US Dollar Reversal and Breakout a Matter of Time – But When?
Fundamental Outlook for US Dollar: Neutral
- US Gross Domestic Product numbers show worst drop in 27 years
- Dollar slipped on S&P rallies through earlier-week trading
- Months of consolidation could foreshadow US Dollar breakdown
The US Dollar finished the week lower against foreign counterparts, but it failed to break below key range-lows despite sharp S&P rallies and fairly disappointing domestic economic developments. The highly-anticipated US Gross Domestic Product showed that the economy contracted less than expected in the second quarter of the year, but noteworthy downward revisions to earlier figures clearly dampened optimism on growth. Government data showed that the economy saw its worst quarter-on-quarter performance in 27 years in Q1. The slower rate of contraction in Q2 may have calmed some nerves, but truly dismal Personal Consumption figures underlined that consumers—the engine of earlier economic growth—remains heavily subdued. The upcoming week brings infamous Non Farm Payrolls data to the fore, and it will be critical to watch for any signs that the US Dollar could finally break its range versus major forex counterparts.
Week in and week out we have discussed potential scenarios for a US Dollar breakout, but FX markets have shown little willingness to push the USD beyond its trading channel through directionless summer trade. Of course, forex market volatility tends to be mean-reverting over the medium-to-long run. Lengthy periods of consolidation most often lead to sharp breakouts, but the timing of said shift remains anything but clear. Forex options markets volatility expectations are near their lowest levels since August, 2008. Anecdotal evidence tells us that trading volumes have fallen sharply through the summer—theoretically making it easier for a big traders to force volatility. Yet few have shown the appetite for moving markets, and we anxiously await signs that the US dollar may finally break out of its consolidative range.
Can the US Non Farm Payrolls report and other key data releases finally break us from our recent range? We will certainly know the answer to this question once the coming week is through, but it is worthwhile to discuss possible scenarios in which the US Dollar could finally move sustainably higher or lower against the Euro and other key counterparts. Consensus forecasts imply that markets expect broad improvements in key NFP and similarly market-moving ISM Manufacturing and Services results. Given the general uptrend in equity markets and general economic mood, such predictions come of little surprise. Yet lofty expectations leave significant room for disappointment, and the very fact that the S&P 500 has rallied so substantially through recent weeks leaves it at risk for a noteworthy correction.
Forex futures and options data shows that traders remain extremely net-short the US Dollar, and our bias remains bullish as a result. The key difficulty remains the timing of any such correction, as market sentiment can remain at extremes for extended stretches. In other words, we know it’s all a matter of time. Given enough of it, we may expect the Greenback to finally break above the Euro 1.4350 mark or below 1.3800. Given enough time, traders will unwind extremely one-sided US Dollar short positions and bring a noteworthy correction. Whether that may be in the week ahead is anyone’s guess, however, and it will be critical to watch for signs of a sustained reversal. Said signal could come from the S&P 500 and other key financial market risk barometers.
Euro May Cash in on its Anti-Dollar Role Before the ECB Decision
Fundamental Forecast for Euro: Bullish
- German unemployment falls for the first time; but this improvement is a result of seasonal adjustments
- German consumer confidence rises for a third month
- What does the technical outlook for the euro look like?
The dollar is near collapse; and its liquid counterparts stand to reap the benefits of the potential cross-currency winds. However, from a fundamental standpoint who stands to benefit the most? Those pairs that have pressed all the way to the edge of their recent historical highs against the ailing reserve currency (the British pound or Aussie dollar) are heavily dependent upon unpredictable risk appetite. The stalwart among the group is the euro. Liquidity, a steady yield, bullish growth forecasts and a policy authority that is confident financial conditions are sound make for an appealing alternative for the most actively traded currency in the market. However, is the outlook truly as bright as the market is pricing in? More importantly; do speculators even care?
In trying to approach the first question, it is important to remember that valuing a currency is always done on a relative basis. For example, the euro could still rise against one of its major counterparts even when the economy is sinking as long as the Euro Zone is contracting at a slower pace. That being said, the objective answer is that the economy is not as stable as the strength of the currency would suggest. We will not see the first round of the German and Euro Zone second quarter GDP figures until August 13th. Nonetheless, expectations will readily discount each indicator that crosses the wires until then. This past week’s data further exposed a significant discrepancy between expectations and actual data. Surveys for consumer, business and economic sentiment all reported improvements in their July readings (though they were mostly still below the net expansion/contraction line). In contrast, the German unemployment rate has held at its highest level since December of 2007. Consumers are the foundation for economic health and will determine whether the Euro Zone will struggle to recovery or truly return to growth. Retail sales, factory orders and industrial production will all factor in to this outlook.
Each of these indicators will feed into the market’s unobserved and dynamic growth forecasting model; but the true benchmarks for economic activity will come from the ECB. The central bank is scheduled to announce rates on Thursday and both the market and economists suspect the benchmark will be left unchanged at 1.00 percent. The real value from the event comes from the statement that accompanies the announcement and President Jean Claude Trichet’s forum with the press shortly after the official release. Political pressure has intensified from some of the region’s largest economies to reign in stimulus to avoid stoking inflation. What’s more, the RBA has set a precedence in suggesting it was taking a cautious, hawkish turn; and the ECB no longer carries the burden to be the first. These factors aside though, the economy is certainly not stable enough to take such a passive (much less hawkish) approach. There are still economies suffering severe recessions; and even those that are considered relatively strong are still contraction. Should the group remove the safety net too soon, they run the risk of exacerbating a pull back that develops later.
Another generally accepted truism that has worked in the euro’s favor is that the region has remained otherwise financial sound while the UK and US were nearing structural collapse. However, many of the biggest risks to the broader markets going forward come from the Euro Zone. A premature draining of financial aid threatens to choke the economy, regional banks have yet to write off their losses (they will) and Eastern Europe threatens to default on its loans to the EZ in masse. All of these are considerations to keep in mind.
Japanese Yen May Trade Heavy If Risk Appetite Continues
Fundamental Forecast for Japanese Yen: Neutral
- Retail Sales fell 0.3% in June and 3.0% from a year ago, declining for the 10th straight month
- Japanese industrial production rose 2.4%, the fourth straight improvement, PMI Moves to expansion at 50.4
- Unemployment rose to a six year high of 5.4%in June
- Consumer Prices fell at a record pace in June to -1.8% from -1.1%
The Yen was mixed to end the week as it rallied against the dollar on the better than expected GDP figures and braid based greenback weakness. However, it would end the week unchanged against the Euro and weaker against the pound as risk appetite continues to weigh it against riskier currencies. Equity markets have show no signs of abating but they are near significant resistance levels and with the U.S. employment report scheduled next week a pull back is possible. Meanwhile, Japanese fundamental data continues to point toward a slow recovery as unemployment rose to a six year high of 5.4% signaling that gains in domestic growth will be challenging going forward. Consumer prices falling at a record pace of -1.8% will continue to squeeze corporate profits and limit the potential for a Japanese recovery. Optimism from the economy can be derived from industrial production rising for a fourth month by 2.4% and PMI returning to expansion levels, which could be a sign that global demand is improving. There were some signs of hope domestically with improvements in small business confidence and household spending.
BoJ member Tadoa Noda stated this week that central bank shouldn’t end their emergency credit programs prematurely as it could limit the scope of a recovery. The central bank this month extended the credit-support programs of buying corporate debt from banks and providing them with unlimited loans to Dec. 31 from Sept. 30 as lending conditions remain frozen. The upcoming economic docket is relatively light with labor cash earnings and leading and coincident reading. The forward looking gauge for the economy is expected to rise to its highest level since November as the outlook continues to improve for the economy. However, price action will most likely be dependent again on risk sentiment which could be limited with US NFP’s looming. The USDJPY has been in a downward trending channel and which was kept intact with Friday’s sell off. Trend line resistance is near 96.15 which is being reinforced by the 38.2% Fibo of 110.69- 87.14. Support may be found at the 20-Day SMA at 94.19 and 93.09-the 7/22 low.
British Pound Volatility Ahead on BOE Rate Decision, Equities Reversal
Fundamental Forecast for British Pound: Neutral
- Buyers Returning to UK Housing Market, Says Hometrack
- GfK Says UK Consumer Confidence Unchanged in July
- UK Mortgage Approvals Rise to Highest in 14 Months
The British Pound is all but guaranteed a week of heavy volatility as the busy economic calendar headlined by a pivotal interest rate announcement from the Bank of England is compounded by hints of a downward reversal in risk appetite. An actual change in benchmark borrowing costs is effectively off the table for the central bank, but traders will be closely watching to see if policymakers choose to ramp up quantitative easing measures after promising to “review the scale” of the program for the August rate decision in conjunction with the release of their quarterly inflation report. Despite the BOE’s apparent optimism and signs of stabilization in some leading indicators, economic growth disappointed in the second quarter, bolstering dovish arguments from the likes of the British Chamber of Commerce and the Shadow Monetary Policy Committee (a group of independent economists that meet at the London-based Institute of Economic Affairs). A timely GDP estimate tracking the pace of economic growth in the three months through July from the National Institute of Economic and Social Research (NIESR) will help set the tone for the monetary policy announcement: while usually quite good at estimating official economic growth figures, NIESR missed the mark in the second quarter having called for output to shrink just -0.4% only to be faced with a -0.8% result; this time around, the prestigious think tank will have likely identified the reason for their previously over-optimistic reading and may offer valuable insight on potentially overlooked weaknesses in the UK economy.
The remainder of the economic calendar is comparatively considering the themes behind further marginal improvements in PMI and Industrial Production are likely to have already been priced into the exchange rate while signs of moderating turmoil in the property market expected to be reported by Halifax have been adequately telegraphed by the latest Hometrack Housing Survey and the Rightmove House Prices report. Indeed, only a meaningful downside surprise in these metrics is likely to prove particularly market-moving, as the trajectory of stock prices and 12-month interest rate expectations (derived from trading in overnight index swaps) over recent months suggest traders are surely looking for the recession to begin to bottom.
Turning to risk sentiment, technical positioning is hinting that the equities rally that began in March is starting to run out of momentum and may be on track to putting in a double top at the October 2008 swing high, with volumes steadily declining since early May and clear negative divergence between rising prices and stalling relative strength studies. A trade-weighted average of the Pound’s value against a basket of major currencies is now over 83% correlated with the MSCI World Stock Index, suggesting sterling will be dragged along if stock markets do indeed turn lower. That said, US news has been the key fundamental catalyst in setting the trajectory of risk-related assets, and expectations of modest improvements for nearly all of the scheduled releases on the US calendar point to smooth sailing for equity markets (barring any significant downside surprises on key metrics or a particularly disappointing second-quarter earnings outcome from a major company).