Highlights
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Commodity reversal is underway |
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Risk aversion to keep carry trades under pressure |
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US housing data will dominate over next two weeks |
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Holiday-thinned trading conditions likely to heighten volatility |
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Commentary
Brian Dolan, Chief Currency Strategist
Carry trades (JPY-crosses) were once again the big movers, with most registering sharp losses as increased risk aversion sends speculative traders running for cover. The heightened risk aversion stems from continuing concerns over the health of the financial sector, owing to still large levels of toxic MBS assets corroding bank balance sheets and fears of further large write-downs in coming quarters. To give you an indication of the level of risk aversion, we are now back at levels last seen at the height of the June/July credit market meltdown. Adding to risk aversion is the approaching end-of-year, which typically sees speculative portfolio flows reduced as asset managers lock in gains and cut losing positions.
The strengthening of the JPY is not solely due to risk aversion. A faster rate of appreciation in the Chinese Yuan has ignited speculation that the second phase of dollar weakness is beginning to unfold, this time cycling around to Asian currencies. Throughout this year the USD most pronounced weakness has been against European and commodity currencies, Anglo-Saxon currencies if you will. This has led to some lessening of the US trade deficit, but Asia is the region with the greatest trade surplus imbalances versus the US trade deficits. If the USD adjustment lower is to continue, I am looking for an intensification of USD weakness against Asian currencies. For the major pairs, that means USD/JPY and the JPY-crosses should continue to move lower. In the short-term, USD/JPY has reached a key support zone at the 108.70-109.00 area. Perhaps most importantly, though, the MOF (Japanese ministry of finance) has made it known that it's not pleased by the speed of the JPY's recent appreciation and hinted at potential intervention of the rapid gains persist. It does not mean that they will necessarily stand in the way of further JPY gains, only that they do not want a too rapid or disorderly adjustment. That should continue to provide for significant volatility and opportunities to re-sell USD/JPY and the JPY-crosses on significant rebounds, for example 113-114 in USD/JPY and EUR/JPY in the 164-166 area. Should USD/JPY post a daily close below the 108.70 level, it very likely signals a ratcheting down of the USD/JPY to a lower level, namely the 105-110 area. In Elliott Wave terms, if the current USD/JPY decline is a Wave 3 (starting at 118) and is simply to match the initial Wave 1 down from 124 to 111.60, the projection is to just above the 105 level. But keep in mind that Wave 3's are typically larger than Wave 1's, so the decline could be even larger. The trigger remains the 10870-109.00 area.
Last week the BOE delivered a dovish quarterly inflation report which highlighted the downside risks to economic growth, while forecasting inflationary pressures are likely improve further in coming quarters. The result is that the next rate move from the BOE will be a cut, and the only question is the timing. A small minority of market analysts is calling for the cut to happen at the next meeting in December, but the larger majority is focusing on Jan/Feb as the most likely time for a cut. The result for GBP has been a sharp reversal which is now in position to threaten the overall uptrend support in the 2.0150-2.0200 area. Going forward, the prospects for a further deterioration in the UK keeps GBP a sell on rallies, which in the current environment could be substantial, namely into the 2.07-2.08 area. A drop below the 2.0150 level on a daily closing basis should trigger further sharp losses into the 1.98-1.99 area. The EUR is unlikely to escape the fallout from the UK and Eurozone economies slowing, and if Cable is viewed a leading indicator, EUR/USD has the potential to adjust lower in the near future. The key support that will serve as the trigger to a downside ratchet in EUR/USD is the 1.4520 level, which was the breakout level on the way up and the intra-week low last week.
Having just highlighted the downside potential for EUR and GBP, the risks to the USD over the next two weeks is also to the downside. The main source of potential USD weakness is the spate of US housing data that arrives in the second half of each month. Over the last several months, there has been a tendency for the USD to slide further in the latter half of each month, and while no one is expecting any improvement in US housing data any time soon, better than expected reports will be needed to prevent further USD weakness. If the housing data remains soft as expected, the result could very well be a further consolidation in both EUR/USD and GBP/USD, as the twin forces of a slowing UK/Eurozone outlook engages in a tug-of-war with further concerns over the fallout of housing on the US outlook.
The key commodity currencies (AUD and CAD) underwent significant reversal last week, with USD/CAD posting a massive 'hammer' reversal signal on the weekly close candlesticks. Rising concerns over the strength of the CAD played into the CAD's reversal, with a heavy short-USD/CAD positioning adding to the rebound. The major commodities, such as oil and gold, have also put in significant tops and are showing signs of undergoing a larger trend reversal, fueled in part by the rise in risk aversion leading to speculators exiting the market. As noted earlier in this report, speculative flows are likely to be lower going into the end of the year, and this suggests that the major uptrend may not re-assert itself this time around. Finally, the more US data points to the risk of a broader slowdown, the more likely these commodities are to see further weakness, as prospects of a slower global growth outlook will restrain commodity gains.
In the US this week, the Thanksgiving holiday comes on Thursday and the week is typically one of the thinnest liquidity weeks in North American trading, which frequently results in range-bound trading punctuated by inexplicable, position-driven bursts of volatility. If Monday's price action so far is any indicator, trading conditions will be treacherous for the rest of the week.
Turning to the data calendar out of the US this week, Tuesday sees Oct. building permits and housing starts released, with further declines expected. Tuesday will also see the minutes from the Oct. 31 FOMC meeting released. As announced by the Fed last week, the Fed will also make available with the minutes the first of its new quarterly economic forecasts. The format is new to the market and will take some time to digest, but Tuesday's Fed report will be much more significant than normal FOMC minutes and traders should be alert to potentially significant market reactions. Wednesday sees weekly mortgage application data and weekly jobless claims, moved ahead by a day due to the Thursday holiday, along with final Nov. Univ. of Michigan sentiment and October LEI. There are no US releases on Thursday or Friday.
Eurozone data sees on Tuesday German producer prices for Oct. along with German Sept construction output. Wednesday has no economic data reports, but German Fin. Min. Steinbrueck is speaking and ECB pres. Trichet will also speak on the French economy. Thursday sees final 3Q German GDP and Sept. Eurozone current account reports and Sept. industrial new orders. Friday sees EC-issued purchasing manager indexes for manufacturing, services, and a composite of the two sectors. Finally on Friday, the ECB's Weber will speak and he has been reliably hawkish recently.
Japanese data sees convenience store sales on Tuesday afternoon. Wednesday morning in Tokyo sees the release of the Oct. merchandise trade balance and the Sept. All-Industry Activity Index. Thursday sees the weekly stock and bond flow report, and BOJ board member Nakamura is to speak in the afternoon, wrapping up Japanese events for the week.
UK data sees Oct. money supply reports and mortgage approvals on Tuesday morning, followed by the CBI Nov. industrial trends survey, a key privately-calculated gauge of manufacturing sentiment. Wednesday's highlight out of the UK will be the release of the BOE MPC minutes from the Nov. meeting. The minutes could provide the clues to the timing of the expected BOE rate cut, so keep a close eye on the vote count, and the more votes in favor of an ease, the sooner markets will expect a rate cut. Thursday sees 3Q total business investment, which could be significant if it reveals any significant slowing on the part of business spending. Friday concludes with preliminary 3Q GDP, private consumption and exports and imports.
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