FX Strategy Weekly

Market Outlook:

• The biggest week of Q4 and anticipation of choppy trading conditions has already been translated in a substantial mark-up in volatility, but the worsening in US confidence data is a new trading theme that may receive more prominence depending how the ISM surveys pan out. The partial withdrawal from risk assets has been replaced by a flight-tosafety of the USD and JPY. Though safe haven flows could gain in popularity if ISM and PMI data disappoint and faltering equities force USD bears to cover, we have doubts over the propensity for USD gains to transpire into a long-term recovery without tightening support from the Fed. In the UK, the BoE may not trust the accuracy of the weak preliminary Q3 GDP figures from the ONS, but downside risks to growth are still evident from low M4 lending and this threatens to keep inflation below the 2% target over a twoyear period. This gives ammunition to the MPC to stay on a more dovish path compared to other G10 central banks. The prospect of the Bank announcing more, and possibly, targeted asset purchases now looks extremely likely. A reduction in Bank rate is not priced in, but along with a cut in commercial bank remuneration rates has to be considered. This would be negative for GBP.

Technicals:

• Dollar bounces on cue and then slides - time to sell or cyclical low?
• Pound rally rolls on, more upside expected
• Can the risk rally continue?

Quantitative Analysis:

• Volatility in G-10 FX beginning to turn higher
• Contrarian indicators move to neutral
• Downside risk for USD, if leading indicators continue higher

Macro Outlook

The biggest week of Q4 and anticipation of choppy trading conditions has already been translated in a substantial mark-up in volatility, but the worsening in US confidence data is a new trading theme that may receive more prominence depending how the ISM surveys pan out. The partial withdrawal from risk assets has been replaced by a flight-to-safety of the USD and JPY. Though safe haven flows could gain in popularity if ISM and PMI data disappoint and faltering equities force USD bears to cover, we have doubts over the propensity for USD gains to transpire into a long-term recovery without tightening support from the Fed. In the UK, the BoE may not trust the accuracy of the weak preliminary Q3 GDP figures from the ONS, but downside risks to growth are still evident from low M4 lending and this threatens to keep inflation below the 2% target over a two-year period. This gives ammunition to the MPC to stay on a more dovish path compared to other G10 central banks. The prospect of the Bank announcing more, and possibly, targeted asset purchases now looks extremely likely. A reduction in Bank rate is not priced in, but along with a cut in commercial bank remuneration rates has to be considered. This would be negative for GBP.

USD

• I am not buying into the bullish USD view based on the premise alone that the Fed will tweak the language of its FOMC statement next week Wednesday to give itself more leeway on interest rates in 2010.
• Based on the deterioration in household confidence in early Q4 and potential spillover to leading indicators for housing etc., USD gains driven only by flight-to-quality may not be sustainable against its major counterparts, especially vs higher yielding and commodity currencies.
• The G20 finmin meeting is something of a wildcard for price action at the end of next week but the recent USD bounce may have taken the sting out of the political debate, especially from the Euro zone.
• The FOMC meeting dominates the calendar but assuming no change in rhetoric, focus will rapidly shift to October non-farm payrolls. EUR/USD is virtually flat since the last FOMC meeting and USD/JPY is down 0.6% just below 91.0. GBP/USD is up 0.6% at 1.6450. An unexpected drop in the October ISM surveys could bolster safe-haven USD demand.

EUR

• Positive EU/US rate spreads and a turn in the German labour market support my call to buy dips in EUR/USD. This week's pullback below 1.4800 is subject to a retracement towards the 1.4580 area if equities lose further altitude, but this should be considered as a buying opportunity as long as the Fed signals its commitment to keep interest rates low.
• I expect the ECB to stay sidelined on interest rates next week - refi at 1% - but EUR crosses could be supported if president Trichet comments on possible changes in future liquidity operations. ECB member Weber has signalled that the Bank may not offer unlimited 12-month liquidity in 2010. This follows lukewarm demand for funds at the September LTRO.
• For EUR/GBP, I have been caught out by the lurch from above 0.94 to below 0.90. I look for a back up to 0.92 based on positive EU/UK 2y spreads (45bps) and a likely increase in QE by the BoE. This should protect EUR/GBP from further downside as buying of sterling for corporate purposes wanes.
• Final EU-16 October PMIs are set to bring confirmation of resilience in manufacturing and services sectors in early Q4. What has been surprising in the euro zone PMIs is the outperformance of France vs Germany and Italy at the start of Q4, with both French PMIs running above 55.0 vs a 51.0 average for Germany and a 48.0 average for Italy.

GBP

• An unwinding of GBP volatility is likely this week following an uninterrupted rise since the start of the month. EUR/GBP vol hit 12.82 on Thursday, the highest since June 10. One-year EUR/GBP vol scaled a six-month high, but 1mth/1y vol curves in GBP/USD and EUR/GBP continue to flatten.
• For GBP spot, I like being short going into the MPC meeting on Thursday for the reasons outlined above. I am also reminded of the implicit BoE objective to keep sterling weak and promote rebalancing of the economy from private consumption towards net trade.
• GBP buying related to corporate dividend payments has been an important driver of sterling support over the latter part of October, but is likely to fade once HSBC's results are published on November 10th. The BoE decision next week could be a catalyst for a reversal in GBP crosses.
• Manufacturing and services PMI data for October on Monday and Wednesday will influence sentiment ahead of the MPC, but may not deter the BoE from its course of action. Remember the MPC decision will be based on the Quarterly Inflation Report, due the week after next.

CAD

• USD/CAD has bounced 5.8% from the 1.0207 low since the Bank of Canada reiterated its disapproval of the strength of the CAD. The resulting decoupling with pro-risk assets has turned the CAD into one of the worst performing G10 currencies this month, with the rally in crude oil above $80pb failing to bring support. Canadian October employment stats are due on November 6th.
• For USD/CAD, failure around the 1.08 area and subsequent reversal to the 1.0675 intra-week low suggests that CAD selling is fading. A break of 1.0544 support is required to reassert a bearish USD/CAD set-up.
• For GBP/CAD, I look for a break below 1.75 support to squeeze the pair back towards 1.71 area. Key resistance is clustered in the 1.80-81 area.

JPY

• The bounce in USD/JPY has been closely correlated with the rise in US 10y yields to 3.55% (see chart). JPY strength vs other G10 currencies except the USD dovetails with solid overseas investment flows into Japanese securities over the last two weeks, led by demand for money market instruments.
• Short-term direction for the JPY essentially depends on broader trends in risk appetite and perceptions over the direction of the US economy in Q4. A quiet week lies ahead for Japanese data. I expect the BoJ to keep its target rate on hold at 0.10% as concerns prevail over the strength of economic recovery.
• For USD/JPY, the October 27 high of 92.32 serves as key resistance. For GBP/ JPY, we look to fade the rally at 152.50 resistance.

SCANDIS

• EUR/NOK and EUR/SEK have both retraced higher over the past week as risk aversion sentiment in financial markets weighed on the Scandinavian currencies. Given the fundamental backdrop of both Norway and Sweden, I would use this opportunity to sell into any rallies - particularly EUR/NOK. As Norway has begun its tightening cycle and the Riksbank is signalling higher rates in the second half of next year, I would expect both currencies to strengthen over the medium-term.
• More immediately, however, PMI surveys will be key next week - not just in Scandinavia but for risk sentiment as a whole. With financial markets feeling jittery, any signs of a turn lower in the forward leading indicators could resurrect risk aversion with a vengeance. The immediate impact of this would be for NOK and SEK to be hit versus EUR and USD. If this were to occur, I see resistance for EURSEK at 10.42 and then 10.64 with EURNOK at 8.57. My favoured view, however, remains bearish for both EURNOK and EURSEK and look to target 7.88 and 9.96 respectively.

AUD

• The latest CPI data for Q3 came in a touch above consensus, slowing to 1.3% (consensus 1.2%) from 1.5% - not quite high enough to seal a 50bps rate hike by the RBA next week (3rd Nov), but not low enough to alter expectations of a 25bps hike. Given the sharp rise in business confidence over the quarter (-4 to +16), I expect a further 25bp in December, taking the Cash Target rate to 3.75% by year-end.
• Consequently, I remain bullish on the AUD, but more cautiously so than last week. The sell-off in AUD/USD from the high of 0.9329 to 0.9078 at the time of writing potentially opens the way for a break lower. A break below 0.8870 would breach the upward trend line (from the March low) and this could see a move down to 0.8750 over the next couple of days.
• Along with the RBA interest rate decision, key events next week include the manufacturing PMI survey as well as retail sales. While the Australian PMI outturn may not be focussed upon as much as the latest round of leading indicators from other countries, a move below 50 (unlikely in my view) would have very negative consequences for the AUD.

AUD

• The October KOF and September CPI releases cover most of the release calendar next week for Switzerland and are likely to be key for near-term direction in CHF crosses.
• For USD/CHF, a pullback from this week's 1.0287 high looks poised to extend towards the 1.01. A strong KOF result - consensus forecast 1.16 vs 0.85 would attract selling below 1.0206 trendline. Key support runs at 1.0150.

Technical View

• Dollar bounces on cue and then slides - time to sell or cyclical low?
• Pound rally rolls on, more upside expected
• Can the risk rally continue?

The past two trading sessions have been characterised by a strong bout of risk aversion followed by a pro-risk rebound as the markets lurch in and out of the US dollar and equities. Among the volatility, it is important to put these moves into context. This time last week I reversed my view of the dollar from bearish to bullish and specifically targeted the emerging market and 'pro-risk' commodity currencies as having significant potential to weaken (my view of the pound has remained bullish, however, as the currency continues to broadly recover from an oversold condition). The strong moves building from last week up to Wednesday were sharply reversed on Thursday and, whilst an oversold rebound was expected, the moves have gone beyond short term pain thresholds for positions. The question from here is: Does risk appetite return in force or is this an opportunity to buy US dollars? My view is that the latter case holds the greatest weight at this juncture, but from a risk perspective we may have to wait for dollar bears to punch themselves out.

The main reason for this view hinges on the technical profile of the equity markets which have initiated sell signals. In April I turned bullish on risk and the equity markets and bearish on the dollar, but have always maintained that this is simply a corrective phase. My timing for a reversal of risk was in Q1 2010, but it appeared that market events had brought this forward sooner, hence my current attempt to pick a significant reversal. Naturally I could be wrong about the current timing, but I will maintain a cautious equity view and a bullish dollar strategy until the S&P can recover the 1,100 handle. This still looks far enough away to be a challenge for the bulls and, if nothing else, the market has proved how fickle it can be in a short space of time. A break back below 76.30 in the dollar index (as shown below) is certainly a set-back, but it is possible the market will retest this major trendline as support having broken as resistance. This would suggest 75.75/80 will hold as support and ignite another dollar rally.

Sterling continues to push broadly higher as EUR/GBP completes a major head and shoulders reversal and cable squeezes back over 1.6500, eyeing the 1.6696 resistance that sent it into a tail spin. Whilst I am bullish on cable, I was looking for lower levels to join the bounce (1.6225), but despite this I can still see scope for a squeeze towards key resistance at 1.6740/60.