This is a week charged with major economic announcements leaving FX traders with two stark choices: make sense of abundant information or stay out of the market until the trend becomes a bit more clear. What follows is our attempt at making sense of what is going on with the USD relative to the euro and sterling.
As important as Non-Farm Payrolls is, we are focused more on mood shifts in EURUSD. There is consensus about the need of the USD to weaken as a reflection of its fiscal outlook and loose monetary policy. There is also consensus that in times of risk aversion, the USD strengthens. Beyond these two broad themes, there is much less clarity.
Risk aversion these days comes up when the US or global recovery appears to stall or when potential disruption in crude oil supplies becomes a distinct possibility. Risk aversion has been declining, however, due to the resilient rally in global equity markets and the steady flow of economic signals that the economies on both sides of the Atlantic are bottoming out.
Our view for what we see in the market can be summarized as follows: At the start of the week the euro appears to have shrugged off Merkel's reelection victory but the European market is not yet open. The key level for EURUSD to test is the 1.45 big figure - we believe it will hold it. We are not sure whether that test will happen early or later in the week. Once EURUSD holds 1.45, we believe the better European fundamentals will continue to prevail for the foreseeable future.
Why does an electoral victory for German Chancellor Merkel mean to the euro? Not much in the short term, but quite a bit in the medium to long term. This election was about having the correct coalition to carry out market-friendly reforms in Germany. The victory of a center-right coalition at the heart of Europe is ironic given the center-left victory in the US that brought Obama to power. Although we don't expect tax cuts (a big Merkel campaign promise) to go into effect anytime soon, it does open the prospect that the business-friendly initiatives of Germany will be followed elsewhere in the continent rendering the euro zone more competitive.
Why will the euro ultimately prevail against the US dollar? We don't buy into the rhetoric that the US dollar doom is imminent. We think that currency markets are pricing in dollar weakness in a measured way. As long as it is measured, there is no reason why Fed Chief Bernanke or ECB President Trichet should object, even if EURUSD reaches 1.60 by year's end.
Something has to be said about unmistakable messages from key central banks, because they have the potential of making the euro to rally too quickly. Twice over the past year the Swiss Central Bank intervened in the markets to warn that the swissie had strengthened too much relative to the euro. Last week, Bank of England Governor King telegraphed its satisfaction with sterling weakness. So, although the ECB, BOE, and Swiss central banks have similar monetary policies, the message from euro-zone neighbors appears to be: sell my currency, buy the euro.
Meanwhile, the US Fed continues to stand by its strong dollar policy. Some may perceive that the Fed is trying to strengthen the greenback. More likely, the Fed and the US Treasury officials are trying to keep the USD from falling too fast - i.e., trying to avoid the loss of confidence on US assets.
Nevertheless, as the global economy bottoms out, investors naturally have to move their funds from US government paper (often selling USD in the process) to diversify their holdings. What goes into ultra-safe investments at some point has to come out. Some, however, mistakenly take the selling of US government paper and US dollars as a show of no confidence on the United States. What matters most is the speed at which this transition takes place. Nothing in the horizon points to a sudden exit of US assets.
There are potential surprises.
#1. Trichet speaks on Monday before the EU Parliament. What a interesting scenario would take place if Trichet were to say something that gives the perception that a strong euro would be hurtful to the euro zone - like Governor King did last week. In that scenario, we would have the USD and the yen rallying in a big way. Our intuition tells us that Trichet does not have at this point enough worry in his mind to spook the market that way, but he might in coming months.
#2. US-Iran meeting on Thursday in Geneva. For the first time in more than 30 years, the US and Iran will hold direct talks. This Thursday the two parties meet in Geneva as a follow up to UN meetings last week where Iran came off on the wrong foot after revealing the existence of a new nuclear plant in a highly militarized zone. The US will demand an unrestricted UN visit of the facility within weeks. Under UN rules for non-proliferation signatories (Iran is one of them), such visit is authorized. The surprise for capital markets is what happens if Iran refuses the visits. Slowly, Iran and the West are moving toward military confrontation or to a pre-emptive attack of Israel on Iran. If Iran continues its hard stance this week, watch for risk aversion to increase and the US dollar to rise.
#3. Bad US economic indicators. US economic indicators, particularly labor figures, are expected to improve. If the numbers were to be very bad, some might expect the USD to suffer. We believe the contrary. Bad US numbers are likely to result in higher risk aversion and stronger interest in US assets. With the recent fall in the USD, Treasury instruments are more attractive than their current yield because they now offer a potential appreciation of the USD.
What specific levels are we watching?
As we mentioned, on the downside we are looking for EURUSD support near 1.4500. There are multiple reasons why we think this is the key level. Our proprietary FMV (fundamental market value) indicator for EURUSD gives us a support price of 1.4530. The FMV line has been EURUSD supportive for most of the past 2.5 months. The FMV line is an indicator that uses fundamental inputs (like CPI, GDP, interest rate differentials) to determine overbought/oversold situations for specific currency pairs.
Another reason for the 1.4500 level is that the 200 moving average line for the 4H chart is near the 1.4480 level. So far, the 50 MA and 100 MA have been challenged and pierced since Friday.
If EURUSD were to be temporarily breached, we see a potential target at 1.4400 but have a real hard time seeing it go beyond that point. Most likely, EURUSD holds 1.45 and that becomes a good point to buy the euro with a 1.4700 target.
For GBPUSD, the FMV for this pair is showing a resistance line at 1.6415, well above the actual GBPUSD value near 1.5800. If GBPUSD does not mount a rally near support at 1.5650, then there is little that would keep it away from 1.5300.
Interesting pairs to watch are EURGBP where the bias is to move towards parity in a few weeks and EURCHF, where fundamental forces are driving EURCHF to test an important support level near 1.5000. We are shorting EURCHF (initial target 1.4850) on fundamental reasons and on what we perceive as more difficulty on the part of the Swiss Central Bank holding back fundamental demand of its currency.