EUR/USD Pullback on Trichet, Fedspeaks ahead

Dollar staged a strong rebound last week, helped by ECB Trichet downplaying the chance of another rate hike from ECB after raising rates by 25bps to 4.25% on Thursday. But the biggest winner was indeed the Aussie which with respective crosses topping the top movers chart even though RBA was on hold and sounded slightly dovish. Also, the rebound in dollar is viewed as a profit taking correction ahead of a long weekend only. With data showing little evidence of a turnaround in the economy and with persistent strength in oil prices that made another record high above $145 a barrel, there is no change in the dollar bearish outlook yet. Looking a head, a number of Fed officials are scheduled to speak this week and should catch much attention from the markets. Other important events include BoE meeting, Canadian job report as well as Australian job report.

Currency Heat Map Weekly View

The labor market in US showed little sign of improvement. The highly anticipated Non-farm payroll report in Jun was close to consensus. Job markets continued to contract for the sixth consecutive months and gave up -62k jobs in Jun, close to expectation of -60k. Unemployment rate was unchanged at 5.5%. Jobless claims rose again to 404k. Employment component in ISM manufacturing index dropped sharply to 43.7. Employment component in ISM Services index dropped sharply to 43.8 in Jun. Both were deep in contraction region.

ISM manufacturing index finally recovered back to above 50 at 50.2 in Jun, signaling mild expansion and that the downturn in the economy is, at least, not worsening further. Price paid component surged to 91.5, confirming the underlying upstream inflationary pressure. However, ISM services missed expectation and dropped back into contraction reading of 48.2. Prices paid surged sharply from 77.0 to 84.5. US Chicago PMI climbed mildly to 49.6 in Jun, above consensus of a fall to 48.4 but remains below 50. Factory orders rose 0.6% in May, above expectation of 0.5%.

Euro was boosted early last week by stronger than expected inflation data but was sold off after ECB meeting. Jun CPI estimate saw consumer inflation surged to 4% yoy, doubling ECB’s target of 2%. PPI report showed producer inflation accelerated sharply from revised 6.2% to 7.1% in May, beating expectation of 6.7%.

ECB raised rate by 25bps to 4.25% as widely expected. However, Trichet said in the post meeting conference that the current monetary stance after last week’s rate hike is enough to achieve ECB’s objective of price stability and he has no bias now. The markets took that as a signal that today’s 25bps hike to 4.25%, was really a one off event and Euro was sold off on profit taking after rumor became news.

Data from Eurozone saw unemployment rate unchanged at 7.2% in May. PMI manufacturing was revised slightly up to 49.2. Services PMI in Eurozone dipped to contraction region of 49.1 too. Retail sales, though, unexpectedly rebound from at 1.2% mom, with yoy rate back to positive at 0.2%.Data from Germany were solid, with retail sales climbing 1.3% mom, 0.7% yoy, unemployment rate dropped slightly further to 7.85%, with -38k drop in unemployment count. German PMI manufacturing was also revised up to 52.6 in Jun.

Japanese Q2 Tankan survey showed confidence among businesses dropped to the lowest in almost five years. Big manufacturer confidence tumbled sharply from 11 to 5 in Q2 but was above consensus of 3. Non-Manufacturing confidence dropped from 12 to 10, also above consensus of 8. Q2 capex rose more than expected by 2.4%. Manufacturing PMI dropped from 47.7 to 46.5 in Jun. Housing starts dropped -6.5% yoy in May to 1.07M. Construction orders fell -25.2% in May. Leading indicators dropped -0.2% in May.

UK Gfk consumer confidence tumbled further from -29 to -34 in Jun, hitting the lowest level since 1990. Nationwide house price dropped by -0.8% mom, dragging yoy rate down to -6.3% yoy in Jun. UK PMI manufacturing index dived to 45.8 in Jun, hitting the lowest reading since Dec 2001. UK Services PMI hit lowest level in seven year at 47.1 in Jun. Construction PMI dropped to an 11 year low of 38.3 in Jun.

Swiss CPI was unchanged at 2.9% yoy in Jun. SVME PMI dropped to 54.9 in Jun

Canadian GDP beat expectation by rebounding 0.4% mom in Apr. Ivey PMI beat expectation by rising to 69.6 in Jun.

It was a volatile week for the Aussie but after all, it was the best overall performer. Aussie extends the pull back from new 25 year high made after RBA left rates unchanged at 7.25% as widely expected. More importantly, the accompanying statement sounded confident that "demand growth will be moderate this year," balancing the "concerning" inflation outlook. While inflation is likely to remain "relatively high" in short term on rises in global oil prices, it’s believed to decline over time. The statement suggests that interest rates will remain at a 12 year high of 7.25% for considerable period of time. Aussie was later boosted by stronger than expected retail sales report. sales jumped 0.7% mom in May, rebounding from prior -0.2% fall and beat expectation of 0.1%. The strength in consumer spending argues that prior tightening may not be enough to really slow demand and inflation. Trade balance turned deficit at -956M in May.

Suggested Readings:

• This Week’s Market Outlook
• Weekly Economic and Financial Commentary
• FX Briefing: ECB in Wait-and-See Mode
• The Weekly Bottom Line
• Australian & New Zealand Weekly
• Weekly Focus: A Summer Theme
• Coming Wave of Regulation and the Risk to the Dollar

ECB

• ECB Hikes and Keeps Options Open
• With Euro Zone GDP Growth Weakening, Economists View ECB’s July Hike as a One-Off
• ECB: Rate Hike but Remarkably Cautious
• ECB’s Trichet Cites Rising Risks to Stability as Reason for 25bp Rate Hike
• ECB Fires A Shot Across the Bow
• ECB Gives Little Sign Of Next Move Following Today’s Hike
• (ECB) Press Conference Introductory Statement 7 July 2008

The Week Ahead

The economic calendar of US is rather light this week. Nevertheless, markets will be busy listening to speeches from a number of Fed officials including Yellen on Monday and Thursday, Bernanke and Lacker on Tuesday. Bernanke and Treasury Paulson will also testify on markets before House Committee on Thursday. Other data from US include pending home sales, wholesale inventories, trade balance, import prices and U of Michigan consumer sentiments. Also, markets will look into Thursday’s jobless claim report to see if it will stay above 400k level.

Focus in the Eurozone will be on Germany industrial production, trade balances and Q1 GDP final. Trichet will speak on Wednesday and Thursday.

BoE is scheduled to meet this week and is widely expected to leave rates unchanged at 5.00%, will likely be a non-event. Economic data include industrial production on Monday, Nationwide consumer confidence on Tuesday and the May trade balance on Wednesday.

The bigger market mover could indeed be the job report from Australian and Canada this week.

Suggested Readings:

• Economic Calendar Summary 7/7 - 7/11
• The Week Ahead Canada and U.S.: Canadian Unemployment, Bernanke Speeches
• The Week Ahead Europe and UK: BOE Rate Decision, German Industrial Production
• The Week Ahead Japan & Australia: Australian Employment, Japanese CGPI
• Economic Outlook: Inflationary Pressure from Import Prices?
• Week Ahead In US Financial Markets (July 7-July 11 2008)
• NZDUSD Rally Should Be Sold
• $ Index, Have to Take What the Market Gives….
• FX Forecast Update: To Catch a Rising Tide

Q3 Outlook

• Euro 2008 Q3 Outlook
• Japanese Yen 2008 Q3 Outlook
• British Pound 2008 Q3 Outlook
• Swiss Franc 2008 Q3 Outlook
• Canadian Dollar 2008 Q3 Outlook
• Australian Dollar 2008 Q3 Outlook
• New Zealand Dollar 2008 Q3 Outlook

EUR/USD Weekly Outlook

EUR/USD’s rise from 1.5302 extended further to as high as 1.5908 last week but reversed sharply on profit taking since then. The break of 1.5843 resistance suggested that consolidation from 1.6019 has already completed at 1.5302 and rise from there represents resumption of the medium term up trend. Hence, the retreat from 1.5908, though steep, is still viewed as correction to rise from 1.5302 only and is expected to be contained by 1.5651 resistance turned support and bring another rally. Above 1.5776 will flip intraday bias back to the upside for 1.5908 first. Break will bring retest of 1.6019 record high. However, break of 1.5651 will dampen this view and turn outlook mixed.

In the bigger picture, a medium term top is in place at 1.6019 after meeting 1.6 psychological resistance. As mentioned before, break of 1.5843 indicates that such consolidation has likely completed at 1.5302 already. Further decisive break of 1.6019 will confirm this case and bring rise to 61.8% projection of 1.4309 to 1.6019 from 1.5284 at 1.6341 first. On the downside, however, below 1.5468 support will mix up the picture by firstly suggesting that rise from 1.5302 has completed. Secondly, it will revive the case that consolidation from 1.6019 is still in progress. Retest of 1.5302 support could be seen in such case.

In the longer term picture, there are various interpretations of the medium term up trend from 1.1639 but none of them is really convincing yet. Rather than focusing on the structure, we’d like to emphasize the pattern of a series of higher highs and higher lower since 1.1639 and as long as this pattern remains, the up trend from 1.1639 is more likely in progress than not. In other words, with 1.4309 medium term support still holds, rise from 1.1639 is still in progress. Such rally is treated as resumption of long term up trend from 0.8223 (00 low) to 1.3668 (04 high) and could still extend to 100% projection of 0.8223 to 1.3668 from 1.1639 at 1.7084, even prolonged medium term consolidation will take place before resumption. However, sustained break of this 1.4309 cluster support, which will also have 55 weeks EMA (now at 1.4816) taken out too, will argue that the whole up trend from 1.1639 has already completed and have medium term outlook turned bearish.

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Will the Swiss Franc Stumble, If The SNB Falls Behind The Curve?

The slowdown in the U.S. and a weakening European economy are beginning to weigh considerably on Swiss growth. Furthermore, inflation concerns continue to mount as energy and raw material costs reached record highs during the past quarter. Yet, despite the upward pressure of rising prices, the SNB has decided to leave their benchmark rate unchanged for the third quarter in a row, at a time when other central banks are expected to tighten monetary policy. Considering the fact that the Swiss monetary authorities only meet once every three months, the SNB may find itself behind the curve, and the low yielding currency could see its interest rate differential erode against other major currencies. Nevertheless, investors’ attitude toward risk may ultimately have the most influence on the currency much as it did during the past quarter with risk appetite ultimately giving way to risk aversion.

Which Way Will Risk Winds Blow?

The Swiss Franc has lost some of its status as a safe haven currency, but risk continues to be the main driver of the currency. The USDCHF started the quarter with a 90 bps jump as Lehman brothers was able to raise $4 billion dollars in convertible preferred stock. The investment bank’s ability to raise capital gave investors hope that the credit markets were improving as central banks supplied the necessary liquidity. However, risk appetite returned when Fed bailed out Bear Stearns and opened the discount window to investment banks. As a result USDCHF would ultimately rally 700 bps from its March 17th low, before peaking on May 8th at 1.0623. The prior quarter saw the Franc trade above the dollar for the first time ever. However, a near 700 point gain in the Dow mid April would send the safe haven currency below the dollar for the remainder of the quarter. Despite the fall, the Franc remains 15% higher than a year ago, as the country’s economy remained resilient and lingering effects from the subprime crisis has tempered risk appetite leading the pair to consolidate in the 1.0150-1.0550 range

Inflation Saps Consumer Spending Despite Strong Labor Market

The Swiss labor market has remained strong in the face of a slowing economy as the jobless rate has held at the lowest level in almost five years at 2.5%. In fact the latest SVME purchasing manger’s index actually showed an increase in the employment component as companies continue to hire. SNB officials have maintained that although they expect household consumption to moderate; it should remain relatively strong over the near-term around 1.9% before falling to 1.6% in 2009. The first two months of the quarter supported the central bank’s case as retail sales in February and March posted gains of 3.3% and 9.7% respectively, as rising wages fueled Swiss spending. However, April’s decline of 9.4% - the first in two years- shows that inflation has begun to erode consumer’s purchasing power. Indeed, the UBS consumption indicator has steadily declined through the period falling from 2.321 to 1.910. The gauge which is based on new car sales, retail sales and the number of overnight hotel stays by Swiss residents within the country is at its lowest level in 17 months. Consumers curbed spending as the growth outlook for the country dimmed reducing their purchases of leisure activities and clothing, which fell 24.5% and 24.7% respectively.

While spending slowed, prices accelerated at the fastest pace in 15 years in May at 2.9% on an annualized basis, rising 0.8% from April. The increase was the largest month to month gain since October 2007, led by rising energy costs. Indeed, heating oil prices rose 58% from a year ago, leading to a 6.0% increase in utilities. Still the majority of the price pressure emanated from outside the country as foreign goods prices rose 1.8% compared with 0.4% increase in domestic prices. The SNB and KOF have raised their inflation expectations for the year to 2.5% and 2.6% respectively, from previous estimates of below 2%. Inflation is expected to continue to weigh on consumers as the quarter saw oil prices reach as high as $140 per barrel. Meanwhile, the labor market is expected to weaken as banks hit by the subprime crisis continue to layoff workers and slowing exports may force manufacturers to do the same. Indeed, the SNB expects employment to fall to 0.5% by next March from 2.0% in June. Therefore, expect consumption to weaken, which may keep the SNB from raising rates in the medium term.

Are Slowing Demand and Rising Costs Too Much For Swiss Manufacturers to Bear?

Inflation is becoming a serious problem for producers as well with input prices rising 3.9% from a year ago. Energy and raw material costs have begun to squeeze margins as costs for petroleum rose 9.2% and metal prices increased 2.5% in May. Since Switzerland fulfills the majority of its raw material needs through imports it will continue to be at the mercy of rising global commodity prices. At the same time growth has slowed, evidenced by the SVME purchasing manger’s index declining three of the last four months. The index in May fell to 55.7 after a rebound in April to 56.7, on declines in output, purchases and backlog of orders. For the time being Swiss producers have been able to differentiate their products making them less sensitive to the current downturn in the global economy. However, the slowdown in the U.S. and Europe has already taken its toll as Swiss exports declined for a second month. Overall, the Swiss economy is losing momentum as its current economic expansion slowed to the weakest pace in 3 1/2 years as GDP rose a mere 0.3% in the first quarter. This has led to the State’s Secretariat’s office lowering its growth forecast for 2008 through the first quarter of 2009 to 1.5% from 1.9%. As the European economy shows more signs of slowing and the U.S. has yet to reach a bottom, demand for Swiss goods should weaken throughout the remainder of the year.

SNB Keeps Rates Unchanged As They See Inflation Transitory.

Given the slowdown in growth it is understandable why the Swiss National Bank left their benchmark interest rate unchanged at 2.75%. Prior to the meeting some market participants speculated that the SNB monetary policy committee would actually hike rates as inflation concerns mounted. Indeed, the statements following the release showed that the central bank increased their inflation expectations for the year from 2.0% to 2.7% as rising energy and food costs continue to filter throughout the economy. However, at present the SNB believes that inflationary pressures are temporary expecting price gauges to ease to 1.7% in 2009 and 1.3% in 2010.

EURCHF Range Bound

The calming of fears pertaining to the financial crisis saw the EURCHF appreciate over 700 points in the quarter. The pair would consolidate in the 1.600-1.6380 range for most of the period, as rising inflation and slowing growth in the region held the pair in check. Although, the ECB is expected to raise rates at its next meeting while the SNB left rates on hold, the pair has failed to exceed its quarterly high of 1.6376 set on May 19th. The return of risk aversion and weaker equity prices have pulled the pair lower heading into the second half of the year.

SNB Holds to Key to the Swissie in Q3

The end of the second quarter saw a flight to safety as the lingering effects of the subprime crisis brought several major banks under the scope. The reemergence of risk aversion will increase the attractiveness of the safe haven Swiss Franc, as traders unwind riskier positions. However, the Swiss economy is also feeling the pain of the current financial crisis, as Swiss banks find themselves at the center of the storm. UBS recently removed four board members as the bank faces an investigation by the U.S. department of Justice concerning alleged U.S. tax evaders. Additionally, the continued downturn in the U.S. and the emerging slowdown in Europe will lead to a significant reduction in demand for Swiss goods and the continued weakening of the manufacturing sector. Oil reaching as high as $140 a barrel will continue to squeeze profit margins and weigh on domestic and global consumer demand. If inflation risks continue to mount, then the SNB’s failure to take preventive measures may prove detrimental for the Swiss economy. However, if the central bank is correct in its assessment that inflation is transitory then the Swiss economy may emerge as the strongest of the G10. Ultimately, risk sentiment will determine the direction of the USDCHF over the next quarter and as long as concerns remain regarding the financial crises the Franc will remain supported. However, the declining prospects for the economy, slowing domestic demand and the potential increase in interest rate differential may leave the pair range bound for the medium term especially if global economic growth slows but does not collapse altogether

USD/CHF Technical Outlook

A new low (below .9647) is expected in the USDCHF. Similar to the EURUSD (but in the inverse), the rally from .9647 was in just 3 waves (see inset). Since we know that 3 wave movements are countertrend, we know that the USDCHF downtrend is not complete. A drop below .9647 would complete 5 waves from 1.3285 and give way to a bottom and reversal. Until then, there is no reason to call a bottom because there is no evidence of a bottom. A bearish bias is warranted against 1.0624.

DailyFX

Disclaimer

Investment in the currency exchange is highly speculative and should only be done with risk capital. Prices rise and fall and past performance is no assurance of future performance. This website is an information site only. Accordingly we make no warranties or guarantees in respect of the content. The publications herein do not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should obtain individual financial advice based on their own particular circumstances before making an investment decision on the basis of the recommendations in this website. While we try to ensure that all of the information provided on this website is kept up-to-date and accurate we accept no responsibility for any use made of the information provided. All intellectual property rights are the property of Daily FX. Daily FX and its affiliates, will not be held responsible for the reliability or accuracy of the information available on this site. The content herein is provided in good faith and believed to be accurate, however, there are no explicit or implicit warranties of accuracy or timeliness made by Daily FX or its affiliates. The reader agrees not to hold Daily FX or any of its affiliates liable for decisions that are based on information from this website. Daily FX highly recommends that before making a decision, the reader collects several opinions related to the decision and verifies facts from at least several independent sources.

The Japanese Yen saw a clear reversal of fortunes in the second quarter, as the previous darling of tumultuous financial markets lost ground when global turmoil began to ease. The low-yielding currency had previously rallied strongly on what was a clear de-leveraging across risky asset classes, but a return to risk appetite allowed forex traders to cautiously re-enter historically profitable carry trades. In Q2 of 2008 financial market conditions made the Japanese Yen trade almost completely correlated to the movements in the Nikkei 225 and US Dow Jones Industrials Average - leaving domestic economic developments relatively unnoticed through recent trading. Indeed, Japanese Yen traders remain almost oblivious to fundamental data out of the world’s second-largest economy, and such a trend will likely continue into the third quarter. The outlook for the yen will thus depend almost exclusively on the outlook for the broader global financial markets.

Risk Appetite will Drive the Japanese Yen in the Second Half of 2008

Whether or not the carry trade can continue to recover arguably remains the most important question in our outlook for the Japanese Yen. Given exceedingly low domestic interest rates, investors will often sell Japanese Yen to buy higher-yielding counterparts and collect the rate differential. These typically highly-leveraged trades will work best when the Yen remains stable or actually depreciates versus said counterparts; if the Yen appreciates rapidly, capital losses in said trades will far outweigh the interest rate payments collected through the short term. The combination of leverage and aversion to sharp price moves makes the JPY-funded carry trade especially sensitive to market risk appetite; a sudden jump in risk aversion will typically force traders to liquidate short positions in the Japanese Yen. In the graph below we see the clear effect of market volatility on the Yen: the JPY has moved nearly in lockstep with our DailyFX Currency Volatility Index. Thus we see reasons why the Japanese Yen, and by extension the carry trade, remain very highly sensitive to broader market risk appetite.

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What Can we Expect out of Risk Appetite and the Carry Trade?

Market conditions can change in an instant, but it seems as though elevated risk aversion and general financial market duress may be here to stay for the foreseeable future. Already we see that major world equity markets - bellwethers for investor optimism - have almost uniformly fallen through the second quarter of the year. What started as an upheaval in US mortgage market has ballooned into a worldwide credit market crunch, and few global financial centers have been left untouched. Various credit indicators actually improved through the second quarter of the year, but a more recent deterioration could actually signal continued duress in global markets. Credit Default Swaps, the cost of protection against default in various debt instruments, fell consistently through mid-May after peaking in March. More recently, we see that the Dow Jones CDS Index has risen significantly from May lows, and the global investors are paying more and more to protect themselves against credit risk across a broad swath of corporate debt instruments. Given system-wide fears of credit default, it seems unlikely that risk appetite can make a significant comeback through the foreseeable future.

Options traders have likewise positioned themselves for further market duress, and demand for Japanese Yen Call options (USDJPY Puts) has dominated trading. A long-term DailyFX study of USDJPY options shows that the Japanese Yen tends to appreciate rapidly when Risk Reversals - the difference between prices paid for out of the money Puts and Calls - fall below -2 percentage points. Options prices did just that at the beginning of the carry trade unwind when the USDJPY traded at 120 and have not turned back since. A look at futures positioning from the CFTC’s Commitment of Traders report shows a similar story in regards to the yen.

Net positioning has unsurprisingly grown more bearish against the Japanese Yen (bullish the USDJPY) through the past quarter of clear depreciation, but increased complacency could nonetheless signal the start of a fresh Japanese Yen rally. When the entire market begins to lean towards the same side of a trade, there is relatively little scope for further price moves in that direction. We saw this dynamic play out many times through the past several years of yen price action, with extreme JPY-short positioning (USDJPY long) preceding impressive yen appreciation. The most recent example of said dynamic came in December, 2007, when net USDJPY positioning rose just below net-long territory. Given a strongly bearish overall trend, the buildup in USDJPY longs provided plenty of fodder for a subsequent unwind and USDJPY tumble. Of course, there may be certain fundamental hurdles in the way of sharp JPY appreciation.

Bank of Japan one of the few central banks not overly worried about inflation

The Japanese Yen has historically weakened on a clearly disadvantageous yield differential against major counterparts, and a relatively bearish outlook on rates may signal further losses through the medium term. The Bank of Japan currently boasts the lowest short-term interest rate target of any major world central bank, and a relatively benign outlook for domestic inflation will likely give it room to keep interest rates low for quite some time. Unlike many other world economies, Japan’s yearly inflation rate rests midway within the central bank’s target range. Sky-high global energy prices likewise have comparatively less scope to force significant price gains in Japan; its economy is one of the least energy-dependent of the industrialized world when adjusted per unit of Gross Domestic Product. It is subsequently little surprise to note that markets have priced in practically zero interest rate hikes from the Bank of Japan through the months ahead.

According to Overnight Index Swaps, markets predict that the BoJ will raise its overnight rate by a cumulative 29 basis points through the second half of 2009 - a number that pales in comparison to 95bp from the US Federal Reserve and 68 from the European Central Bank. A widening interest rate differential leaves the yen at a further disadvantage against higher-yielding counterparts, and such pressures could lead to further JPY weakness. Already we see that the New Zealand dollar has consistently underperformed on the basis of interest rate expectations. Indeed, the Reserve Bank of New Zealand doomed the Kiwi to swift declines when it explicitly said that it looked to cut interest rates sooner than previously anticipated through the coming months. Overnight Index Swaps now show forecasts of a whopping 125 basis points in interest rate cuts from the NZ central bank, and the New Zealand dollar has traded lower as a result.

It will be important to watch the outlook for the Japanese economy as it relates to the future of domestic interest rates. Though somewhat unlikely, we could see inflationary pressures rapidly accelerate and derail price stability. Such a dynamic would force the Bank of Japan’s hand and bring higher interest rates to the low-yielding yen, but we must likewise keep in mind that the BoJ will likely be slow to move except in the direst of circumstances. Given a fairly recent 7-year period of deflation, Japan is only now seeing CPI changes in positive territory. It can subsequently be argued that the current spike in headline CPI may not translate into a sustained rise in inflation expectations, as a generation of year-over-year price decreases remains ingrained in the psyche of the domestic consumer. Furthermore, the Bank of Japan will be especially reticent to constrain monetary policy in the face of anemic domestic household spending. According to government statisticians, Household Spending has fallen 3.2 percent on a year-over-year basis through May - it’s worst showing in nearly two years. Given these factors, one could easily argue that the Bank of Japan will be slower to raise interest rates than other major central banks. Therefore the Japanese Yen will remain at a continued yield disadvantage against its higher-yielding counterparts.

EURJPY Could Continue to Rise on Hawkish European Central Bank Rate Outlook (To be revised post-ECB)

Relatively clear expectations for European Central Bank interest rate hikes have significantly boosted the euro’s implied yield advantage against the yen, and the EURJPY has scaled fresh record-highs on the clearly bullish developments. Whether the euro may continue to gain will likely depend on whether the ECB decides to follow through on aggressive market forecasts for the future of the European yield curve; official rhetoric to date has not made it exactly clear that the central bank will raise rates as high as market yields imply. It will be very important to monitor official ECB statements as it relates to the future of domestic yields, as it seems that risks arguably remain to the downside on any disappointments. The same risk sentiment-based pressures that affect the USDJPY likewise threaten to derail EURJPY; any significant flare-up in market turmoil could cause dramatic EURJPY tumbles. Given that the EURJPY fell nearly 1400 pips in just 30 days through the beginning of the subprime crisis, one could easily imagine similar episodes on a recurrence of worldwide financial panic.

What to watch for in the Third Quarter for the Japanese Yen

Whether or not the Japanese Yen will continue its second quarter decline will almost exclusively depend on outlook for global financial markets, but currency traders will likewise place weight on relevant interest rate outlooks for Japan and other major economies. We saw the Japanese Yen strengthen significantly through the second half of 2007 and the first quarter of 2008 on clear financial market turmoil, but broad improvements in market conditions made the low-yielder the worst performing G10 currency since April. Yet it remains clear that financial markets may not be out of the woods just yet; several key indicators signal persistently low risk appetite across important asset classes. Such a dynamic translates into strong demand for protection against Japanese Yen appreciation; given fears of rapid JPY gains, options traders have kept USDJPY Puts very well bid. All in all, we would argue that risks remain to the upside for the Japanese Yen (downside for USDJPY) through the second quarter, but a number of factors make our JPY outlook far from certain and much will depend on similarly indecisive global markets.

USD/JPY Technical Outlook

By Jamie Saettele

There is no change to the longer term call for a drop to below 80 but the count from the 124.13 top has changed. The preferred count treats the decline from 124.13 is a leading diagonal. Under this count (and given near term weakness), the entire advance from 95.72 could be a completed wave 2. If so, then wave 3 down is in its early stages. However, it is more likely that the rally from 95.72 completed just wave a of 2. Leading diagonals are typically followed by deep retracements - often as deep as 78.6% of the move. A 78.6% retracement would place a wave 2 top near 118.00. Just a 61.8% retracement places a wave 2 top at 113.30. The expected path of the USDJPY is shown on the chart (down in wave b of 2, then higher and into a top in wave c of 2). The alternate treats the drop from 124.13-95.72 as a W-X-Y decline (7 waves, which is corrective). However, it is not clear where this fits in the larger pattern (take a look at the monthly, and it is quite clear that the USDJPY has broken from a 4th wave bearish triangle).

DailyFX

Disclaimer

Investment in the currency exchange is highly speculative and should only be done with risk capital. Prices rise and fall and past performance is no assurance of future performance. This website is an information site only. Accordingly we make no warranties or guarantees in respect of the content. The publications herein do not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should obtain individual financial advice based on their own particular circumstances before making an investment decision on the basis of the recommendations in this website. While we try to ensure that all of the information provided on this website is kept up-to-date and accurate we accept no responsibility for any use made of the information provided. All intellectual property rights are the property of Daily FX. Daily FX and its affiliates, will not be held responsible for the reliability or accuracy of the information available on this site. The content herein is provided in good faith and believed to be accurate, however, there are no explicit or implicit warranties of accuracy or timeliness made by Daily FX or its affiliates. The reader agrees not to hold Daily FX or any of its affiliates liable for decisions that are based on information from this website. Daily FX highly recommends that before making a decision, the reader collects several opinions related to the decision and verifies facts from at least several independent sources.

Following a rapid appreciation amid the subprime-fueled dollar selloff, the Canadian dollar settled into a range against its US counterpart, oscillating around parity between 1.0360 and 0.9740. This is not surprising given that nearly 80% of Canadian exports are destined for the US market, making Canada highly sensitive to the slowdown in the States. Canadian firms saw growth in export volumes tumble nearly 215% from their 2007 high in March to reach the lowest readings in 6 years by December. Output followed suit, with the pace of GDP growth slowing by over 35% in the final two quarters of 2007. The Bank of Canada followed closely after the US Federal Reserve to cut borrowing costs as the economy sagged (see Figure 1). The symmetry in the impact of the US crisis on both North American economies and the resulting symmetry in monetary policy have locked USDCAD in place.

Canadian Exports Will Continue to Suffer in 2008

On the face of it, matters began to improve in the first quarter of this year. Headline export metrics bounced back smartly, posting a cautious expansion of 0.2% in the year to February after a -10.7% contraction in December. Given such readings, one would suspect the economy is on the come-back trail. And yet, things are not as rosy as they seem: annualized first-quarter GDP growth fell to just 0.8%, the lowest since 2001. Surely, an improvement in exports is supposed act positively on the overall trade balance thereby elevating GDP higher, so why the doom and gloom?

Evidence suggests the headline exports figure is misleading, inflated higher by the break-neck oil rally. Specifically, the price of crude added another 26.5% from peak to trough in the first quarter. Canada is the premier supplier of oil to the United States: petroleum products account for a whopping 24.2% of all Canadian exports to its Southern neighbor. A casual look at the trajectory of Canadian exports to the United States vis-à-vis the price of crude reveals a relationship apparent to the naked eye (see Figure 2). Removing oil and automotive goods (to filter out unwanted distortions from a strike at a US auto parts producer that disrupted shipments) reveals that the trajectory of core exports is decidedly downward (see Figure 3). Therefore, the come-back in export growth is accounted for by rising crude prices rather than an actual increase in the volume of goods shipped across the border. With little to suggest that the US consumer will return in force any time soon, Canadian exports and by extension the economy itself will continue to struggle.

BOC Rate Cuts End Abruptly, Policy Following the US Fed

The BOC followed the Federal Reserve’s shift of policy away from deteriorating growth to inflation stoked by booming oil and food prices. For his part, Fed Chairman Ben Bernanke ended monetary easing in June citing that the “latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.” He added that "[the Fed] will strongly resist an erosion of longer-term inflation expectations, as an un-anchoring of those expectations would be destabilizing for growth as well as for inflation." The BOC’s Mark Carney followed suit, surprising the markets on June 10th by opting to forego the expected rate cut and changing the accompanying rhetoric to project a decidedly hawkish tone. The bank noted that “many” of the previously feared risks to growth have moderated in recent months and revised GDP projections upward in both 2008 and 2009. Meanwhile, Carney warned that inflation could reach 3% this year assuming energy prices persist at current levels. The statement concluded that the current policy rate was “appropriately accommodative”, suggesting rate cuts were over for the time being.

Oil Will Cause USDCAD To Break Above The Current Range

The above analysis of trade and monetary policy trends suggests little will change in the underlying fundamentals driving USDCAD. Poor performance in the export sector will continue to drag down the Canadian economy along with that of the US. A static yield gap lends further credence to the persistence of a range bound scenario. Even so, there is compelling evidence that these forces will take a back seat to another catalyst - the end of the oil rally.

All signs point to the conclusion that the fundamentals of crude production and consumption are not behind the current rise in prices. Rather, the current rally is primarily driven by speculative bets against the US dollar. As stocks fell to risk aversion and the US dollar tumbled, traders were desperate for a refuge destination to protect their assets. Blossoming demand for commodity imports from emerging markets such as India and China offered a rare positive story in an otherwise shaken marketplace, attracting huge inflows of speculative capital and leading prices to balloon higher. A report from the Organization of the Petroleum Exporting Countries (OPEC) was explicit in saying that “the falling value of the US dollar has encouraged inflows of new money into the crude oil futures market…Crude oil prices have become detached from the dynamics of supply and demand fundamentals, since, in spite of the persistent price rises, the market remains well-supplied with crude.” In point of fact, the inverse correlation between the rate of change in the dollar index and that of the price of oil is at the highest in over a decade.

With economic slowdown spreading globally, it is reasonable to think that traders will shift focus from looking for places where the crisis isn’t to those where it will end first. The proactive monetary and fiscal response to current issues on the part of American authorities makes it likely the US will lead the recovery while other countries lag behind. Further, US Treasuries will be bought as a standby safe-haven asset in a global decline scenario, prompting an inflow of capital into US debt markets. The absence of further interest rate cuts (and possibly even a rate hike) will bolster the greenback’s strength via a re-alignment of yield gap expectations. These factors will prompt investors to buy dollars, with the subsequent appreciation in and of itself depressing oil prices as the dollar regains purchasing power.

USDCAD will push higher as the rally in oil prices reverses. Historically, the Canadian dollar has been highly correlated with crude, seeing the two tracking each other with over 80% precision. The relationship has been particularly notable in the USDCAD pair because the global price of oil is denominated in US dollars. If the Canadian dollar is over 80% correlated with the price of crude, then one would reckon that an appreciation in oil would see an analogous depreciation in USDCAD over 80% of the time. This correlation has been weak of late as oil made outsized leaps to record levels. However, history teaches that similar divergences in the recent past have been followed by sharp corrections (see Figure 4). As the markets return to buy the dollar, the appreciation will blow the speculative froth off crude and send USDCAD higher as oil drops. This will realign the current divergence, making for a lucrative trading opportunity.

Canadian Dollar Trend Depends upon Oil vs. Growth

Canada’s export sector has been badly hurt by slowing demand in the United States. This has dragged down overall GDP growth, suggesting the close trade relationship will see the two North American economies rise and fall together. The Canadian dollar has faithfully reproduced the pattern, oscillating in a narrow range against its US counterpart since December. Ranging conditions have been reinforced by the Bank of Canada’s emulation of the US Fed’s monetary policy, leaving interest rate expectations at a standstill.

Although headline export figures improved in the first quarter, the increase is rooted in rising oil prices rather than recovering US demand. In fact, there has been no substantial evidence suggesting any forthcoming changes in the trade or monetary policy dynamic.

While this ought to point to a continuation of range-bound trading, we see USDCAD break higher driven by a correction in the recent breakdown of the pair’s historic correlation with the price of oil.

The current rally in crude prices has been primarily driven by speculative bets against the US dollar. We see investors re-appraise the greenback in the coming quarter as hopes that the world economy will decouple from that of the United States are finally abandoned in favor of a widely accepted global slowdown scenario. In this instance, US assets will be bought as a safe-haven investment vehicle, with the subsequent dollar appreciation driving USDCAD higher as oil drops from its record highs.

USD/CAD Technical Outlook

The USDCAD should higher in a C wave from .9710. The structure of the rally from .9055 has cleared up. A triangle is unfolding as an X wave (triangles can only occur as B waves, 4th waves, or X waves), indicating that the next move is higher in wave Y. A target for wave Y is 1.0800/50. 1.0866 is the 8/16 high, 1.0849 is the 61.8% extension of wave W (extended from 1.0047, which is presumed to be the end of the triangle as of now) and 1.0798 is the 61.8% retracement of 1.1875-.9055. The rally to 1.08 will complete a correction from .9055 (since the advance will be in just 3 waves) and likely lead to a new low (below .9055) to complete the entire drop from near 1.60.

DailyFX

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