Forex Weekly Trading Forecast - 05.31.10

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[B]US Dollar Awaits the Return of Liquidity, NFPs and the G-20 Meeting[/B]

Fundamental Outlook for US Dollar: Neutral

- The OECD upgrades growth forecasts for the world's largest economy, recommends policy tightening before year's end

- Consumer confidence hits its highest level in two years, but details give reason for caution

- The EURUSD stalls just at the midpoint of its historical range

The impressive rally the dollar has forged over the past six months is coming up to another critical point of speculative, fundamental and technical reflection. It is perhaps more than coincidence that the benchmark currency would find a temporary level of equilibrium just ahead of the extended holiday weekend when volatility is expected to evaporate. Furthermore, this stalled progress has occurred at exactly the moment the market's most liquid pair (EURUSD) came face to face with its historical midpoint (1.2135). No doubt there is ample fundamental reason that this should happen; but these market basic observations help establish the fact that market flow plays a critical part in determining the path any currency or asset establish. However, if we want to establish the probabilities for volatility and direction going forward, we need to look back to those fundamental considerations that threaten to put things back into motion. There are three primary concerns next week: a return of risk appetite trends; a redoubled focus on growth and interest rate expectations; and Friday's non-farm payrolls.

Starting with the most expansive and recurring fundamental driver the dollar faces, underlying investor sentiment is difficult to properly benchmark. Come Monday, things may still be quiet as both the US and UK markets are offline for holiday. However, when things pick back up on Tuesday, we will have a precedence of high volatility and a steady stream of (relatively) discouraging news that has until recently found a very receptive and bearish crowd. Is this pause a sign that the masses are no longer worried about another lull in the global economy or a second financial crisis? If that is the case, there may be a significant reversal ahead of us. The dollar has rallied nearly 18 percent on a trade-weighted basis over the past six months. This is the performance of a safe haven. For those assets with a positive link to risk, we have seen dramatic deleveraging and declines in benchmarks to match. The most accessible driver for sentiment considerations going forward is a refocus on the EU's troubles. However, now we have a possible Korean war, a Chinese asset bubble and sovereign debt concerns the world over among other things.

While many may simply attribute the greenback's performance so far this year to its role as a safe haven and move on; they are missing an important fact. The economic and interest rate expectations for the US economy are better than many of its primary counterparts. For interest rates, the market may only be pricing in 42 basis points worth of hikes from the Fed over the coming 12 months; but that is still better than the ECB (40), BoE (26.3), SNB (9) and RBA (18). What's more, this past week, the OECD would recommend movement on the central banks part before the end of the year and Board of Governors actually announced its schedule for Term Deposit Facilities.

Speaking of growth and interest rate speculations - not to mention risk appetite - the most prominent event over the coming week is Friday's NFPs. This employment indicator has been hit or miss these past few months as the struggle that comes with absorbing 8 million lost jobs while meeting new entrants comes to light; but this month's reading may be different. Looking at the Bloomberg consensus, we see a forecast for a 500,000 net increase. Though it may be a factor of calculation; this could still spark the animal instinct in traders. - JK

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The Euro pared Friday's rally as Fitch cut its AAA credit rating for Spain, and fears surrounding the European debt crisis could weigh on the single-currency over the following week as policy makers take unprecedented steps to stem the risks of contagion.

[B]Fundamental Forecast for Euro: Neutral[/B]

- IMF Sees Spain Banking Sector "Under Pressures"

- ECB Says Bond Purchases Are "Temporary"

- Bundesbank President Says "Too Early" To Declare End To Financial Crisis

The Euro pared Friday's rally as Fitch cut its AAA credit rating for Spain, and fears surrounding the European debt crisis could weigh on the single-currency over the following week as policy makers take unprecedented steps to stem the risks of contagion. At the same time, members of the European Central Bank have tried to talk down market speculation and said that its asset purchase program has not changed the Governing Council's stance on monetary policy as the central bank reiterates that it will not be engaging in quantitative easing. Moreover, the ECB said that market developments will determine the timeframe for the government bond purchases as it aims to stabilize the financial markets, and acknowledged that the euro is trading within a normal range with the U.S. dollar, which should benefit the economy as it increases the competitiveness of European goods on a global scale.

As a result, Organization for Economic Cooperation and Development said that the Governing Council should maintain a loose policy stance and support the economy "until late 2010," and encouraged the governments operating under the fixed-exchange rate system to take further steps to balance the imbalances between the countries. Meanwhile, China's State Administration of Foreign Exchange voiced support for Europe and said "the euro zone will definitely overcome difficulty and safeguard the stable and healthy development of the financial markets," and went onto say that the region will remain a key investment for the emerging economy as policy makers take the appropriate steps to contain the risks for contagion. At the same time, the Bundesbank expects Europe's largest economy to grow "strongly" in the second-quarter as global trade picks up, and the improvement in the economic outlook paired with the rebound in global growth could support the euro over the near-term as fears surrounding the debt crisis tempers off.

Nevertheless, as the preliminary first-quarter GDP reading is expected to show the growth rate expanding 0.2% after unexpectedly holding flat during the last three-months of 2009, while the CPI estimate is projected to increase to an annualized pace of 1.7% in May, which would be the highest reading since November 2008. As growth and inflation improve, the central bank may show an increased willingness to normalize policy further this year, but the spillover effects of the financial crisis could weigh on the exchange rate over the near-term as the central bank remains dovish. - DS

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[B]Japanese Yen Tied to Risk Trends Ahead of US Jobs Report[/B]

Fundamental Forecast for Japanese Yen: Neutral

- Japan's Jobless Rate Unexpectedly Rises, Deflation Accelerates

- Annual Exports Rise for Fifth Consecutive Month on Asian Demand

The Japanese Yen soared to the highest in 15 months last week as intense risk aversion fueled by lingering concerns about the European sovereign debt fiasco encouraged trades to liquidate carry trades funded cheaply in the low-yielding currency. A pull-back may be ahead if US labor market figures prove to bolster confidence in the week ahead.

The coming week promises to be a decisive one for risk sentiment across financial markets. Friday's downgrade of Spain's credit rating by Fitch on the grounds that the country's debt burden will bring higher borrowing costs and undermine growth underscores the global implications of the EU fiasco for the global recovery at large. Taken together, the European Union amounts to the world's largest economy; if fiscally responsible EU members take it upon themselves to bail out the spendthrift ones (as is apparently the case), they too will accumulate a large amount of debt, the financing of which will indeed drive bond yields higher and weigh on growth across the region. With Europe thereby tethered and China actively pushing to slow its buoyant economy amid fears of asset bubbles and runaway inflation, this leaves the United States as the sole significant engine of growth left to drive the global recovery.

On balance, this puts the onus on the considerably busy US data docket, with natural emphasis on the Friday release of May's labor market figures. Expectations call for nonfarm payrolls to rise 508,000 - the largest increase in nearly thirteen years - while the unemployment rate declines to 9.8 percent. If this proves to reassure the markets that a firming US economy can shoulder the burden of dragging the world along the path to recovery even as China and EU put on the brakes, the Japanese Yen is likely to sell off as carry trades advance along with a broad rebound in risky assets.

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[B]British Pound Could Falter On Weak Manufacturing [/B]

The British Pound would mark gains against most currencies during the past week despite ending flat against the dollar as concerns that the European debt crisis would make its way to the U.K.'s doorstep eased.

Fundamental Forecast for British Pound: Neutral

- U.K. GDP Revised Higher To 0.3% From 0.2%

- Mortgages Rose to 37,00 from 35,729 in April According to BBA

- Retail Sales Fall to 14 Month Low According to CBI

The British Pound would mark gains against most currencies during the past week despite ending flat against the dollar as concerns that the European debt crisis would make its way to the U.K.'s doorstep eased. However, a Fitch downgrade of Spain's sovereign rating to "AA+" from "AAA" reminded markets that the Euro-area is far from circumventing the problem weighing on the Cable despite pre-holiday volume. Sterling booked most of its weekly gains on the back of a surge in risk appetite following comments from China that the Asian giant was remaining a long-term investor in Europe. The remarks and the implementation of measures to bring budgets under control have helped stabilize yields. Improving U.K. fundamentals also helped generate sterling support as the second reading of first quarter GDP was revised higher to 0.3% from 0.2%, and home loans rose to 37,000 from 35,0444. However, a 14 month low in retail sales underlines the country's dependence on demand from abroad to generate growth especially with large cuts in government spending expected from the new government.

The coalition of the Conservatives and Liberal democrats set out this week to start measures that would slash public spending by 6 billion pounds from a budget deficit that has reached above 150 billion approximately 11% of GDP. However, there are already signs that the honeymoon is ending for the adjoining parties as there are rumblings over a proposed capital gains tax. If markets lose confidence that the government can push through the necessary legislation to rein in the deficit, then we could see additional sterling weakness. In his first major speech since taking office two weeks ago, on Friday David Cameron named cutting the budget deficit as one of the top priorities for the new administration as it will help restrain inflationary pressures and allow for interest rates to remain lower for an extended period.

The Prime Minister also stated that "We have seen a slightly worrying increase in inflation in recent months, so interest rates will be set to control inflation." The comments were viewed as a hint to the BoE to look to prevent further appreciation of prices. Indeed, the Organization for Economic Cooperation and Development recommended that the central bank hike rates sharply to prevent a rise in inflation and the damaging effect that it brings. Talk of future tightening could become a supporting factor if it leads to a rise in interest rate expectations. However, Governor King has dismissed the recent rise in consumer prices to 3.7% as policy makers continue to forecast that existing slack in the economy will bring rates back to their 2.0% target.

The economic docket will bring event risk in the form of the PMI manufacturing report as the sector has been the main driver of growth. Forecasts are for a slowdown in activity which could raise growth concerns and dim the prospect of a rate hike. Conversely, the service sector reading is expected to show improvement which could raise the hope that domestic growth is strengthening. The pound continues to see its correlation with equities increase as the BoE is expected to remain on hold, so its fate will most likely be tied to risk trends on the week. - JR

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[B]Canadian Dollar Looks to Fortify Strength with a Rate Hike and Growth[/B]

Fundamental Forecast for Canadian Dollar: Neutral

- Canadian Dollar stands to take over the Aussie dollar's old role with rate hikes and unmatched growth

- USDCAD may have breached a long-term trend; but a reversal pattern could stall its advance

It may not have been so easy to define the Canadian dollar's source of strength over the past year or so (hint: it is not a simple connection to crude oil); but we should have no trouble in determining where its next fundamental drive will come from over the coming week. On deck for the 'loonie' over the coming week are a critical Bank of Canada rate decision and the long overdue release of first quarter GDP. Given the consensus forecast for both events, the currency may find itself taking over the role that the Australian dollar has so clearly coveted since the global economic recovery took hold last year. If indeed the affair goes off as expected, the Canadian dollar may find itself with a growth advantage that no other major economy can match along with interest rate potential that is surely not yet fully priced in. On the other hand, it is clear that the market is already heavily biased on the outcome of these events. Disappointments would very likely illicit more of a reaction from currency traders than merely meeting bullish expectations. What's more, it should not be forgotten that the currency has already appreciated significantly alongside its commodity currency counterparts. Will this moderate further gains or swamp tangible fundamentals with current changes in sentiment?

For the traditional fundamental trader (who likes to see his or her potential driver ahead of time), the first thing to be concerned about its Monday's release of the first quarter growth report. We have already seen the first January and February monthly readings of economic activity; so we have a feeling for how the broader period may fair. And, given the relatively good performance over the first two months of the year, the 5.9 percent forecasted annualized pace of growth does not seem unreasonable. For context, this would be the fastest pace of growth in over 10-years and it would confirm speculation that the Canadian economy will outpace its global counterparts and is better positioned should there be a second slump in global activity levels going forward. This can prove a crucial source of strength for the currency because relative growth will rise in importance for long-term capital flows going forward. Economic activity is the backdrop of expected return on a nation's assets; and a performance of this magnitude coupled with the knowledge that Canada was able to weather recession and financial crisis much better than its peers these past years will no doubt peak investors interests.

However, for returns, growth is only one component of a benchmark. Interest rates are another factor. According to overnight index swaps from Credit Suisse, the market is pricing in a 68 percent probability that the BoC will hike on Tuesday. That is perhaps lowballing the potential given the hawkish turn the group has taken recently and the OECD's recommendations that it should start removing accommodation immediately. What's more, the forecast for nearly six quarter point interest rate hikes over the coming 12 months has recently been reduced to approximately four. With this decision, we will likely see forecasts take a dramatic turn for the better or worse depending on the outcome.

It is important to watch both of these scheduled events and evaluate their influence again the backdrop of risk appetite. As it stands, the Canadian dollar has a significant risk premium and relatively little fundamental swagger to back it up. The loonie does not have the yield that its Aussie and kiwi counterparts maintain. Growth is running hot; but so the US economy. To find the ability to further appreciate (especially in the face of risk aversion), the currency needs to establish a high level of safety and potential return. This would be a unique combination that no other economy can match (Australia is fading). Yet, should these fundamental highlights not come to fruition, it could prove the Canadian dollar's undoing. - JK

[B]Australian Dollar To Come Under Pressure as RBA Holds Cash Rate[/B]

The Australian dollar rallied to a high of 0.8548 during the final full week of May following a rebound in risk sentiment however, the market moving event risks scheduled for the first week of June is likely to stoke increased volatility in the exchange rate as investors weigh the outlook for the $1T economy.

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Fundamental Outlook for US Dollar: Bearish

- Westpac Leading Indicator Rises Most in Four Months

- Private Capital Expenditure Expectedly Declines in First Quarter

- Equities, Commodities and Currency Markets Concede to Risk Aversion and Deleveraging

The Australian dollar rallied to a high of 0.8548 during the final full week of May following a rebound in risk sentiment however, the market moving event risks scheduled for the first week of June is likely to stoke increased volatility in the exchange rate as investors weigh the outlook for the $1T economy. The Reserve Bank of Australia is widely expected to maintain a neutral policy stance next month as the interest rate returns to "average" levels, and the central bank may adopt a wait-and-see approach going forward as policy makers assess the impact of its recent rate hikes.

A Bloomberg News survey shows all of the 22 economists polled forecast the RBA to hold the cash rate steady at 4.50% in June after rising borrowing costs six times during the last seven meeting, while investors are pricing a zero percent change to a rate hike according to Credit Suisse overnight index swaps as the board sees "monetary policy well placed for the present. Moreover, the central bank said that the board "spent considerable time discussing the disturbances in financial markets" sparked by the European debt crisis, and argued that a case "could be made for a pause in the process of normalizing interest rates owing to the uncertainties in the euro-area." However, Governor Glenn Stevens maintained an improved outlook for growth and inflation and expects economic activity to "strengthen further over the next couple of years," and the central bank may look to raise the cash rate further in the second-half of the year as the isle-nation continues to benefit from the expansion in China, Australia's biggest trading partner.

Nevertheless, economic activity is forecasted to increase 0.6% in the first quarter following the 0.9% expansion during the last three-months of 2009, while company operating profits are projected to increase 3.0% during the same period, which would be the fastest pace of growth since the third-quarter of 2008. At the same time, business inventories are anticipated to rise for the third consecutive quarter, with market participants forecasting a 0.5% advance in stockpiles on unsold goods, and the rise in economic activity could benefit the Australian dollar as the outlook for future growth improves. - DS

[B]New Zealand Dollar to Face Whipsaw Price Amid External Fears[/B]

The New Zealand dollar extended last week's southern descent, ending the week slightly lower against the U.S. dollar and finishing as the fourth-worst major currency through Friday's close.

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Fundamental Forecast for Australian Dollar: Neutral

- New Zealand Posts First Annual Trade Surplus in Eight Years

- New Zealand Dollar Outlook Undermined by Downgraded Interest Rate Projects

The New Zealand dollar extended last week's southern descent, ending the week slightly lower against the U.S. dollar and finishing as the fourth-worst major currency through Friday's close. The economic docket in the high-yielding currency this past week was relatively light as the two year inflation expectation for the second quarter rose 2.8 percent from 2.7 percent the quarter prior. Meanwhile, trade surplus widened in April amid soaring commodity prices which kept exports near record levels, while imports of crude oil and machinery tumbled lower.

In the week ahead, NZD traders will turn their focus to business confidence, and the commodity price index. Thus, with a light economic calendar, the RBNZ rate decision on tap for June 9th, and the U.S. markets closed on Monday in observance of Memorial Day, we are likely to see whipsaw price action this coming week. Indeed, investors are pricing in a sixty six percent chance that policy makers will raise rates twenty five basis points at its next rate decision, according to the Credit Suisse Overnight Index swaps. At the same time, there is a slight possibility that we may see the central bank refrain from raising rates as the country is an external debater, making New Zealand defenseless against renewed fears of the European debt crisis.

On the other hand, though it seems unlikely in the short term, it is worth noting the possibility of an increase in Chinese interest rates in the medium term as local governments and banks have been the main factors hindering at a rise in rates. China is one of New Zealand's key trading partners, and in turn, a rise in borrowing costs from the world's second largest country will taper exports and growth in New Zealand. Nonetheless, the country's largest vulnerability is now its large and growing net external liabilities which are expected to increase over the next five years as government debt soars from 14 percent to 21 percent this year. In regards to price action, we have seen a lackluster performance this week in the NZDUSD as the pair trades in the congested area of 0.6868 - 0.6618. Going forward, we may see the pair test 0.6500 for support, with price action likely to be capped around 0.7000 as the pair recently managed to break below the 200-day SMA. - MW

[B]Gold to Rise if US Jobs Report Boosts Growth, Inflation Outlook[/B]

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Gold to Rise if US Jobs Report Boosts Growth, Inflation Outlook

Fundamental Forecast for Gold: Bullish

- Gold Prices Mute on Spain Downgrade Amid Draining Liquidity

- Fundamental Uncertainty Overrides Risk Trends, Pushes Gold Higher

Gold has shifted away from trading as a safe-haven asset toward behaving as an inflation hedge, with prices set to rise if May's US jobs report proves to boost risk sentiment despite headwinds in China and the EU.

The yellow metal's anti-risk credentials seem to have been eroded, with prices conspicuously little changed in the last two trading sessions of last week even as equities soared on Thursday and retreated Friday. Indeed, 20-day correlation studies between the metal and the MSCI World Stock Index show virtually no link at present compared with a hefty -0.8 inverse relationship a mere two weeks ago. Meanwhile, the correlation of gold to US breakeven rates - spreads between yields on regular and inflation-indexed US Treasuries that serve as a gauge of the markets' price growth expectations - has firmed significantly over the same period. This suggests that the yellow metal is once again trading as an inflation hedge, meaning it ought to decline if global economic growth expectations (and with them the spectrum of risky assets including stocks, commodities and carry trades) turn lower.

The coming week promises to be a decisive one for risk sentiment across financial markets. Friday's downgrade of Spain's credit rating by Fitch on the grounds that the country's debt burden will bring higher borrowing costs and undermine growth underscores the global implications of the EU fiasco for the global recovery at large. Taken together, the European Union amounts to the world's largest economy; if fiscally responsible EU members take it upon themselves to bail out the spendthrift ones (as is apparently the case), they too will accumulate a large amount of debt, the financing of which will indeed drive bond yields higher and weigh on growth across the region. With Europe thereby tethered and China actively pushing to slow its buoyant economy amid fears of asset bubbles and runaway inflation, this leaves the United States as the sole significant engine of growth left to drive the global recovery.

On balance, this puts the onus on the considerably busy US data docket, with natural emphasis on the Friday release of May's labor market figures. Expectations call for nonfarm payrolls to rise 508,000 - the largest increase in nearly thirteen years - while the unemployment rate declines to 9.8 percent. If this proves to reassure the markets that a firming US economy can shoulder the burden of dragging the world along the path to recovery even as China and EU put on the brakes, gold prices stand to gain along with a rebound in risky assets.