The Week Ahead : The US Dollar advances, but we're not chasing the Tiger

Highlights

• The US Dollar advances, but we're not chasing the Tiger
• Some key price developments and levels to watch
• Fed's latest move should not be discounted
• EMU issues set to maintain pressure on the EUR
• Outlook for cable worsens
• Key data and events to watch next week

The USD put in a mixed week, as risk appetites overall managed to hang on to recent gains. The buck gained ground against the JPY, EUR, CHF and GBP, but lost ground against CAD, AUD and gold, highlighting the growth divergence currently unfolding. Europe and the UK remain the laggards, while commodity producers' remain the leaders. Risk assets, as indicated by stocks and JPY-crosses generally posted gains, again with the above divergences holding sway--EUR/JPY is still below the breakdown from two weeks ago, while AUD/JPY is at a 3-week high. We expect these divergences to continue to be operative in the weeks ahead and we would look for opportunities to re-buy the leaders on pullbacks and re-sell the laggards on corrective bounces.

For the USD, next week promises to see further choppy trading conditions and we would maintain an extremely short-term focus, using data reports and key technical levels as guide posts. We would also note the return of Chinese markets to the fray, following a week's hiatus for the Lunar New Year, which ushered in the Year of the Tiger. (Perhaps a positive omen for risk appetites?) Chinese markets did not have the chance to react to the Feb. 12 increase in the PBOC (Peoples Bank of China) reserve ratio requirement, so the early reaction on Monday in Asian markets will be an important indication of how risk sentiment may fare for the week. Along those lines, we would observe that risk assets generally shrugged off the Fed's discount rate hike, ultimately buying the Fed statement that the move held no implications for higher US rates any time soon. That noted, US Treasury yields are at recent range highs (e.g. 10-year 3.80%) and we will be watching rates closely to see if gains extend or reverse.

Some key price developments and levels to watch

The USD index made new highs for the overall advance, but the high was exactly contained by the base of the weekly Ichimoku cloud at 81.343. The past week also ended with a second spinning top on the weekly candlesticks, an indication of uncertainty over the current directional move (higher), and a potential early warning sign of a reversal lower. In EUR/USD, the key 1.3450/3500 area effectively held and Friday's daily candle suggested a hammer (bullish reversal pattern after a decline), while the weekly candle posted a doji, a sign of uncertainty similar to a spinning top, and closed just above the weekly cloud bottom at 1.3598. The top of the weekly cloud is at 1.3821 next week, and the daily Tenkan line is at 1.3642. We would be reluctant to be short EUR/USD at current levels and prefer to be sellers on strength back into 1.3850/13950 area. USD/JPY tested above the daily cloud on Thursday at 91.59, but closed the week just below it, suggesting a possible rejection from just below the 200-day sma at 92.28. We would look to re-buy USD/JPY on weakness around the Kijun line at 90.35/40 in light of the bullish crossover (on both daily and weekly) of the Tenkan/Kijun lines. GBP/USD looks the weakest among the major dollar-pairs (see Sterling below), but it also posted a hammer on Friday, potentially signaling a near-term bounce. The 1.5650/5700 area looks to offer an attractive level to short Cable. Gold prices tested the bottom of the daily cloud this past week (at 1128.80/29.50 next week) and overall looks to be consolidating between the 1095/1100 level on the downside and 1125/1130 above. A break higher into the cloud will be needed soon, or a failure and decline seem likely; below 1095 exposes a return to 1045/50 initially.

Fed's latest move should not be discounted

The Fed's decision to raise the discount rate this week caught the markets off guard and in our view is another step in the direction of monetary policy tightening. Chairman Bernanke pretty well telegraphed the move in his most recent speech and the hike to 0.75% dovetails with the elimination of many of the Fed's extraordinary liquidity programs this month. The Fed made it a point to note that this is not a shift in policy and while they do have about 50 more basis points of discount rate hiking room (typical spread between the target funds rate and the discount rate is 100 basis points), they will be hard-pressed to convince the market that this does not – at the margin – suggest a tighter Fed sooner rather than later.

The increase suggests that in the medium-term, the Fed will likely adopt a policy of paying higher interest on reserves in order to keep the more than $1 trillion in excess monies from pouring into the economy and creating an inflation problem. The increase in the discount rate would eliminate the potential for arbitrage as the banks would not be able to borrow for less than the Fed would pay out in interest.

The surprise move also elicited a smart rally in the US dollar and we believe it adds yet another fundamental ingredient to what has become a dollar-positive cocktail. Not only is economic data in the US handily outperforming that of the Eurozone, UK and Japan, but now it is clear that the Fed will be much more aggressive in tightening the noose than any central bank in those regions. The ECB remains handcuffed by the peripheral debt problems and the BOE and BOJ can hardly tighten policy in the face of what are still economic doldrums. Higher interest rates in the US should drive capital flows away from these relatively riskier investments and back into US dollar denominated assets.

The incoming data on growth and inflation will remain extremely important for Fed policy and this week's recent consumer price report looks to have taken some of the edge off the Fed's rate hike. Core consumer prices slipped -0.1% in January and this took the annual rate to 1.6% from 1.8% prior. The low inflation news sparked what looks to be a profit taking sell-off in the US dollar as we head into the weekend. All eyes will now be on Fed Chairman Bernanke next week when he delivers his Monetary Policy Report before the House and Senate panels on Wednesday and Thursday.

EMU issues set to maintain pressure on the EUR

The Greek government may have bought itself a month's stay of execution in order to persuade the EU and the markets that it can reduce its budget deficit to an acceptable equilibrium in less than three years, but the inexorable position is that this will be a nigh on impossible task. Greece's problems will remain in one month's time and the discussion over whether Greece will eventually go cap in hand to the IMF or revert to a devalued drachma is likely to intensify over this period. Crucial for the EUR is the broader discussion over whether monetary union can be sustained without either tighter fiscal union or an acknowledgement from the wealthier more productive members that they will have to increase their support for the less fiscally prudent. Politically, neither scenario is a winner. Also crucial for the EUR is the news that certain states including Greece and Italy may have used derivatives operations to bolster the appearance of their budgets going into EMU. This is a mockery of the limited fiscal controls that EMU has. In summary, with so much uncertainty haunting the EUR buyers are likely to remain scarce. Since inception the average level for EUR/USD is 1.18, EUR/USD could move lower this year.

The release of the German IFO data this week may bring further signs that the pace of the recovery has increased modestly in Q1. The market is expecting the German final Q4 GDP release to remain unrevised at flat q/q. In view of EMU's woes and the likelihood that the ECB will be hiking rates after the Fed this cycle, any support for the EUR on the IFO release is likely to be short-lived.

Outlook for cable worsens

The outlook for cable has taken a hit over the past week. Data releases have highlighted a sharp drop in retail sales, a surge in the jobless count and record public sector borrowing. Poor weather and a hike in VAT may have contributed to the poor performance of the retail sector in January. Even so, with the labor market taking a turn for the worse, it would be optimistic to assume that the consumer sector will remain anything but weak going into the spring. These data force the question of how sustainable the UK economy recovery will be in 2010 if fiscal support is rapidly withdrawn. This debate is already intensifying ahead of the spring general election. From a policy perspective there may exist a fine line where a moderate dose of fiscal austerity would be consistent with economic growth. This scenario would bolster investor confidence and the pound.

However, given the risks on either side of this line could swing as far as a debt crisis (if no austerity is introduced) to a double dip recession (if too much austerity was seen), the outlook is fairly grim. Neither scenario would be good for the pound and in all likelihood sterling buyers particularly vs. the US dollar will remain scarce into the spring and most likely beyond. Some comfort for the pound may be offered by the revision to the Q4 GDP data. The market is hopeful of a small upward revision to +0.2% q/q. However, this would hardly change the view that the economy is struggling to shake off the shackles of recession. The break below the key GBP/USD1.5540 swing target was a negative technical indicator and strengthens the likelihood of a move to USD1.5270 ahead of USD1.500 and potentially back to last year's low at USD1.3750 on a 6 mth view.

Key data and events to watch next week

The calendar in the US heats up again next week. The Chicago Fed National Activity index kicks off the action on Monday. Tuesday brings the Case-Shiller home price index and consumer confidence while Wednesday has crude oil inventories and new home sales lined up. Durable goods, initial jobless claims and home prices are up on Thursday and Friday rounds out the week with GDP, Chicago PMI, University of Michigan consumer confidence and existing home sales. Also, be on the lookout for Fed Chairman Bernanke's testimony to the House and Senate panels on Wednesday and Thursday.

The Eurozone is also quite busy. French consumer prices, French consumer spending and the German IFO (business survey) start off the week on Tuesday. On Wednesday we are scheduled to see industrial new orders, French jobseekers, German GDP and the German GfK consumer confidence survey. French producer prices are up on Thursday while Friday has German employment, Eurozone CPI and German CPI.
The UK is on the light side. Home loans are due up on Tuesday while Thursday has total business investment data on deck. Friday closes out the week with GfK consumer confidence and the GDP report.

Japan is a touch busier than usual. The Bank of Japan meeting minutes are front and center on Monday while Tuesday has the all-important trade data on tap. Small business confidence is scheduled for Wednesday while Thursday brings manufacturing PMI, consumer prices, industrial production and retail sales. Friday closes things out with housing starts.

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