Forex - The Week Ahead

(N.B.: Monday May 31 is a holiday in the UK and US. Market liquidity is likely to be lower and volatility may be higher as a consequence.)

Risk sentiment and markets stabilizing; rebound potential

Global stock markets appeared to stabilize in the past week on signs that the recent sell-off was extreme and that the global recovery was continuing. The MSCI World index managed to rebound slightly after falling to new lows for the decline, generating a sizeable 'hammer' pattern on weekly candlestick charts, a potential bullish reversal indicator. The S&P 500 also saw a sharp rebound from the significant 1040/45 level, potentially putting in a key price low. Other risk assets recovered more convincingly, such as the CRB commodity index, which held the prior week's lows and closed up about 1.5%. US Treasury yields also gained on the week in another sign that demand for safe haven assets was beginning to ebb. In currencies, the JPY-crosses (e.g. AUD/JPY, CAD/JPY) mostly held above recent lows and posted gains for the week, the exception being EUR/JPY. Gold prices also saw some bounce after a week of vicious liquidations and regained the $1200 level.

We think there is further potential for risk assets to recover in coming weeks, though there are certainly many different headwinds. Overall, the credit crisis in Europe appears to be receding, with some slight declines toward the end of the week in sovereign debt credit default swaps (CDS), a measure of the risk of default. To be sure, concerns over the health of European private sector banks remain, and this is the most likely source of further risk aversion in the near-term. But as long as credit markets continue to calm down, investors desperate for returns are most likely to return and buoy risk assets. We think it's significant that Chinese officials immediately squelched speculation they were abandoning Europe and suggests intense global coordination to stem the latest financial sector crisis. Also, as a contrarian indicator, investors holding bearish outlooks over the next six months outnumbered bullish views by 21%, the highest split since Nov. 2009. We would also look at the likely capitulation of two weeks ago as significant turning point. In currencies, we would look for opportunities to buy JPY-crosses on weakness and remain diligent in protecting and taking profits on gains in light of the many potential potholes out there.

Spanish downgrade latest threat to EUR

Just when you thought it was safe to go back in the risk waters, Fitch comes out and downgrades Spain from AAA to AA+ after the European close on Friday. EUR/USD responded by dropping a quick 80-90 points, but then stabilized in a holiday-thinned NY market around 1.2300. The downgrade was not unexpected, coming one month to the day after S&P cut its Spain sovereign debt rating. Fitch indicated that Spain's rating outlook was now 'stable.' While certainly a reminder of the hazards of calling for a rebound in the EUR, the ratings action may not be a lead balloon either. Back on April 27, S&P surprised with a downgrade to Portugal's sovereign credit rating, sending EUR/USD from around 1.3500 to a low near 1.3150. On the following day, S&P announced a cut to Spain, and EUR/USD made minor new lows, only to rebound over the next few days to 1.3350 into the end of the month.

Next week will see month-end, followed by the start of a new month and new asset allocation flows. We are monitoring a potential 'double bottom' formation in EUR/USD at 1.2140/50 and immediate trend line resistance at 1.2420/40 area. (The 'neckline' for the double bottom pattern is at 1.2680 and, if broken, suggests a measured move objective to about 1.3200.) Markets will have a long weekend to fret about the plight of Europe and the fate of the EUR, and we should see a fuller reaction in FX to start the week. If the Euro is able to shrug off the Spanish downgrade and hold above recent lows, it will be the proverbial 'dog that didn't bark' and may signal a larger rebound in both EUR and risk overall. If 1.2140/50 breaks on a daily closing basis, or if 1.2090 is traded at any time, a fresh wave lower in EUR is likely underway.

Easing of tensions bodes well for the EUR

While risk indicators such as Libor and the Vix remain elevated, conditions in the markets have clearly been less tense in the second half of this week. The better tone in markets begs the question as to whether corrections in markets such as oil and stocks is complete or whether only a temporary base has been reached. On the whole US economic data has been fairly encouraging. This week the Bundesbank reported that the pace of the German economic recovery increased in Q2; its exporters likely benefiting from the softer EUR. The perception that the global economic recovery remains on track may encourage a continuation of the short-squeeze in the EUR in the near-term. That said there is still the potential for bad news particularly relating to levels of debt in the Eurozone and whether or not some holders of debt are facing haircuts. News from the Spanish regulator that it has tightened its rules for banks' provisions against bad loans will help shore up confidence in Spain's banking sector over the longer-term. However, in the near term is may bring forward the shake out of the banks most heavily exposed to the Spain's crumbling property market. Last weekend brought news of the failure of the small savings bank Cajasur. This bank is too small to be significant in itself but does suggest there may be more bad news over the next couple of months. Coming on the back of continued concerns that Greek debt will have to be restructured sooner or later and given simmering worries over the tangible increase in sovereign default risk in Portugal, Italy and Ireland over the past year or so, respite for the EUR could prove to be short-lived. A move to the long-term average of USD1.18 and below in a 1 to 3 mth view is likely.

EUR/GBP still sitting above key support

Choppy trading in cable this week has been emphasized by speculation regarding large M&A flows. This may continue into the new week although a squeeze higher in EUR/USD may allow cable to win back some ground. A squeeze in the EUR may also strengthen the resolve of the EUR/GBP 0.8400 technical support. That said, the government has underpinned its resolve to tackle the budget deficit and further indications in this direction ahead of the June 22 budget should win back further confidence in the pound suggesting a significant break lower for EUR/GBP may be brewing.