US currency. One
potential market-mover may come from a non-traditional source: the
Chinese government will release initial estimates of Q4, 2010 GDP growth
on Wednesday night/Thursday morning.

The Asian titan has defied a broader global economic slowdown and
continued to grow at impressive double-digit rates, but markets will
likely need to see similarly robust expansion into the final quarter of
the year. Any significant disappointments could especially affect the
Australian Dollar and New Zealand Dollars—forcing them lower against
their US namesake.

The month of January is often critical in determining trends for the
following 11 months of the year, and the fact that the Euro/US Dollar is
essentially unchanged through the first two weeks leaves medium term
trends in the balance. The determining factor may come down to whether
the US S&P 500 and broader risk sentiment can continue to improve
into the New Year. We have made little secret of the fact that we
believe the Dow Jones Industrial Average and broader ‘risk’ may see a
substantial correction following robust gains. Yet any attempts at
betting on such weakness have done quite poorly through continued
rallies. It will be critical to watch the trajectory of ‘risk’ and its
effects on the US Dollar through the final weeks of January. – DR

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Euro Recovery on Rate Expectations and EU Promises Likely Limited
Fundamental Forecast for Euro: Neutral

- EU floats proposals that would dramatically increase the crisis fight

- The ECB turns up the heat on interest rate expectations

- A sharp reversal in EURUSD still holds to a range – improving traders positioning

The euro surged this past week – fully recovering the substantial losses
of the opening week of the year. It is difficult to separate the impact
that the unusual liquidity conditions had in this scenario from the
true fundamental developments. However, the events that have transpired
so far this year certainly warrant the level of activity we have seen.
When traders first returned to the market, they picked up on the same
concerns about a deteriorating financial backdrop for the Euro Zone that
they had left off with in 2010. Perhaps noticing the gravity of the
situation and the futility of policy officials voicing optimism in the
public forum; the heads of state finally stepped up to the problem with
an open-ended discussion of drastically expanding the EU’s efforts to
quell a crisis in the region. And, taking it a step further for the
euro, the ECB finally seemed to turn the corner on its neutral policy
stance to finally start talking interest rate hikes. The week ahead will
be critical as it will tell us just how much influence each of these
developments can carry through speculation alone.

It would certainly be remarkable if the EU passed a range of policy
steps to expand its stimulus efforts and the ECB started to lift the
benchmark lending rate in quarter point steps. In fact, if that were to
happen; the euro would surge. And, really, even a strong belief that
either or both of these events could occur in the near term would drive
the shared currency to new highs. However, are these bullish objectives
actually credible? First we start with the more complicated proposals
supposedly being debated by European officials. Among the points being
discussed are an expansion of the EFSF bailout program, lower rates to
access the emergency funds, additional guarantees, the ability to
intervene in the bond market, a direct line of credit to Portugal, the
purchase of Greek bonds and other enticing endeavors. Again, if all of
these were passed; it would be a significant relief from the perceived
threat to the region. Yet, why should we believe these are realistic
measures that will be taken when there has debate over much smaller
points. What’s more, does this solve the problem of recessions in some
EU member economies and the cost incurred by others? No. The market will
be quick to recall this fact should the summit this coming week doesn’t
produce any tangibles. An estimate of a real results not coming until
March sets a realistic time frame.

As for the probability of an ECB rate hike, President Trichet said quite
clearly that interest rates were “appropriate” at the outset of his
discussion. And, though he noted the risk that near-term inflation could
climb; he didn’t explicit voice concern about medium-term inflation.
Independence is important to the major central banks; and they will
express this freedom by suggesting they are willing to fight inflation
even when there is a fiscal and economic struggle at hand. However,
raising rates in the EU would severely burden member economies that are
already truly struggling. Knowing this, policy officials are very
unlikely to act on price pressures that are largely centered on food and
fuel costs. So while further jawboning inflation may keep the euro
buoyant; reality will soon set in.

The two major themes mentioned above will almost certainly define the
euro’s path going forward; but it is the market’s assessment of their
development that ultimately matters. For that, we should keep a close
eye on underlying risk appetite. If investor optimism rises, they will
be more prone to believing the bullish chatter; and pessimism will lead
traders right back to the underlying problems. As for the economic
docket, the focus actually lies on sentiment. Consumer and business
optimism will paint the economic picture; but it is the ZEW investor
survey that is really interesting. This is polling those that are
actually buying European debt. - JK

British Pound May Consolidate On Mixed Batch Of U.K. Data
Fundamental Forecast for British Pound: Neutral

* U.K. Retail Sales Expands At Slower Pace
* U.K Trade Deficit Unexpectedly Widens on Oil Imports
* BoE Holds Rate at 1.00%, Asset Purchase Target at GBP 200B

The British Pound rallied to a fresh monthly high of 1.5888 on Friday,
and the exchange rate may continue to push higher over the near-term as
investors speculate the Bank of England to start normalizing monetary
policy later this year. The economic docket for the following week is
expected to show inflation expanding at the fastest pace since May, with
market participants forecasting consumer prices to rise at an
annualized pace of 3.4% in December, and the stickiness in price growth
is likely to spark a bullish reaction in the sterling as the central
bank drops its dovish outlook for future policy.

At the same time, retail spending in the U.K. is projected to weaken
0.3% during the same period, while jobless claims are expected to hold
flat after slipping 1.2K in November, and the mixed batch of data could
lead the GBP/USD to consolidate over the following week as investors
eagerly wait for the BoE policy meeting minutes due out on January 26.
As price pressures intensify, we are likely to see the MPC turn
increasingly hawkish over the coming months, and the central bank may
see scope to lift the benchmark interest rate off the record-low as it
aims to balance the risk for the region. According to Credit Suisse
overnight index swaps, investors expect the BoE to hike borrowing costs
by at least 50bp this year, and the rise in interest rate expectations
may gather pace over the coming months as the central bank struggles to
contain the acceleration in price growth. However, we expect to see
another three-way split within the committee as board member Adam Posen
anticipates the ongoing weakness in the economy to bear down on price
growth, and there could be a growing tear within the MPC as the
fundamental outlook remains clouded with uncertainties.

As the recent rally in the GBP/USD tapers off ahead of the December high
(1.5910), we may see a corrective retracement unfold next week, and the
exchange rate may trend sideways over the coming days as the relative
strength index holds below 70. However, another break to the upside
should lead the pound-dollar to retrace the decline from back in
November, and the British Pound may outperform against its major
counterparts next week as interest rate expectations increase. - DS

Japanese Yen Vulnerable with Strong Corporate Earnings Expected
Fundamental Forecast for the Japanese Yen: Bearish

* Domestic corporate goods price index in December rose to 1.2% from 0.9%
* Current account surplus narrowed to 926.2B in November from 1436.2B
* Japanese Finance Minister Yoshihiko Noda threw support behind European Bonds

The Japanese yen was flat on the week against the dollar but saw sharp
declines against the Euro and Pound. The single currency gained over 3%
against the Asian currency impart due to actions from Finance minister
Yoshihiko Noda. The Japanese official stated that it was appropriate to
buy bonds from Ireland which followed a similar vote of confidence from
China. The apparent global support for the region’s debt helped ease
concerns over the debt crisis and helped deliver successful auctions
from Portugal, Spain and Italy. Rising interest rate expectations in the
U.K. and Euro-zone also weighed on the Yen against its European
counterparts. However, declining yield expectations in the U.S. kept the
greenback from gaining ground as last week’s disappointing labor report
was followed by misses in retail sales and consumer confidence.

Improving domestic fundamentals failed to generate volatility but dimmed
the prospect of more BoJ intervention which opens the door for Yen
strength. A rise in whole sales prices to 1.2% should ease deflation
concerns for policy makers which are expected to lift growth forecasts
at their upcoming meeting. A rise in import cost for raw materials and
energy are helping offset Yen strength which led to Japan’s current
account surplus shrank for the first time in three months in November.
The news isn’t all good as exporters continue to see demand wane on the
back of persistent Yen support. An improvement in the Eco watcher’s
survey for the second consecutive month reflects an improving domestic
economy as the current conditions gauge rose to 45.1 from 43.6 in
November.

The improving economy is expected to have brightened the outlook in
Japanese households with the consumer confidence metric forecasted to
rise to 41.6 from 40.4. Industrial production, machine tool orders and
nationwide Dept store sales will also cross the wires but traders
shouldn’t expect significant volatility from the domestic economic
docket. U.S. yields continue to have a major influence on the USD/JPY
which puts the focus on earnings season. Next week we will see a number
of blue chip names report which could impact risk appetite and demand
for bonds. If companies continue to show the ability to improve their
bottom line then we could see broad based yen weakness. However, mixed
results will leave price action to the prevailing broader themes of
European debt and U.S. growth which should lose some focus next week but
have the potential to generate support for the funding currency if
confidence in either deteriorates.-JR

Gold Prices to Fall as ETF Holdings Hit Four-Month Low
Unlike most benchmark assets, gold had largely decoupled from the
risk-on / risk-off dichotomy that ruled financial markets in the
aftermath of the 2008 meltdown, with the metal managing to remain
broadly well-supported throughout. This resilience reflected the
prevalence of “extreme” bullish or bearish views on the pace of the
global recovery, both of which saw gold as an attractive store of value
within their respective outlooks. Both camps increasingly appear to have
been off the mark however, hinting the breakneck gold rally may be on
the cusp of a major reversal.

For the bulls, the central fear was and is inflation. In their scenario,
global growth will snap back faster than central banks are able to mop
up the flood of liquidity created through record-low interest rates and
quantitative easing. This will see prices soar on a global scale,
debauching paper currencies and making a hard asset store of value like
gold a very attractive alternative. Meanwhile, the bears didn’t believe
that mounds of fiscal stimulus would create much more than a temporary
reprieve akin to putting a band-aid on a broken arm, forecasting the
recovery would fail as soon governments withdrew their support. This
would see the spectrum of risky assets “artificially” buoyed by said
stimulus collapse anew, making gold attractive for its tangible store of
value properties once more.

As we have discussed previously, this has meant that the most reliable
long-term driver of the metal’s prices over recent years has been the
trend in gold ETF holdings. This suffered a major set-back last week,
with the Bloomberg gauge of total known holdings snapping the rising
trend carved out through the fourth quarter of last year to drop to the
lowest since mid-September. The reversal in investment demand seems
reasonable. US economic data – the bellwether for the global recovery at
large – has materially improved over recent weeks, hinting a back-slide
into recession is decidedly unlikely. However, all signs point to a
rebound that is slow and uneven, with headwinds in the looming slowdown
in China and the lingering debt crisis in the Euro Zone likely to assure
the road to broad-based pre-crisis prosperity will amount to a long,
hard slog over the years ahead. On balance, this means the “extreme”
scenarios at the bullish and bearish ends of the spectrum appear
unlikely, opening the door for gold to begin a long-overdue correction
lower.

Canadian Dollar Looks to BoC Interest Rate Decision For Direction
Fundamental Forecast for Canadian Dollar: Neutral

- Canadian Dollar Calls for Strength Against U.S. Dollar - Canadian Dollar Shows Little Reaction to Trade Figures

The Canadian dollar pushed higher against its U.S. namesake last week,
climbing some 0.41 percent. Indeed, the advance in the loonie marks the
four successive week that the currency rallied against the greenback;
however, the gain in the Canadian dollar may be short-lived as focus
shifts to the Bank of Canada interest rate decision. Furthermore, crude
oil’s failure to break above 92.60 after testing the level for a third
time this past week is hinting at a slight correction.

During this past week, the dismal economic releases in Canada failed to
ease strength in loonie against the buck as risk appetite weighed on the
greenback. Taking a look at the recent developments, Canadian building
permits disappointed in November as figures dropped 11.2 percent amid
economics’ estimates of a 1.5 percent increase, while housing starts
fell to 171.5K in December from a revised 198.2K the month prior. With
regards to the former, because of the high outlays needed for
construction projects, the reading suggests lower consumer and corporate
optimism. Not to overlook, traders also shrugged off Canada’s trade
deficit which narrowed in November amid a decline in energy imports.
Though markets dismissed the data, the release is worrisome due to the
fact that Canada relies on exports and the report showed the largest
decline in purchases from overseas since March 2009. These developments
combined with consumer prices which recently slowed to 2.0 percent in
November will lead the Bank of Canada to refrain from raising its key
overnight lending rate.

As of late, traders are pricing in a four percent chance that the BoC
will hike rates twenty five basis points at its rate decision meeting on
January 18th. At last month’s meeting, the central bank kept its
overnight lending rate unchanged amid uncertainty surrounding its
economic outlook and a strong Canadian dollar which may weigh on growth
as U.S. which is Canada’s key trading partner continues to battle tight
credit conditions, a high unemployment rate and subdued wage growth. At
the same time, a strong loonie could widen the trade imbalance even
further. Though Canada’s international ties are worrisome in these
market conditions, policy makers last month were not as concerned as
many economists surrounding the Euro-zone troubles. I expect the central
bank to remain optimistic about growth in the 17 member euro area
following the recent bond auction in the bloc. All in all, the Bank of
Canada is widely expected to hold its key benchmark interest rate at
1.00 percent; however, comments following the rate decision will likely
dictate price action and a slightly more dovish statement will surely
add weight onto the loonie. Also on tap will be the leading indicators
and retail sales reports.

Taking a look at price action, the pair continues to trade in a
descending channel on the daily chart. Indeed, the price action provided
a false breakout on the hourly chart, but as daily studies enter
oversold levels, traders should not rule out a reverse in course. It is
also worth noting that our speculative sentiment index stands at 6.65
and signals for additional losses in the near term. -MW

Australian Dollar Carves Head-And-Shoulders Top in 2011
Fundamental Outlook for Australian Dollar: Bearish

* Queensland Floods Pressure the Australian Dollar
* Australian Job Growth Cools in December
* The Threat of a Surge in Risk Appetite Trends Looms Heavy for the Dollar and S&P 500

The small rebound in the Australian dollar was certainly short-lived as
the exchange rate fell back below parity on Friday, and the
high-yielding currency may continue to depreciate over the following
week as the outlook for global growth deteriorates. At the same time,
the AUD/USD appears to be carving out a head-and-shoulders top in 2011,
and there exchange rate may push sharply lower over the near-term as it
looks to complete the right shoulder around 1.0000.

The People’s Bank of China raised its reserve ratio for commercial banks
by 50bp this week in an effort to contain inflation, and the central
bank may continue to aggressively tighten monetary policy throughout the
first-half of the year in order to prevent the economy from
overheating. As China aims to cool the marked expansion in economic
activity, the recent moves by its largest trading partner could dampen
the recovery in the isle-nation, and the Reserve Bank of Australia may
look to retain its wait-and-see approach throughout the first quarter of
2011 as region copes with the flood in Queensland paired with the
slowdown in global trade. According to Credit Suisse overnight index
swaps, investors pricing one more rate hike by the RBA for the next 12
months, but interest rate expectations may deteriorate further over the
coming months as central bank Governor Glenn Stevens holds a cautious
outlook for the region. The RBA said monetary policy was “mildly
restrictive” after holding the benchmark interest steady at 4.75% in
December, and the central bank may continue to drop its hawkish outlook
for inflation as households curb spending and increase their rate of
saving.

After topping out at a record-high of 1.0256 in December, the AUD/USD
looks poised to weaken further as the recent rebound in the exchange
rate fails to push the pair back above the 20-Day SMA at 1.0024. As a
result, we expect the head-and-shoulders pattern to pan out over the
near-term, and the exchange rate may fall back towards the 100-Day SMA
at 0.9766 as it searches for support. As the economic docket for the
isle-nation remains bare until the last days of January, risk trends are
likely to dictate price action going forward, but the recent rebound in
the greenback may gather pace over the following week as the recovery
in the world’s largest economy gradually gathers pace. In turn, I will
look to maintain my short AUD/USD position going into the following
week, and the pair may continue to retrace the advance from the previous
year as the uncertainties surrounding the global economy bears down on
market sentiment. – DS

New Zealand Dollar Volatility Expected on Jump in 4Q Inflation
The New Zealand Dollar joined the Euro and Pound as the biggest gainers
on the week with the commodity dollar improving against all of the
majors except its two European counterparts. Easing concerns over the
debt crisis benefitted the Kiwi as it became the high yielder of choice
with its antipode cousin the Australian dollar falling out of favor.
Indeed, severe flooding in the Queensland took the luster off of the
Aussie, but Kiwi bulls shouldn’t forget New Zealand continues to feel
the impact from its own natural disaster. The country’s worst earthquake
in eighty years has economists forecasting a potential double dip
recession for the export driven economy and the weak growth outlook
could become a weighing factor.

An 8.0% rise in building permits for November helped ease some growth
concerns, but the gain was primarily in apartments which detract from
the improvement. The trade balance deficit narrowed on the month to
–NZ186 million as the drop in imports outpaced a slip in exports. The
weaker demand from abroad won’t encourage any optimism for future growth
as Asian demand is expected to ease with China’s efforts to slow their
domestic economy. Indeed, the PBOC raised the level of reserve
requirements for banks in an effort to put the brakes on growth, as they
look to head off inflation. Major Chinese bank will have to hold onto
19% of their assets with medium and smaller institutions accountable for
15.5%. Despite the prospect of slower demand for exports and domestic
hurdles, we saw interest rate expectations jump during the week with
overnight index swaps now pricing in 65 bps in tightening over the next
twelve months, up from 48 bps on January 11th.

The likely culprit for the brighter yield outlook is the forecast for
inflation to have accelerated to 4.0% from 1.5% in the fourth quarter,
well above their 1%-3% target. Consumer demand is also expected to have
rebounded in November by 1.2% following a 2.5% drop the month prior
which should ease some domestic growth concerns. However, although the
rise in consumer prices makes the case for future tightening, it also
warns of lower consumer spending which could be bearish for the Kiwi
considering the dimming outlook. -JR

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