A test of 1.4626 clears the path for a retracement to 1.45

Tue, Jan 12 2010, 12:35 GMT
by Lloyds TSB Financial Markets Economic Research Team

Market Outlook

Sovereign credit market turbulence, threats of currency intervention and lower volatility are dictating flows in the major currencies as we approach a traditional year-end lull in activity and light trading volumes. Rising long term yields and higher term premia could temper enthusiasm to push equity indices higher and curb appetite for carry trades and pro-risk strategies. Beyond the short-term, the case for holding high yield currencies remains compelling based on actual and implied interest rate differentials. Positive data surprises from Australia and a hawkish RBNZ statement have to be squared with attempts by other G10 central banks to manage ‘exit’ expectations and can, in our view, best be expressed through long AUD and NZD vs short JPY and CHF with returns partially contingent on rallies in the S&P-500 over 1,100 and Shanghai composite to 3,360. For GBP, year-end repatriation flows may tempt sterling bulls for a year-end flourish, though the scale of a relief bounce may depend on next week’s market moving data trio of November CPI, unemployment and retail sales and deliberations over the UK’s credit status.

• USD
  
  The dollar index has consolidated post-NFP gains above 75.0 but the narrow trading range this week points to an absence of clear conviction to push the index higher near-term. Key upside resistance runs at 76.71, the 100d MA. Positive surprises for US data or a more hawkish FOMC statement next week will be required to entice dollar bulls into year-end.
  
  
  
  Fed chairman Bernanke in his nomination hearing last week played down optimism for a swift recovery and warned of potential further declines in core inflation. Whilst precise details of Bernanke’s own view on exit strategy remains unclear, we take the view that the next FOMC meeting will favour a status quo vs November.
  
  The USD is attracting good demand this month especially vs the EUR, GBP and JPY. Aided by a narrowing in implied rate differentials - May-10 Eonia/FF strip trades below 30bps - EUR/USD is in danger of testing the November 3 low of 1.4626. The 50d MA runs at 1.4879.
  
  The last full week of 2009 will be dominated by the FOMC meeting on Tuesday. October TIC and November capacity utilisation data are equally scheduled for Tuesday. November CPI is due on Wednesday and the Philly Fed is due on Thursday. Continuing claims have made impressive progress by falling below 5.2mln for the first time since February.

• EUR
  
  Default concerns in Greece and wider spreads over 10y bunds have translated into an greater degree of bearishness vis-a-vis EUR/USD. A decline from the December 3 high (1.5141) below the 50d MA of 1.4879 triggered selling to a one-month low (1.4668) where trendline support is situated. A test of 1.4626 clears the path for a retracement to 1.45.
  
  The unwinding of EUR/USD longs comes despite a more upbeat outlook for the euro zone economy in 2010 and proves that implied EU/US interest rate differentials could play a pivotal role in early 2010, especially if US labour market trends show conclusive evidence of a return to positive employment growth in Q1-10.
  
  
  
  A fall in one-month EUR/USD vol below 10.0 pushes the 1mth/1y spread over 3.40. Oversold conditions in the one-month favours spread compression going into the New Year. EUR/USD one-month risk reversals are rangebound but still show a heavy skew towards EUR puts (-1.17)
  
  The EU-16 flash PMIs for November are due on Wednesday, along with the ECB’s last one-year tender. A surge in demand for funds compared to the lukewarm September LTRO could rekindle balance sheet concerns and would encourage participants to trim long EUR positions.

• GBP
  
  Sharp falls in GBP vol have been recorded this week, led by a collapse in EUR/GBP one-month vol below 9.0 Conflicting short and medium-term forces may start to impact GBP crosses going into the New Year. Prospects of a spike in CPI inflation (short-term bullish) have to be balanced with the uncertainty surrounding the election/credit rating (medium-term bearish).
  
  For GBP/USD, a rebound to 1.6424, the 50d MA, is required to negate the bearish trend in place since mid-November. A stronger set of UK data next week including CPI, unemployment and retail sales along with repatriation flows could lift the mood of GBP bulls. Key support rests at 1.6168.
  
  For EUR/GBP, a test of 0.90 trendline support is favoured next week with the cross tipped to extend to 0.8955 support. Our call is supported by a decline in the EU/UK 2y spread to a two-week low of 6bps, though CDS spreads pose challenge. Following the SNB meeting this week, we look for GBP/CHF to extend towards the 1.6800-50 resistance area.
  
  
  

• CAD
  
  USD/CAD has been remarkably resistant to the plunge in Nymex crude below $75pb and suggests that positive CA/US rate differentials are offering good support for the cross. CA/US 2y spreads rebounded off the November 26 low of 37.5bps and have settled in the 45bps area following the strongest gain in Canadian employment in 14 months.
  
  
  
  Key support for crude comes in around $68.90 where a break could spur a retracement to $65.90. Dec-10 CA/FF futures vaulted 70bps resistance and could approach 75bps next week if the FOMC statement reiterates its stance on rates and agency MBS and agency debt purchases.
  
  Canadian economic data next week features November CPI and the leading indicators. BoC governor Carney speaks on Wednesday and, armed with the latest inflation figures, may elaborate on the economic and rate outlook for 2010. The Bank decided this week to keep the overnight rate on hold at 0.25% and reaffirmed the outlook for rates to stay at 0.25% until Q2-10.
  
  For GBP/CAD, a pullback from the November 1.7934 high gathered momentum this week with the pair falling below 1.71. A test of 1.70 could vindicate GBP bears and would force dealers to lower short-term targets to 1.65. Sell GBP/CAD on a bounce to 1.75.

• JPY
  
  IMM stats still show an overwhelming preference for long JPY which is at odds with the currency’s dreadful performance over the past two weeks and the whopping downward revision in Q3 GDP. The JPY has lost ground against all of its G10 peers since the start of the month, marked by 3% plus declines against higher yielding AUD, NZD and the commodity based CAD.
  
  The IMM imbalance exposes dangers of being caught out in the event of a squeeze in USD/JPY and an unwinding of JPY longs on a test of key resistance in the 89.50 area. Key support runs at 87.37. This level has held since the BoJ announced QE last week. Foreign bonds purchases by Japanese investors rose last week to the highest level since November 2007.
  
  We favour long USD/JPY positions with target situated at 91.33, supported by finance minister Kamei’s statement on the potential for overseas investment of funds from Japan Post, the world’s largest holder of JGBs. For GBP/JPY, we like selling rallies and target key resistance at 147.0. }
  
  
  
  The Q4 Tankan survey will be released late on Sunday and is forecast to improve to -27 from -33. The BoJ is expected to leave the key target rate on hold at 0.10% on Friday.

• NOK & SEK
  
  The Scandinavian currencies remain range bound versus the G3 currencies of USD, EUR and GBP as the years’ gains are consolidated. Despite little movement over the past two months, we expect further strength in NOK and SEK next year as the theme of global growth drives currency moves - as opposed to the risk drivers that so dominated markets in 2009. We would choose to express this via a short EURNOK position given the large widening in EU/NW interest rate differentials in Norway’s favour as well as the EUR being 10% overvalued on a PPP basis against NOK. In the short-term, we look for EURNOK to test 8.317, the November low. On the upside, there is strong resistance at the 8.55 level.
  
  
  
  Whilst we expect no change from the Riksbank and Norges Bank at next weeks monetary policy meetings, both countries look set for rate hikes relatively early next year compared to other western economies. Despite the Riskbank remaining cautious about raising rates until H2, there is a shift occurring within the committee with two members registering hawkish reservations about the current growth and inflation profile. We think there is a strong possibility that rate hikes in Sweden may be brought forward next year, thus leading to SEK outperformance. We target a move lower in EURSEK to 10.15.

• AUD
  
  Stronger than forecast Australian employment data and rising inflation expectations are stoking speculation that the RBA will pursue its tightening strategy in early Q1. AU/US interest rate differentials and strong economic data from China remain overall supportive of a higher AUD, though this has to be squared with a lack of conviction among equity bulls.
  
  Lower highs in AUD/USD since mid-November suggest the cross may be running out of steam in the 0.92 area. Key trendline resistance comes in around 0.9260-80. Support runs at 0.9035. A test of 0.9323, the December 3 high opens perspectives for a rally up to 0.9400 into year-end.
  
  
  
  Q3 GDP will be published next week Wednesday and could be a market mover for AUD crosses. The consensus is for a 0.4% q/q gain, a fraction below the Q2 gain of 0.6%. RBA deputy governor Battellino also speaks on Wednesday and may comment on the Bank’s policy stance heading into 2010. The next RBA meeting is scheduled for February.

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