• USD advance continues

• GBP falls into the abyss

• Risk appetite returns after more bad news from sub-prime

• What’s wrong with this picture?

The USD continued to firm against other major currencies this week, even as more sub-prime related losses were announced by major US investment banks. The USD’s gains are as much the result of other currencies being marked down on lower growth and interest rate outlooks as they are short-covering of excessive USD short positioning. Riskier assets, as indicated by JPY-crosses and equities, managed to stage a rebound at the end of the week, largely on the back of news that Merrill Lynch will receive a $5 bio investment from Singapore’s sovereign wealth fund, Temasek Holdings. The news comes just one day after analysts at another investment house suggested Merrill would need to write down an additional $8 bio on sub-prime tainted securities.

Other major Wall Street firms announced stunning losses this past week, but the negativity was tempered by simultaneous announcements of significant capital infusions from other Asian investors. The short-term feeling is that the acknowledgment of losses represents some light at the end of the sub-prime tunnel. And the ready access to fresh capital went further to allaying the capital adequacy fears that have been hanging over some of the largest financial firms since autumn. But I suspect that glimmer of light at the end of the tunnel is more likely an oncoming locomotive rather than the sunny transparency of a new day.

The main reason is that the plight of bond insurers took a turn for the worse, as ratings agencies cut one ‘monoline’ to ‘junk-bond’ status and others had their outlooks revised to negative. Investment banks were reported to be in talks to bail out the smaller, now-junk-level bond insurer ACA, which has insured significant amount of impaired debt on the books of those same investment banks. That’s comparable to investing the proceeds of a life insurance policy in the insurance company that underwrote your policy in the first place, bringing new meaning to the term shell-game. Most compellingly the announcements by other ‘monolines’ that more sub-prime debt than previously acknowledged is covered by them suggests the situation is going to get worse, not better. If and when the bond insurers have their ratings reduced, the securities that they have insured will also see their ratings cut, which is likely to unleash another wave of forced debt sales. But, in this worst case scenario, the affected debt will not be limited to sub-prime derivatives, but hit mainstream corporate bonds and state and municipal-issued debt. If this scenario plays out, it will make the sub-prime problems seem like a walk in the park. I continue to expect further announcements of sub-prime related losses going forward and the potential for cuts to the credit ratings of bond insurers in the weeks ahead is very real. As a result, Friday’s rebound in riskier assets, most notably the JPY-crosses, offers another chance to bet on heightened volatility by selling them on strength.

The fundamental data this week saw sentiment slip further in the Eurozone, as the German IFO corporate sentiment survey fell more than expected. Even hawkish rhetoric from ECB Pres. Trichet to the effect that high inflation precluded rate cuts failed to give the EUR more than a brief respite. In the UK, core inflation fell further and housing prices ratcheted lower for the third month in a row, highlighting the slippery slope of GBP. The icing on the cake came with the BOE’s MPC minutes, which revealed a unanimous vote to cut rates back at the beginning of Dec., which propelled markets to increase bets on a second rate cut at the Jan. 10 BOE meeting. Cable was further pummeled by a sharply wider 3Q current account deficit, adding to the list another reason to keep selling GBP.

US data this past week was slightly better than expected, with Friday’s Nov. jump in consumer spending echoing stronger Nov. retail sales reported last Friday. The outlook for the US remains highly uncertain, however, and together with slowing growth in Europe and Japan, suggests that optimistic global growth outlooks still need to be tempered further. Against this backdrop, the USD should continue to do better than most, mainly on the back of short-covering rather than as an outright USD-buy. The key levels to watch next week are 1.4270/80 support in EUR/USD and 78.15/20 (prior all-time low) resistance in the US dollar index.

Last week I noted that USD/JPY and the JPY-crosses had spent the prior week testing Ichimoku cloud resistance with minimal success, and that this pointed to lower JPY-crosses ahead. The JPY-crosses were indeed lower for most of the week, but have since staged a comeback. USD/JPY has made an important advance and looks set close above key Ichimoku cloud resistance at 113.54, potentially signaling a shift in trend to the upside. EUR/JPY also looks set to close above its cloud at 163.20, as does NZD/JPY, but other JPY-crosses are still below their clouds. However, in USD/JPY, Friday’s gains have stalled at 114.10/20, which is marked by trendline resistance from the August highs and the 100-day moving average. Next week, the Ichimoku cloud falls sharply, so if USD/JPY has made a false break out of the cloud, the give back could be large and swift, targeting 110.00-50 by the end of next week. The USD’s recovery is beginning to look a bit strained from a momentum standpoint, but still shows no signs of reversing. Heading into the Christmas holiday week, traders should be aware that liquidity conditions will remain thinner than usual, which typically increases volatility, compounded by holiday closings in key markets.

US data next week begins on Wednesday with the Oct. S&P/Case-Shiller home price index and the Dec. Richmond Fed manufacturing index. Thursday sees Nov. durable goods orders, weekly jobless claims, and Dec. consumer confidence. Friday finishes up with Dec. Chicago PMI and Nov. new home sales. There are no Fed speakers scheduled next week.

The only Eurozone data of note is preliminary Dec. German CPI on Friday.

Japan has the busiest calendar next week, beginning on Tuesday morning with the 4Q BSI Large All Industry and Manufacturing sentiment gauges and the Nov. corporate services price index. The BOJ will release the minutes from its Oct. 31 meeting on Wednesday. Thursday afternoon sees Nov. housing starts and construction orders, along with Dec. small business confidence. Friday morning sees a slew of data reports: Nov. employment; Nov. household spending; Dec. Tokyo CPI; Nov. national CPI; preliminary Nov. industrial production (key); and Nov. retail trade, followed in the afternoon by Nov. overtime and labor cash earnings.

UK data on Thursday sees 3Q housing equity withdrawal figures from the BOE and Nov. home loans reports from the British Bankers Association. Friday sees only Dec. Nationwide Building Society house prices.

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.