Forex Investment and Currency Trading

USD vulnerable
USD came under renewed downward pressure late in July, after trading in a tight range through mid-month, when equity indices were testing key support. Early Q3 earning reports helped rekindle appetite for risk sending the S&P 500 from around 880 and the then 200-DMA to over 1000. As risk sentiment improved, USD tumbled and it remains vulnerable to further declines in risk aversion. Over the next 6-12 months FED exit strategies will be in key focus. Not only will this relate to stimulative fiscal and monetary policy, it also relates to Fed Chairman Bernanke whose term as Fed Chairman officially runs out in February 2010. That means short of a reappointment through the summer, the focus after Labour Day will turn intensely toward Bernanke’s fate. Given that whoever is appointed with have to deal with the process of removing monetary stimulus, amid still very loose fiscal policy, the market will pay critical attention. If the appointment is interpreted as increasing the likelihood that the Fed will monetize the ballooning Federal debt, longer-term concerns about USD could be compressed into a shorter-term time horizon.

EURO - modest further gains
Although EUR/USD ended July up slightly from June and toward the top of its recent range, this belies a generally poor performance on the major crosses. In fact, crossed against a basket of the high risk AUD and low risk JPY, EUR continued to trend lower through the month. In markets that continue to be dominated by the ebb and flow of risk appetite, EUR has been rather sidelined as it trades neither as a risky asset nor a safe haven. As such, the bulk of EUR/USD comes from USD rather than EUR.

Although only a secondary driver of EUR direction, domestic fundamentals in the Eurozone are moderately positive. On balance, economic activity data are surprising to the upside by a wide margin and the ECB is unlikely to go any further down the unconventional policy road leaving EUR free from the “sticker shock” risk that was so negative for USD and GBP in the early stages of QE. ECB rates are likely on hold for a prolonged period.

Technically, support at 1.4075 and 1.3734 is expected to attract buying interest based on the uptrend in place for a test of 1.4713 .

Longer term, forecasts continue to show modest gains for EUR/USD, though no re-test of the 2008 high just above 1.60. Moreover, note that this is a view driven primarily by USD weakness rather than EUR strength and EUR continues to under-perform more broadly, particularly against the currencies more aggressively geared to rising activity – the commodity currencies and GBP in particular.

Japanese Yen - range trade, no direction

USD/JPY remained essentially range-bound through the course of July, ending the month in the middle of the 92-97 range that prevailed. The trendless nature of USD/JPY trade recently is partly a reflection of the dominance of risk appetite as a market driver and the fact that both USD and JPY trade as safe havens. Beyond this, capital flows appear much better balanced than the very bearish consensus forecast for JPY would suggest. Continue to see USD/JPY and range trade as a result, with resistance at 96.77 and 98.88 expected to attract selling interest for a move to support at 92.16.

The constraints that are trapping USD/JPY in a narrow range short term are also likely to apply in the longer term – until there is rise in global short term interest rates sufficiently large to “force” institutional investors to take currency risk on overseas bond holdings.

Sterling - further outperformance

After GBP was the best performing G10 currency through 2009 H1, EUR/GBP spent July grinding higher and GBP generally traded poorly. Although the trend out-performance of financial stocks – the principal driver of GBP strength - continued in July, the pace slowed substantially, taking the wind of GBP’s sails. GBP is seen underperformance in July as a correction in a otherwise bullish trend and GBP is expected to resume its strengthening trend against most of the major in the coming months.

EUR/GBP in particular is best seen as proxy for the performance of financial services (the UK’s forte) compared to industry (the key drover of German economic performance). Survey indicators suggest the trend out-performance of financial services will continue near term. Domestic policy drivers are also turning in GBP’s favour, with this month’s MPC meeting likely to begin the process of winding down QE. Politics remains the wild card for GBP. So far, markets have paid little attention to the impending general election (June 2010 at the latest). A clear cut opposition victory, however, is by no means a foregone conclusion and should opinion polls start to reflect this, GBP could come under pressure as a solution to the UK’s medium term fiscal woes would be that much more difficult under a weak coalition government.

Swiss Franc - SNB truly wary of CHF strength

The SNB remains wary of CHF strength, but the aggressive intervention in late June that encompassed buying both EUR/CHF and USD/CHF, seems to have been successful in that EUR/CHF has since remained above 1.51. The CHF effective exchange rate also reveals the lingering impact of the SNB activities in March and June. Those FX interventions resulted in SNB’s FX reserves surging to a new high. The force behind the SNB action on the currency was the underlying weakness in the economy and a deflation threat. Both continue to linger leaving the SNB notably wary of CHF strength. Export volumes illustrate the ongoing pressure on the Swiss economy and SNB’s resolution to limit CHF strength. Over the next 6-12 months the pressure on the SNB is expected to abate. EUR/CHF is expected to grind higher, heading toward 1.60 by mid-2010, as the global economy gains traction, and the demand for safe haven currencies abates.

Canadian Dollar - closer to parity

CAD outperformed its G10 peers in July, with USD/CAD dropping 7.9%. However, the general outperformance during July was in part a reversal of June’s underperformance after the BoC expressed concern about a stronger currency, noting that further CAD strength “could fully offset” positive economic developments in Canada. At the July meeting, the BoC softened its tone and removed a key hindrance to CAD strength. The extraordinary improvement in the BoC’s Financial Conditions Index since the June 4th meeting, the improving global economic backdrop, the continued credibility of the inflation target (minimal risk of persistent deflation) and expectations that positive Canadian growth will return as early as the third quarter of this year gave the BoC more confidence that CAD strength would not necessary derail the economic recovery. However, CAD strength is still ‘significantly moderating” the pace of the recovery. Whether CAD continues to rally or not in the short-term, will largely depend on developments in China. China has already indicated the desire to “fine tune” its monetary policy, thereby paving the way for the normalization of monetary policy. Any unexpected fallout during the normalizing process could easily spill-over into doubts about the pace and sustainability of the global economic recovery, adversely affecting commodity currencies. Following the adjustment period, commodity currencies are expected to embark on a renewed path of appreciation, albeit at a slower pace than seen between March and July 09. For CAD, the moderate pace of the global recovery in 2010 will hinder a sustained move towards parity.

Australian Dollar - upside on earlier RBA tightening cycle

AUD was one of the best performing primary currencies in the month of July. Rising commodity prices and increased rate hike expectations prompted the sharp rebound in AUD in the month. The RBA dropped its easing bias in favour of a neutral bias in August, reflecting the continued improvement in financial markets, further stabilisation of the global economy, and economic conditions in AU which have surprised to the upside. Earlier RBA tightening cycle means higher eventual upside for AUD.

Chinese Yuan - USD/CNY steady in the near term

USD/CNY traded in a narrow band of 6.830-6.835 throughout July, with little sign of any significant change in the near-term. Dollar weakness in recent months has resulted in an effective depreciation for CNY on trade-weighted terms, providing some relief to exporters, but with external demand still weak, Beijing is expected to retain its preference for steady USD/CNY in the near-term.

Strong stimulus (delivered mainly via very high bank lending) has started to work, with GDP growth rebounding impressively in Q2. But top officials have stressed that China’s recovery is not yet well-established, reflecting ongoing weakness in external demand and the labor market. The surge in bank lending also creates the risk of potential side-effects, including asset price bubbles and a spike in bad loans. Dealing with these issues will be a difficult policy challenge, but in the near-term, China will keep the focus on supporting growth, with a stable USD/CNY as part of the package. This policy stance will change only when officials are confident that the domestic recovery is well-established, and such confidence is unlikely until there is stronger evidence of a sustained recovery in the global economy. Also, there is little prospect of USD losing its reserve currency status in the foreseeable future, with greater acceptance of CNY hampered by its non-deliverability and the continued presence of significant current and capital account controls.

Mexican Peso - MXN still stuck in well-worn range

USD/MXN remained trapped in a 13.20-13.75 range in July, the fourth consecutive month it has been unable to sustainably break the 13.00 mark to the downside despite a sharp March-July recovery across most global/EM risk assets. This well-worn range is expected to hold in the short-term, but a more aggressive/sustained USD/MXN downside break will be seen in Q3/Q4. Two well-known factors explain the MXN’s continued laggard status and why investors remain overwhelmingly underweight-MXN – Mexico’s deeper link to the U.S. business cycle (resulting in a “harder domestic economic landing”) and widely held expectations that at least one of the big 3 rating agencies will downgrade Mexico’s LT FC sovereign debt rating (Baa1/BBB+/BBB+) on long-term fiscal deterioration. However, both factors are largely priced in and should be less of a MXN-driver role as 09-H2 progresses. USD/MXN is expected to gently trend lower, helped by an improvement in growth dynamics and a weaker USD-trend. Any set-back in the U.S. economy/financial assets is a key MXN risk, notably the U.S. unsuccessfully exiting its stimulus efforts triggering a double-dip recession.

Brazilian Real - BRL to remain an outperformer

BRL is expected to remain among the top performing currencies worldwide, driven by sustained improvement in its fundamentals, strong investor demand for Brazilian exposure, its resilience to the crisis and strong demand for commodities out of China. A strong pipeline of IPOs and external bond issuance has been, and will likely remain, strong drivers of dollar inflows into Brazil. An additional boost could materialize in the form of potential credit ratings upgrades, which although they are now fully priced in, would likely still lead to a rally when they materialize. The minutes from the July COPOM meeting (where the board decided to cut the SELIC rate by 50bp) look fairly balanced (they mention that the current monetary stance will help boost the economic rebound, while being consistent with the BCB’s inflation target of 4.5%) and suggest that future rate moves will be data dependent. The minutes do highlight the existence of certain potential inflationary pressures which lead the market to believe that Brazil could begin hiking rates in the near term. Rising yields in Brazil could be another source of outperformance for BRL.Overall, Brazil’s economic performance, positive investor sentiment and attractive yields should lead BRL to outperform.