US Dollar Risks Collapse on Dow Surge…If this is a True Risk Rally

Fundamental Forecast for the US Dollar: Neutral

• January NFPs beat expectations with a 243,00 increase, but there are holes in the data
• Persistent risk appetite sabotages the US dollar’s ability to recover lost ground
• EURUSD slips despite a surge from equities to fresh, multi-year highs

There is little debating the greenback’s immediate trend. In approximately three weeks the Dow Jones FXCM Dollar Index has dropped nearly 360 points or 3.6 percent – a significant change in bearing from the start of the year when the benchmark was threatening to move on 12-month highs. Technically, the fundamental justification for a retreat is there. We have seen the Dow Jones Industrial Average lead a powerful swell in risk trends that won the index itself a close at four year highs. And, if risk trends are surging ahead; there is little to prevent the safe haven, low-yield dollar from faltering. However, what if we aren’t confident in this climb in optimism…

In reality, there are thousands of different elements that go into the fair value of a currency (such as housing sector health, availability of capital, consumption of raw materials, proclivity for stimulus or the outlook for interest rates amongst many more). Yet, luckily for us, there are generally only a few key drivers that have an overwhelming influence over the performance of a currency. The difficulty is in identifying those catalysts and assessing their influence. For the dollar, the fundamental cocktail contains: risk trends, the effort to diversify away from the euro and speculation of QE3.

If you run a rolling 20-day correlation between the benchmark US Dollar Index and the S&P 500, you’d see that the premiere safe haven and standard for blind risk appetite have a -0.87 connection. That is an exceptionally strong link that indicates they have moved in opposing directions and at the same level of intensity much of the time. Therefore, the S&P 500’s surge to a six-month high and the Dow’s close at a four-year summit spells out the situation pretty clearly. On the other hand, the fundamental drive itself (risk appetite) isn’t assured. Equities and prominent carry pairs have trended higher since the end of December. For the most recent, highly-publicized push, we were given an additional boost by the release of the January employment figures.

We should cast a critical eye on the durability of investor optimism and start with Friday’s employment figures. The readings of a 243,000 net increase in payrolls and three-year low in the jobless rate (at 8.3 percent) are met with many skeptics about the adjustments the BLS makes to this data (particularly how they account for those disgruntled Americans leaving the labor force). Yet, we don’t need to delve into a debate on this. What matters for price action is what the market considers market worthy (sensible or not). Even if we considered the labor statistics definitive, the January reading does little to deviate from the engrained trend (meaning this was largely priced in) and such a pace doesn’t do much to return the US to a state of ‘full employment’ through the foreseeable future. Furthermore, a steady – if lackluster – trend in labor health will curb the pressure for the much-sought-after QE3 that many have come to rely on.

Beyond the payrolls impact, we have questioned conviction in leveraging riskier positions for some time. Strong trends are defined by meaningful participation that solidifies levels already reached and keeps markets moving forward. That said, volume figures have never quiet metabolized in this move. It’s not difficult to understand why as fears of a global slowdown, fading yields and signs of financial strain in different areas of the world cast a dark cloud over the market. While it isn’t prudent to fight a prevailing trend, we should be aware than a low-volume advance can succumb to aggressive corrections should skeptics return in full force.

Another factor to consider at the start of the upcoming trading weak is what happens to the euro. Renewed fears that the Greek deal could fall through prevented the shared currency from taking higher Friday. This is an additional boon from the liquid dollar.– JK

--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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Euro Fails to Crack $1.32 – Greek Tragedy Enters Final Act

Fundamental Forecast for the Euro: Bearish

• Fresh Euro Highs Favored on Sentiment
• Rally on Hold as the Euro Fails at 1.3200
• U.S. Dollar Reversal Underway, Euro eyes 23.6%

This could be it. We’ve been saying that for months, as Euro-zone leaders play a dangerous game of chicken with Greek politicians and market participants, having brought us to the edge of imminent collapse multiple times in the second half of 2011 alone. Unlike other times, in which all actors appeared to have the same long-term goals, this viewing of the Greek drama looks to chart a new course – right out of the Euro-zone.

It’s been a far-fetched scenario to suggest that Greece may leave the Euro-zone altogether, as an orderly default seemed like the likely outcome. The script changed this past week, with tensions finally cracking in the Euro-zone’s core, while supranational European bodies struggle to find an answer in the Greek debt-swap impasse. After months of negotiations, and countless times of being told that we were within “hours” of a resolution, recent rhetoric suggests that a resolution may be a long ways away. The European Central Bank has publicly stated that it will not take a haircut on its Greek debt; Greek Prime Minister Lucas Papademos is reportedly threatening to step down over the negotiations; the European Troika has threatened to withhold any further bailout funds unless the debt-deal is completed and additional austerity measures are implemented; and German leadership has asked for control of Greek finances.

The situation is clearly a mess. Chatter across trade desks today suggested that a Greek default could occur as soon as this weekend, with an exit soon after. Markets have not priced this in considering the recent rally, and the exceptionally bullish U.S. labor market reading on Friday overshadowed these recent developments. In my opinion, market participants are vastly underestimating the notion of a Greek default; while a “Lehman Moment” may be off the table thanks to the ECB’s long-term refinancing operation (LTRO), the issue at hand is what will happen to sentiment. I remain highly skeptical that a Greek default would just be brushed aside; the ECB would need to be extra diligent to prevent other PIIGS’ bond yields from soaring on the threat of contagion. This is the most important item to keep in mind for the coming days.

In light of the recent optimism, and now the even more recent hesitation, the Euro has struggled this week to break the psychologically significant 1.3200 level against the U.S. Dollar. This level was key support in mid-December, and since then, the EUR/USD has failed to post consecutive closes above 1.3200 since then. This is our line in the sand for further advances by risk-correlated assets, specifically equity markets and periphery bonds.

With all of this in mind, the most important scheduled event for the Euro during the first full week of February is the ECB rate decision on Thursday. President Mario Draghi’s LTRO has saved the market from a major collapse, in my opinion, as it unclogged the increasingly frozen European interbank markets. Additionally, the ECB’s bond purchase program – one which Draghi has called “temporary by nature” – has helped quell concerns that Italian and Spanish 10-year bond yields would make a sustainable break above the 7.000 percent threshold, the yield at which Greece, Ireland, and Portugal asked for international assistance. With no rate cut expected, Draghi’s post-meeting conference becomes that more important, and could mark another decisive moment in the crisis amid the breakdown in the Greek debt-swap negotiations. –CV

Japanese Yen Outlook in Disarray as Greek Fiasco Beckons Intervention

Fundamental Forecast for Japanese Yen: Neutral

• FX Options Traders Most Bullish US Dollar in 8 Years vs. Yen
• Speculative Sentiment Positioning Hints USDJPY Bottom May Be Set

Just when Japanese Yen price action appeared to be regaining a sense of normalcy, the Eurozone debt crisis elbowed its way back into the picture. Leave it to Greece to muck up the works again. The Yen began to return to its long-term relationship with US Treasury yields this month as the Federal Reserve extended its projected period of “exceptionally low” interest rates by 18 months to the end of 2014 and ominously hinted it may launch a third round of quantitative easing (QE3), with USDJPY sinking dangerously close to the intervention-prone area around the 76.00 figure.

This made sense. The level of US yields has long served as a benchmark for returns on Dollar-denominated assets for Japanese investors who must perpetually decide what to do with a pile of USD left on their hands courtesy of the island nation’s trade surplus with America. When US yields rose, it made sense to recycle this surplus back into USD-based assets, driving USDJPY higher; when yields fell, the reverse was prudent, so it was quite reasonable to see USDJPY head south amid expectations that Ben Bernanke and company were preparing to ramp up asset purchases anew.

An unexpectedly robust US employment report seemingly cemented the relationship by showing it worked in reverse as well. Nonfarm payrolls crushed expectations, showing the US economy added 243,000 jobs in January compared with forecasts calling for a paltry 140,000 increase. While a long list of pundits commenced to squabble over the report’s validity after the release, the markets’ verdict was clear: the benchmark 10-year Treasury yield rose 116bps to mark the largest daily jump in over 6 weeks, hinting QE3 bets were being unwound and pulling USDJPY higher by a healthy 0.5 percent.

Holding out hope for more of the same appears ill-advised however amid reports that all three of the parties in Greece’s ruling coalition have rejected deeper austerity measures required to receive the next tranche of EU/IMF funding before €14.5 billion in maturing debt comes due on March 20. This makes the tense negotiations between Athens and its private creditors over a bond swap program meant to cut Greece’s debt burden and push out the due date on what remains further into the future effectively moot. Some reports suggest caretaker Prime Minister Lucas Papademos even resign over the dispute.

Needless to say, this lays the groundwork for a Greek default. In practice, that is not nearly as ominous of a prospect as it was even 2 months ago. The ECB has funneled close to half a trillion euro into the banks via its 3-year LTRO and has been dutifully buying other countries’ bonds, so the firewall against a massive credit crunch (especially given small the size of Greece’s economy) is arguably in place. That probably won’t prevent the markets from entering panic mode however, first as an initial knee-jerk reaction and later as traders extrapolate the Greek scenario to other, larger countries. The resulting bout of risk aversion is likely to spur safe-haven Yen buying once again, and with USDJPY still close to the 76.00 figure, bring intervention back into the picture to derail fundamentally-driven trend formation once again. - IS

British Pound To Reverse Course As BoE Expands QE

Fundamental Forecast for British Pound: Bearish

• GBPUSD: Weakness Hinted at Key Resistance
• British Pound Trades into November Congestion Zone
• British Pound Targets Peaks

The British Pound extended the advance from the previous month to reach a fresh yearly high of 1.5882, but we are going to see the sterling come under pressure next week should the Bank of England take additional steps to stimulate the ailing economy. Although the BoE is widely expected to keep the benchmark interest rate at 0.50%, all of the 50 economist polled by Bloomberg News see the Monetary Policy Committee expanding its Asset Purchase Facility beyond the GBP 275B target, and the central bank may keep the door open to expand its balance sheet further in an effort to stem the risk of a double-dip recession.

BoE board member Adam Posen struck a highly dovish tone for monetary policy as he expects to see subdued inflation in 2012, and said that there’s a case for another GBP 75B in quantitative easing in light of the ongoing weakness in the real economy. In contrast, MPC member David Miles argued that it’s presumptuous’ to assume that the central bank will raise the limit on the APF as policy makers expect the economic recovery to gather pace ‘through this year and into next year.’ Indeed, the opposing comments from the BoE could foreshadow a rift within the MPC, and we may see the committee preserve a wait-and-see approach in the first-half of the year as the fundamental outlook for the region remains clouded with high uncertainty. Meanwhile, the National Institute for Economic and Social Research encouraged Chancellor of the Exchequer George Osborne to draw up a stimulus package as the group forecasts the U.K. economy to contract 0.1% in 2012, and calls for fiscal stimulus may keep the BoE on the sidelines as monetary policy remains highly accommodative.

As the GBP/USD breaks out of the upward trending channel carried over from the previous month, we may see a short-term reversal pan out next week, but the exchange rate may track sideways ahead of the BoE rate decision as long as the 38.2% Fibonacci retracement from the 2009 low to high around 1.5730-50 holds up as support. However, the BoE rate decision could spark a sharp selloff in the exchange rate as the central bank maintains a cautious tone for the region, and a break and a close below the 10-Day SMA (1.5716) could pave the way for a test of the 50.0% Fib around 1.5300 as fundamental outlook for the U.K. deteriorates. - DS

Gold Fails to Break December Highs - Bearish Tone

Fundamental Forecast for Gold: Bearish

• Gold Next Resistance is December High
• Gold Consolidates above 1700
• Gold Correlation with Risk Still Robust Following FOMC Decision

Gold was virtually unchanged on the week after the precious metal saw its largest one-month advance in January since last August. Year-to-date gold has advanced nearly 11% as the dollar came under tremendous pressure on speculation that the Fed would indeed move to implement further quantitative easing measures. However with today’s blow-out non-farm payroll figures, the recent rally may be at risk.

Non-farm payrolls rose by 243K in January, far surpassing consensus estimates for a print of just 140K with the unemployment rate falling to 8.3% from 8.5%. Later in the day the ISM non-manufacturing composite also topped estimates with a print of 56.8, its highest level since February 2011 and besting calls for a read of 53.2. The data fueled a rally in risk assets with the dollar finally finding some support as calls for additional quantitative easing from the Fed eased. Speculation that the central bank will look to further ease monetary policy surged after the FOMC rate decision last week where Chairman Bernanke pledged to keep interest rates anchored through late 2014. Accordingly gold was bid higher as investors flocked into the precious metal as a classic hedge against inflationary fears on concerns that the Fed may look to implement further dollar diluting policies to prop up the economy.

However as US economic data continues to improve, calls for easing from the Fed are likely to subside with gold risking a substantial pullback from the massive advance seen since the start of the year. As noted in last week’s gold forecast, a look at historical data suggests that the yellow metal may be in for a larger correction with two of the past three record monthly advances posting a sharp decline of 7% or more on an open-to-close basis the following month.

Looking ahead to next week, traders will be closely eying Fed Chairman Ben Bernanke as he testifies before the Senate Banking Committee. Although Bernanke is likely to reiterate the remarks made this week before the House Budget Committee, the chairman could face increased scrutiny on the back of Friday’s blow-out NFP print with members of congress likely to question the central bank’s decision to maintain its zero interest rate policy through late 2014. Should Bernanke further soften his dovish outlook on the economy, look for gold to come under pressure as the dollar finds bids with the Dow Jones FXCM Dollar Index (Ticker: USDOLLAR) resting near three month lows just above the 9700 level.

Gold encountered resistance at the December highs at $1763 before pulling back on Friday’s positive NFP print. Interim support now rests at the 61.8% Fibonacci extension taken from the September 26th and December 29th troughs at $1690 with subsequent floors seen at the 50% extension at $1658 and $1640. A breach above the December highs eyes topside targets at 100% extension at $1795 backed by $1820 and $1845. Look for gold to ease next week as QE prospects diminish with a bout of dollar strength likely to further weigh on the precious metal. Note that the medium-to-long-term outlook for gold remains weighted to the topside with prices expected to top last year’s record highs in 2012. – MB

Canadian Dollar Outlook Turns Bearish

Fundamental Forecast for Canadian Dollar: Bearish

- Canadian Dollar Focus is on 200 Day Average

- Canadian Dollar Forecast to Strengthen

The Canadian Dollar had a modestly strong week, climbing 1.1 percent against the U.S. Dollar, though it lagged the other commodity currencies. Its commodity comrades, the Australian and New Zealand Dollars, gained 1.63 percent and 2.18 percent, respectively. The Loonie was supported by a slightly firmer crude oil, which was up 1.63 percent on the week. The trend is clear: without the support of broader markets, there was little reason for the Canadian Dollar to gain against the U.S. Dollar.

Data this past week was bullish for the Canadian Dollar, but only marginally. Leading indicators expanded by 0.8 percent in December, a tenth of a percentage less than November’s positively revised figure. Retail sales for November were better than expected, though the growth was less than the prior reading. Thus, in both cases, the data was positive, just not as good as the prior month; is this a sign that the Canadian economy is facing some headwinds? Only time will tell, though.

Looking ahead, the event docket features two considerable data prints that will stoke volatility across Loonie-based pairs during the first week of February. On Wednesday, monthly growth figures are due, with the November GDP reading forecasted to show a slight 0.2 percent bump. On a year-over-year basis, growth is expected to have declined to a modest 2.3 percent pace. Considering that Canada is the number one exporter of oil to the United States, and now that the United States is a net exporter of oil, the Canadian economy might see a slowdown in this respect.

Volatility is likely to be high as well on Friday, when the monthly Canadian labor market reading is due. The Canadian labor market is forecasted to have improved slightly in January, adding 22.0K jobs, up from the 21.7K jobs added in December. The net effect is expected to be minimal, with the unemployment rate forecasted to hold at 7.5 percent, according to a Bloomberg News survey.

If there is one thing to take away from this piece, note the rhetoric employed: not much exciting data is due, and there is nothing substantial neither in the rear view mirror nor on the road ahead to keep the Canadian Dollar from depreciating against the U.S. Dollar. Without the further support of global risk trends, the coming week could be rough for the Loonie. –CV

Australian Dollar At Risk Of Major Selloff Amid RBA Rate Cut

Fundamental Forecast for Australian Dollar: Bearish

• AUDUSD: Triple Top Begins Taking Shape
• Australian Dollar at Channel Resistance-Probes October High
• Australian Dollar Strongly Correlated to Gold, Silver, Steel Prices

Although the Australian dollar had a great run coming into February, we expect the high-yielding currency to come under pressure next week as the Reserve Bank of Australia is expected to lower the benchmark interest rate from 4.25%. According to Credit Suisse overnight index swaps, investors are pricing a 79% chance for a 25bp rate cut, while market participants see borrowing costs falling by nearly 100bp over the next 12-months as the central bank tries to shield the $1T economy.

At the same time, 24 of the 27 economists polled by Bloomberg News expect to see the RBA lower the cash rate to 4.00%, but we may see central bank Governor Glenn Stevens talk up speculation for lower borrowing costs as the slowing recovery dampens the outlook for inflation. As the slowdown in global trade paired with the ongoing turmoil in the euro-area dampens the prospects for a more robust recovery, we expect the central bank to maintain a dovish tone for monetary policy, and Mr. Stevens may continue to strike a cautious outlook for the region as the central bank anticipates to see slow growth in China – Australian’s largest trading partner. In contrast, Australian Treasurer Wayne Swan argued that there is too much focus on the downside risks for the economy as he expects to region to withstand ‘the worst the world can throw at us.’ In turn, the encourage comments by Mr. Swan may lead the RBA to soften its dovish tone for monetary policy, but the central bank may show an greater willingness to cut borrowing costs further in order to stem the downside risks for the region.

As the AUD/USD fails to push above 1.0800, the pair appears to have carved out a triple-top in February, and the technical outlook foreshadows a sharp selloff in the exchange rate as the high-yielding currency remains overbought. However, we will be closely watching the 10-Day SMA (1.0628) as it holds up as short-term support, but a break and a close below the moving average should expose former resistance around the 23.6% Fib from the 2010 low to the 2011 high (1.0350-60), which could act as new support. – DS

When Will the Kiwi’s Remarkable Run End? Now.

Fundamental Forecast for New Zealand Dollar: Neutral

• Kiwi Continues to Outperform in 2012 – Jordan Remarks Send Franc Lower
• Kiwi Powers Ahead, Euro Barely Up Amid Swirling Bailout Rumors

The New Zealand Dollar posted another strong week, gaining 1.31 percent against the U.S. Dollar, topping all of the major currencies covered by DailyFX in the process. The Kiwi’s run this year has truly been remarkable, despite not being the highest yielding major currency: it is up 7.53 percent year-to-date. Global data has been improving, as evidenced by January’s labor market for the United States and the recent swath of better than expected PMI figures across the Euro-zone. These prints, coupled with additional monetary easing measures signaled by the Federal Reserve and other major central banks, has contributed to the New Zealand’s meteoric rise thus far in 2012.

And yet, despite all of this optimism surrounding the markets, the Kiwi’s aggregate outlook for the period ahead is neutral, given the balance between the fundamentals and the technicals. Briefly, from a technical picture, the NZD/USD’s sharp advance has now become overbought, with the daily RSI reading now at 77.80. The pair also broke out of a steep ascending channel in place since mid-December, positioning it neatly up against right shoulder resistance on a long-term head and shoulders pattern that has been forming since late-2010.

While the technical picture is dictating a pullback in the near-term, the fundamentals that have led the Kiwi higher remain in place: expectations of more monetary easing in the future by the world’s largest central banks; improving data out of the United States; and a sense of calm emerging over the Euro-zone debt crisis. Domestically, the only significant piece of data due are the unemployment figures, which are forecasted to show a slight improvement in the New Zealand labor market. Unemployment is forecasted to have ticked slightly lower in the fourth quarter, from 6.6 percent to 6.5 percent, on the back of a projected 0.4 percent quarterly gain.

Accordingly, the best conclusion to draw from the picture recent price action is as such: the long-term downtrend remains, but the intermediate trend is firmly to the upside. A shift in short-term sentiment as market participants take profits may occur, and technically speaking that is warranted. Fundamentally, with Euro-zone issues on the backburner (ignoring the potential Greek default as that is too complex to speculate on in this piece alone) and global growth prospects turning higher, a continuation could occur. Barring some unforeseen ‘black swan’ that throws awry liquidity markets, we will looks towards a technical pullback to enter long NZD/USD positions, as the fundamental picture remains ripe. – CV