US Dollar Ready to Revive Bull Run, Volatility and QE3 Key Topics

Fundamental Forecast for the US Dollar: Bullish

• US Dollar traders starting to hear the rumblings of panic after JPMorgan reports trading loss
• Treasury auctions 10 year notes to weakest demand since November, 30 year bond yield near record low
• Looking at the technical picture of the dollar’s breakout potential

The markets are stirring and a number of currency crosses and benchmark assets are starting to show genuine progress towards deleveraging risk. That said, we haven’t yet made the critical transition in sentiment that overwhelms expectations of the unlimited stimulus safety yet. For the Dow Jones FXCM Dollar Index (ticker = USDollar) to move from congestion to a true bull trend – something not seen since the first half of 2009 – an escalation of risk aversion must be made. We need to see volatility spike as the cost of insurance against losses soars while the stalwart barometers of risk appetite suffer disorderly declines. It is in that level of tumult where the greenback once again shines for the stability seen in its liquidity.

Risk appetite trends are at the root of all investment decisions made, and thereby we can garner a solid fundamental assessment of each currency by establishing where it stands on the ‘high-yield-to-safe-haven’ spectrum as well as how the current of investor confidence is flowing. As for the spectrum read, the assessment isn’t difficult. The dollar is indisputably a safe haven. In fact, its treatment during the 2008 Financial Crisis has sealed its role as an absolute liquidity haven – a ‘last resort’ quality. That said, there is a favorable aspect in that – though the Fed has flooded the market with dollars – there is relatively limited cross boarder carry interest as the market is hesitant on exceptionally thin differentials and there is a heightened concern that the US will be hiking around the same its global counterparts will.

Therefore, dollar traders should really focus on the ebb and flow of risk appetite. And, that is why trading conditions look so ripe: because sentiment is starting to falter, but it has yet to really capsize into the panicked territory that leverages the greenback so well. This is the difference between seeing small swings in favor of the dollar within broader confines of congestion (USDollar) or perhaps more consistent advances against particularly weak currencies (AUDUSD) and an outright, market-wide bull trend. To measure the dollar’s potential, there are a few gauges to watch: the USDollar, the Dow Jones Industrial Average and volatility readings.

Watching the dollar index and the benchmark US equities index offers a straightforward technical assessment of progress: the currency has 16-month resistance at 11,000 and the stock aggregate spots three-month support at 12,750. The Dow however carries another particularly important fundamental characteristic though – its connection to the stimulus efforts (and speculative of stimulus efforts). In other words, US equities tumble it suggests that confidence in further government/central bank support has evaporated or (far more troublesome) the masses simply believe it cannot stop the deleveraging. That said, a full-blown crisis – arguably the best situation for rapid dollar gains – could actually prove detrimental. If the fabric of the financial system once again begins to come apart, it could spur the Fed and its global counterparts into action. It is really the Fed, though, that is the worry for the dollar.

We know how to measure where the dollar is positioned for potential and kinetic energy, but it’s the catalysts that get us moving that are important. We can point to many individual indicators and events as possible sparks next week (CPI, retail sales, net investment, the Fed minutes), but a change of this magnitude requires tapping into the elemental themes. At this point, the European financial troubles are the greatest threat to global financial stability and thereby present the most likely driver. Already on the cusp, if the Euro-area situation erupts, we have a dual appeal: demand for safety and the shrinking of the most prevalent alternative to the US dollar’s reserve status. – JK

Euro Tumbles the Start of a Much Bigger Breakdown

Euro Tumbles the Start of a Much Bigger Breakdown

Fundamental Forecast for the Euro: Bearish

• Euro falls sharply on further Spanish government troubles
• Greek election turmoil causes sharp Euro declines, Spain seals the deal
• Retail trader forex sentiment suggests Euro may fall further

The Euro broke decisively lower against the US Dollar as disappointments in Greek elections and broader Euro Zone difficulties proved enough to force a major shift across financial markets. It was initially a feeling of déjà vu as the EURUSD dropped sharply into the first week of May—just as it had done in April only to finish where it began. Yet clear fundamental and sentiment shifts suggest this may be the break many have expected, and volatility seems all but guaranteed in the week ahead.

A clear disappointment in Greek general elections sparked renewed market tensions, and a deterioration in Spanish fiscal and financial conditions only stoked further European financial market turmoil. Successive years of biting austerity for Greece meant that voters forced out the ruling party and showed record support for a fiercely anti-austerity party on the far left. Yet the sharp swings essentially produced a stalemate as the top three parties seem unable to form a majority government. In effect this leaves Greece to unable to comply with stringent fiscal rules attached to recent bailouts. And indeed, it seems as though the election results leave Greece even closer to hard default and likely exit from the single currency union.

Spain likewise drew headlines as the Spanish government announced it would fail to meet targets for fiscal tightening, while officials nationalized another domestic bank at clear risk of insolvency. The combination served as clear reminder of the difficulties surrounding the Euro Zone’s fifth-largest economy.

Years of impressive real estate growth left the Spanish banking system with massive loan portfolios, and a sharp economic downturn has produced significant losses. All the while, the central government not-so-subtly depends on Spanish banks to buy government debt as international investors turn away. In short: the Spanish government needs continued bond purchases from domestic banks to avoid seeking international bailouts. Yet those same banks may need bailouts of their own, and the risks to Spanish sovereign debt and credit markets are clear.

Is this all enough to force a sustained Euro breakdown? If so, why haven’t previous episodes of fiscal tensions been enough to force the Euro/US Dollar significantly lower? The US CFTC Commitment of Traders report shows that Non-Commercial traders—typically professional speculators—have remained aggressively net-short Euro futures despite an important EURUSD bounce through 2012. In other words: many have kept their Euro-bearish bets through choppy market conditions.

Recent COT data shows that speculators increased their net-short Euro position by the most since the week ending May 10, 2011. The shift came soon after the Euro set an important top above the $1.48 mark, and the most recent sharp shift warns of the potential for similar price action in the future. In subsequent weeks the pair fell another 400 pips before bouncing sharply and consolidating for the next four months. Could we see similar moves in the weeks ahead? Given such a sharp week-over-week shift in positioning, we think further volatility seems all but guaranteed. - DR

Japanese Yen to Strengthen amid Dash to Safety

Fundamental Forecast for Japanese Yen: Bearish

• Australian Dollar, Euro Back at Monthly Lows as Dollar Surges
• British Pound Targets Lows versus Japanese Yen
• Dollar, Yen Aim Higher as S&P 500 Futures Point to Risk Aversion

The Japanese Yen had a very strong week, finishing second among the majors, only losing 0.10 percent to the top performer, the US Dollar. The Yen was strongest against the Asian-Oceanic currencies, the Australian and New Zealand Dollars, appreciating by 1.49 percent and 1.54 percent, respectively, as a continued stream of poor data from China alongside further stresses in the Euro-zone have provoked a dash for safety – highly liquid assets. The primary beneficiaries of these financial stresses have been the Japanese Yen and the US Dollar, and with no end in sight – objectively speaking, Europe’s problems are not going to be going anywhere the next week – we maintain a bullish bias for the Yen in the periods ahead.

With a studded economic docket this week, for the first time since early February, we can safely say that Japanese data this week could have a strong influence on the Yen. On Tuesday, Consumer Confidence and Machine Orders are due, but considering that one is expected to show an improvement (confidence up to 40.8 in April from 40.3 in March) and another to showed slow growth (orders up 4.4 percent y/y in March from 8.9 percent in February), there should be a net-neutral impact on the Yen. The main piece of data to keep an eye on is the GDP release on Wednesday.

After weak data throughout much of 2011 (predicated largely around the earthquake and ensuing nuclear disaster in March), 2012 growth figures look to start off on the right foot with an annualized growth rate of 3.5 percent in the first quarter. Nominal GDP is expected to increase by 1.0 percent after contracting by 0.5 percent in the fourth quarter of 2011. These figures are very important to the Bank of Japan. If growth undershoots these targets despite a substantially weaker Yen in the first quarter of 2011 – the Yen depreciated by 7.75 percent against the US dollar and by 10.93 percent against the Euro – the BoJ is likely to step into the markets and warn about devaluing the Yen further. In fact, back in February, after the disappointing round of fourth quarter GDP figures, the BoJ announced a $10 trillion ($128 billion) stimulus package. While this would weaken the Yen, we don’t expect the GDP print to disappoint so in our eyes, this shouldn’t be an impediment to the Yen in the near-term.

The main reason why the Japanese Yen is poised to strengthen have been developments out of Europe. As one of the world’s most liquid currencies, during times of less liquid markets, we tend to see a flight from the higher yielding currencies, such as the Australian and New Zealand Dollars, and back into the safe havens, the Japanese Yen and the US Dollar. With little relief in sight for European banks – the European Central Bank is against another longer-term refinancing operation, for now – investors are likely to hoard more liquid assets. In the current environment where “cash is king,” the Japanese Yen stands to be one of the top performing currencies going forward. –CV

British Pound: BOE Inflation Report, Euro Zone Debt Crisis in Focus

Fundamental Forecast for British Pound: Bullish

• UK Economic Growth Remained Anemic in April, Says NIESR
• British Pound Finds Support as BOE Holds Rates, QE Size Unchanged
• Speculative Sentiment Trends Hint Pound to Gain Against the Euro

Familiar themes persist for the British Pound in the week ahead, with prices relying on a precarious balance between the impact of Eurozone crisis fears and an outlook for Bank of England monetary policy that appears to be turning relatively hawkish. In the week ahead, both drivers will find ample triggers for volatility, but the path of least resistance appears to point toward a broadly supportive environment for the UK currency against most of its top counterparts.

On the monetary policy front, the focus will be on the updated BOE quarterly Inflation Report. The document served as the basis for last week’s MPC decision to leave benchmark interest rates on hold as well as opt not to expand the score of the quantitative easing program. Since the BOE typically doesn’t release a statement when no changes to policy are made, the report will serve as the markets’ leading guide on the central bank’s thinking for the coming three months, and thereby carries heavy implications for the Pound.

Minutes from April’s sit-down of the rate-setting committee showed it’s theretofore most dovish voice – Adam Posen – withdrew his long-standing call for additional QE amid concerns about sticky core inflation. If Mr. Posen believes that price growth concerns overshadow the UK economy’s descent into a technical recession as the chief concern of policy, there is a good chance that other less-dovish members of the committee are likewise if not more perturbed. Confirmation of such a shift in tone is likely to prove supportive for Sterling, boosting front-end yields and scattering dilution fears.

In the Eurozone, uncertainty persists over the political landscape in Greece as the Pasok party attempts to cobble together a ruling coalition able to meet the country’s commitments under the EU/IMF bailout program. Failure to do so would reinforce increasingly credible fears that Greece may be forced to leave the Eurozone and possibly the EU altogether, an unprecedented outcome with no forecast-able benchmark in terms of its practical implications for financial markets. With that in mind, continued uncertainty is likely to perpetuate capital flight out of Euro-denominated assets. Given the floor imposed on the Swiss Franc via SNB intervention, the next logical regional haven has become the Pound. - IS

Gold Techs Point to Further Weakness- Outlook Hinges on FOMC Minutes

Fundamental Forecast for Gold: Bearish

• Gold Resistance from 1615 to 1630
• Commodities Sold as Risk Appetite Unravels, US Data May Cap Losses
• Guest Commentary: Gold & Silver Daily Outlook 05.11.2012

Gold ended the week off by more than 3.8% with the precious metal closing within striking distance of the 2012 lows at $1569. The classic notion of gold’s use as a safe haven play has been clearly refuted this week as prices tracked risk lower amid a broad based sell-off in equity markets. As global growth concerns continue to weigh on risk appetite, declines in broader commodity prices are likely to keep pressure on the yellow metal with platinum and silver both off by more than 4% this week while palladium posted a staggering decline of 7.6%. A breakdown in copper and crude prices have also eluded to further weakness in gold with bullion the last to top in the recent decline seen in asset prices.

Looking ahead, traders will be eyeing minutes from the April 25th FOMC meeting amid speculation that the Fed may be easing its dovish tone as the outlook for growth and inflation picks up. Remarks made by various FOMC members this week continues to suggest that the central bank may look to alter the 2014 pledge with Cleveland Fed President Sandra Pianalto highlighting an improved outlook for the US economy as she expects growth to increase by 2.5% or more this year. New York Fed President William Dudley also softened his dovish tone amid ongoing stickiness in underlying inflation with Dudley citing that the Fed will bring quantitative easing to a halt, “the moment they become inconsistent with our dual mandate objectives.” As such, it’s likely that demand for gold as a classic hedge against inflation to continue to wane with ongoing concerns regarding the deepening crisis in Europe to keep pressure on the precious metal.

From a technical standpoint, gold remains within the confines of descending channel formation dating back to the March 1st highs with the precious metal closing out the week just above the confluence of channel support and the 78.6% Fibonacci retracement taken from the December 29th advance at $1580. Subsequent downside targets are eyed at trendline support dating back to May 5th 2011, currently around $1555 and the December low at $1523. Topside resistance now stands at the April lows at $1612 backed closely by the 61.8% retracement at $1625 and channel resistance (currently at $1655). -MB

Canadian Dollar Correction To Gather Pace On Sticky Inflation

Fundamental Forecast for Canadian Dollar: Neutral

• USDCAD Pattern is Bullish but Don’t Dismiss Dip Potential
• USDCAD: Trend-Defining Resistance in Play
• Canadian Dollar Surges on Impressive Labor Market Reading

The Canadian dollar continued to weaken against its U.S. counterpart, with the USDCAD rallying to a fresh monthly high of 1.0062, but we may see the pair consolidate next week as it maintains the range-bounce price action from earlier this year. Indeed, the loonie snapped back on Friday as the ongoing improvement in the labor market spurred increased bets for a rate hike, and the economic developments on tap for the following week may continue to fuel speculation for higher borrowing costs as the recovery gathers pace.

As the headline and core reading for consumer prices are expected to hold steady in April, the stickiness in price growth certainly raises the risk for inflation, and we may see the Bank of Canada continue to strike a hawkish tone for monetary policy as private sector activity picks up. According to Credit Suisse overnight index swaps, market participants see a 25bp rate hike in the next 12-months, but it may only be a one-time deal as the central bank tries to address the record rise in household indebtedness. As Governor Mark Carney continues to highlight the risk generated by the surge in private sector lending, it seems as though the central bank head is making an effort to talk down the rise in household borrowing, but the BoC may have little choice to but to raise the benchmark interest rate from 1.00% as the board raises its fundamental assessment for the economy. In turn, we do not expect to see a series of rate hikes amid the uncertainties surrounding the region, and Governor Carney may revert back to a more balanced tone following a rate hike as external headwinds continue to pose a threat to the recovery.

As the USDCAD maintains the range from earlier this month, we may see the short-term pullback in the exchange rate turn into a larger correction, and we may see the pair fall back towards the 0.9900 to test for interim support. However, should the inflation report top market expectations, a marked rise in interest rate expectations could spur another run at the 0.9800 figure, but we may see the dollar-loonie threaten the sideways price action ahead of the second-half of the year as the BoC is scheduled to meet on June 5th. - DS

Australian Dollar May Struggle To Find Support On RBA Policy

Fundamental Forecast for Australian Dollar: Bearish

• AUDUSD Short Term Focus Still on Trendline at 9975
• AUDUSD: Sellers Threaten Multi-Year Support
• Australian Dollar’s Post Employment Glow Fades Back into Risk

The Australian dollar came under pressure despite the slew of positive developments coming out of the $1T economy, and the high-yielding currency may depreciate further in the week ahead should the Reserve Bank of Australia talk up speculation for additional monetary support. Indeed, Australian Prime Minister Julia Gillard said the RBA has ‘maximum room’ to adjust monetary policy as the government shoots for a A$1.54B budget surplus for the fiscal year starting July 1, and the central bank may embark on a series of rate cuts in an effort to encourage a stronger recovery.

As the RBA meeting minutes highlight the biggest event risk for the following week, we should see the central bank maintain a dovish tone for monetary policy, and the fresh batch of central bank rhetoric is likely to drag on the exchange rate as market participants anticipate to see lower borrowing costs in 2012. According to Credit Suisse overnight index swaps, market participants are pricing a 63% chance for a 25bp rate cut in June, while they still see the benchmark interest rate falling by more than 75bp in the next 12-months as the central bank strikes a cautious tone for the region. Moreover, a survey by Bloomberg News shows 25 of the 28 economists polled expect the RBA to keep the cash rate on hold at 3.75%, but we should see Governor Glenn Stevens carry the easing cycle into the second-half of the year as the slowing recovery in China – Australia’s largest trading partner – dampens the outlook for growth and inflation. At the same time, the flight to safety could further limit any advances in the AUDUSD as heightening fears surrounding the sovereign debt crisis continues to drag on market sentiment, and the shift away from risk-taking behavior may gather pace next week as European policy makers struggle to stem the threat for contagion.

As the AUDUSD fails to maintain the range-bound price action from April, we should see former support around 1.0200 act as new resistance, and we may see the pair threaten the 38.2% Fibonacci retracement from the 2010 low to the 2011 high around 0.9930-50 as it searches for a floor. However, we will be keeping a close eye on the relative strength index as it approaches oversold territory, but a break below 30 should send the pair even lower as market participants turn increasingly bearish against the Australian dollar. At the same time, we’re still holding onto our short AUDNZD position from 1.2814 as the pair looks poised to mark fresh lows for 2012, and we will build up this position on the way down as it carves out a lower top in May. - DS

New Zealand Dollar Looks Vulnerable as Risk Trends Collapse

Fundamental Forecast for New Zealand Dollar: Bearish

• April REINZ Home Sales Fell, NZD Pares Loss
• Despite Weak Chinese Data, Dollar and Yen Sold-off in Favor of Aussie
• New Zealand Dollar Loses but Quickly Recovers

The New Zealand Dollar had another poor week, finishing last among the majors in terms of overall performance, depreciating by 1.71 percent against the top performer, the US Dollar. The Kiwi’s performance was also underwhelming against the Japanese Yen, to which it lost 1.60 percent, and against the recently-bullish British Pound and Canadian Dollar (diverting hawkish monetary policy), to which it shed 1.22 percent and 1.28 percent, respectively. As Chinese data continues to disappoint and Euro-zone concerns continue to mount, the New Zealand Dollar has been of the worst performing major currencies over the past few weeks; and with little resolution in sight for either major issue, we maintain our bearish bias on the New Zealand Dollar for the next five days.

With respect to the economic calendar, little comes by way of fundamental event risk. The main event to watch comes at the start of trading at the Sunday open, when retail sales data for the first quarter is due. After a modest gain of 2.2 percent in the fourth quarter of 2011, retail sales have taken a step back, contracting by 0.5 percent in the first quarter, according to a Bloomberg News survey. A contraction would be the first such occurrence since the fourth quarter of 2010, when retail sales dropped by 0.4 percent. Recent data out of New Zealand hasn’t been supportive of a stronger Kiwi (but for labor market data, which, despite showing a bump in the unemployment, showed an equal if not more crucial jump in the participation rate), and commentary out of the Reserve Bank of New Zealand suggests that the current monetary policy path is likely to remain on hold. However, like the outlook from last week, our outlook for the Kiwi is bearish for exogenous reasons, mainly rooted in China and Europe.

To reiterate a point raised in last week’s forecast, the New Zealand Dollar’s recent weakness has a lot to do with the decline in Chinese growth. This has hit the Kiwi two-fold. First, as New Zealand’s second-largest export market (12.5 percent in 2011), a drop in demand for foreign goods by Chinese businesses and consumers has and will hurt New Zealand producers of goods and services. On Thursday, Chinese trade figures showed that imports collapsed, gaining 0.3 percent in April against a forecast of 10.9 percent. Furthermore, after this week’s poor data all-around (industrial production, trade figures, price pressures) it’s evident that the Chinese economy has not yet bottomed. Further downside pressure in the Chinese economy will only weigh on the Kiwi going forward.

What has also hurt the New Zealand Dollar in recent weeks has been the Euro-zone crisis. On February 6, Moody’s Investors Service said that the New Zealand economy was among the “most exposed” to the crisis, further noting that its banking system (along with Australia’s and Korea’s) is “more vulnerable to the first-round impact of a further worsening of the euro area crisis than other systems in Asia Pacific.” Indeed, since mid-March, when the Euro-zone crisis started reheating, New Zealand 5-year CDS have climbed over 41 percent, from 65.98 to 93.30 at the time of writing today. If Euro-zone issues persist alongside softening Asia-Pacific growth prospects, the New Zealand Dollar will remain under pressure; and going into a tumultuous weak for the Euro-zone (Greek backlash, potential Italian downgrade), global risk trends lead us to a fundamentally weaker Kiwi for the coming week. – CV