Forex Outlook

• FX View: 3Q GDP, the FOMC decision on QE2, non-farm payrolls and mid-term elections – all from the US – shape the picture and on balance may result in a weaker USD.
• EUR: EUR-USD should be highly dependent on the size of QE2 by the Fed. Asset purchasing of good size may push the pair to 1.43 in the medium term, while a more gradual approach could cement current levels.
• GBP: The healthy 3Q UK GDP reading is to keep sterling on bid, especially against the greenback.

QE2 – it’s crunch time for the USD
The meeting of G-20 finance ministers and central bank governors resulted in an accord of non-belligerence, which, although it helped to stabilize the greenback, at least in theory could have even implied a stronger USD in the short term. This was particularly so due to the fact that investors keep scaling back their quantitative easing 2 (QE2) bets ahead of the November 2-3 FOMC meeting, which helped to stabilize the greenback across the board, but failed to trigger a USD recovery. Furthermore, US data on the housing market and consumer confidence finally came out stronger too, helping the dollar, but risks of a much weaker USD might still be realized following the Fed decision next week.

The reaction of the USD to the theoretically possible Fed outcomes might in the end prove to be asymmetrical. For example, an expected USD depreciation, in the case of a strong Fed signal regarding bond purchases, with the Fed announcing to embark on a large-scale asset purchase program, might be of a bigger magnitude than the respective USD appreciation, in case the Fed announces a smallerthan- expected bond purchasing program. Market positioning maintains a dollar-bearish bias as indicated by noncommercial
contracts at the CFTC. Our baseline scenario remains an announcement of Fed asset purchases of around
USD 300-500bn. An outcome at the lower end of this range might already prove slightly USD positive, while an outcome at the higher end may lead to more pronounced USD losses.

The influence of major US data releases, such as the advance estimate of 3Q US GDP, and next Friday’s nonfarm payrolls report, should not be underestimated, and the same holds true for Monday's US mid-term elections, which could potentially prove USD negative if the outcome should mean gridlock in Congress.


QE2 size to make EUR-USD fortunes
The ECB rate decision is coming up next week, but, with rates firmly on hold, the Q&A session of Mr. Trichet’s press conference might easily attract the most interest again, especially if further information on the ECB exit strategy is provided. The main drivers should still be the abovementioned US key events and data releases. The gradual scaling back of the expectations on the size of QE2 has stabilized EUR-USD below 1.40, but the 1.37 support level proved safe for now, even with stronger US housing data and consumer confidence. Today’s 3Q US advance GDP estimate, the QE2 decision on Wednesday, and the non-farm
payrolls reading next Friday, should determine the mediumterm outlook of EUR-USD, especially if the worries about the Irish and Portuguese budget processes will continue to attract only minor interest on FX markets. GDP and non-farm payrolls may both fall short of market consensus, helping EUR-USD, while for the impact of QE2 the same logic used above should apply. If the Fed in the end will opt for a smaller initial asset purchase target, between USD 200 and 300bn, EUR-USD, although maintaining its current moderate
upside bias, may return to the 1.4150 level only if US macroeconomic data releases should disappoint. On the other hand, if the Fed might announce initially asset purchases of USD 400-500bn, investors should take this as a sign that the Fed aims at a substantial easing in monetary conditions and this should warrant a return in EUR-USD to levels not seen since the beginning of the year, around 1.43 and above.

3Q GDP reading to keep sterling bid
UK 3Q GDP coming in ahead of expectations definitely helped sterling’s medium-term outlook as fears about more quantitative easing by the Bank of England were largely swept away.


A quick look at our graph shows that interest rate differentials between the eurozone and the UK began to tighten following the better-than-expected UK GDP reading, thus putting EURGBP under pressure too, and stopping the euro’s first assault on the psychologically important 0.90 level since March, which had been mainly motivated by largely overdone market fears that the BoE could decide to do more QE, too.
In the very short term, further sterling strength may be explored more through GBP-USD long positions than
through EUR-GBP shorts, as EUR-GBP should find buyers on falls between the important 0.87 level and 0.86, while cable might still have some upside potential, given the Fed decision on QE2 and as the US GDP and payroll numbers may fall short of expectations. Cable again got close to the 1.60 level, and the essential stability of next week’s UK PMIs, might increase chances to finally stay above this level if the Fed will not disappoint markets on QE2 expectations.

The BoE meeting should not interfere too much with sterling bulls as the healthy 3Q GDP reading seems to have pulled the carpet from under the feet of supporters of more monetary easing at the BoE.
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Full report: Forex Outlook