Sunday, November 7, 2010

Forex Outlook

Forex Outlook
■ FX View: The Fed’s QE2 raises fears about a debasing of the USD, but Treasury purchases may be already largely priced in, and FX intervention by several countries will smoothen the USD slide.
■ EUR: The EUR-USD picture looks bullish, but the G-20 summit, and eurozone budget woes hitting the wires, favor a brief consolidation phase.
■ JPY: Fears about BoJ intervention prevent USD bears from aggressively selling USD-JPY at current levels. In turn, EUR-JPY prospects have clearly improved.

The Fed debasing the buck?
Deliberately or not – the Federal Reserve’s decision to buy a further USD 850-900bn of Treasuries by the end of 2Q11, including reinvestments of maturing agency and agency mortgage-debt securities worth USD 250-300bn, seems to debase the greenback across the board, ringing alarm bells about local currency appreciation across the globe.

These worries might be more warranted regarding emerging market countries’ currencies than regarding G-10 currencies. While the global liquidity glut should keep inflows to emerging markets going, boosting their currencies, most G-10 currencies have already priced in USD weakness to a good degree. The USD probably won’t remain unscathed in the future, but we do not expect it to take a new hammering in the near term. Especially the improvement in US consumer confidence and in the ISM indices in October warrants some USD stabilization now. The next test for the USD is today’s nonfarm payrolls report, but the main driver for the next weeks might easily be the upcoming G-20 summit in South Korea on 11-12 November.

Indeed, the Japanese and the Chinese stance on exchange rate policy will increasingly shape the fortunes of the greenback. Although some Japanese firms have been reported to prepare for life with USD-JPY at the 70 level, Japan cannot afford a further strong appreciation of its currency against the dollar, the yuan and the euro amid the flagging economic recovery at home. With emerging markets’ central banks resisting a stronger appreciation of their currencies, Japan sticking to further verbal and physical intervention against the yen, and China continuing to refuse a major appreciation of its currency, the USD TWI (Trade-weighted index) should at least not tank totally in the quarters ahead.

As shown in our chart, following the FOMC decision to buy an additional USD 850-900bn of Treasuries, the Fed balance sheet is set to nearly quadruple compared to summer 2008. The Fed’s quantitative easing went hand in hand with a much weaker dollar across the board, as the USD weakened a lot against the currencies which have the biggest weight in the USD TWI, namely EUR, JPY and GBP. While the EUR and the GBP are free floating and, therefore, will continue to absorb further weakness in USD crosses in the future too, the fact that the BoJ seems to be determined to halt a further appreciation of the JPY from here implies as well reduced downward pressure on the USD TWI. If the BoJ succeeds in keeping USD-JPY from falling significantly below the 80 level during the next 12 months, the USD TWI should hang on at least to the 75 level.

EUR looks bullish – but consolidation
phase may be needed
Yesterday’s ECB meeting proved quite uneventful, as the ultimate confirmation of the further steps regarding the ECB’s exit strategy, like the removal of the 3M LTRO, are expected to come up only at the December meeting. The Fed’s monetary policy remains the main driver in EUR-USD, although the discussion about the budget situation in Ireland and Portugal is increasingly heating up.

The additional Fed asset purchases should be largely priced in EUR-USD, but the bias for further USD weakness is still in place. The October nonfarm payrolls reading in the US today should do little to change this trend. Payrolls are seen expanding by 50K, following a 95K decline in September, and a rise in the unemployment rate to 9.7% could add further gloom to the US outlook, although recent survey indicators for October point to some stabilization in the economy. Next week’s US trade balance and University of Michigan consumer confidence readings are seen improving, but should not alter the bias towards an even weaker dollar. Industrial production and GDP data from several eurozone countries should confirm the cautiously optimistic outlook for the eurozone economy, although probably underlining again stark growth differentials at the single country level. From a technical perspective, this implies that a further advance in EUR-USD towards 1.4410 and 1.4550 cannot be ruled out. However, the usual caveats such as risks of profit-taking apply at current levels, especially following recent weeks’ wild ride.

More tangible factors standing in the way of a stronger euro could be this weekend’s local elections in Greece, and further spread tightening amid the Irish and Portuguese budget discussions, and, last but not least, the upcoming G-20 meeting in South Korea on 11-12 November. Especially the run-up to the G-20 summit may increasingly put investors’ willingness of pushing EUR-USD to new highs to a test, as speculation on an accord against further currency devaluation could temporarily favor FX market volatility and result in some relief for the greenback. From an operational viewpoint, this implies that pullbacks towards 1.40 and below should be used to enter new long positions, as the current rally should be aborted only by a correction below 1.37.

JPY trapped between FOMC and G-20
The BoJ convened during the last two days in order to define the exact terms of the new JPY 5tn asset purchase program introduced at its October policy meeting. The fact that the BoJ had moved up its regular policy meeting from the end of November to the beginning of November, immediately after the crucial Fed meeting, raised market hopes that the BoJ in the end may come up with a somewhat bigger asset purchase program than the JPY 5tn initially announced, in order to keep the yen from rising to record highs against the dollar. The JPY 5tn of planned purchases of government bonds, corporate bonds and ETFs, on top of the already existing monthly JPY 1.8tn government bond buying facility and the unaltered JPY 30tn corporate credit program, should fuel confidence in the Japanese economy, but at the end of the day the additional asset purchases equate to just less than 1% of Japanese GDP. This clearly falls short of throwing money out of a helicopter to stimulate the Japanese economy and combat deflationary expectations for good.

Although a less cautious approach on asset-buying by the BoJ would be required to combat deflationary pressures and weaken the yen, fears about possible physical intervention in USD-JPY should prevent a successful test of the all-time low at 79.75 for now. As already suggested by the muted reaction of the cross to the Fed QE2 decision, further downward pressure should not develop ahead of next week’s G-20 meeting. In turn, this implies that the EUR-JPY prospects have brightened again. EUR-JPY should benefit again if EUR-USD firms further, limiting its downside potential to 113, and keeping the door for a test of 118 open, in case USD-JPY manages to hold the line.
Full report: Forex Outlook

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