FX Strategy Weekly

Market Outlook:

A wobble in pro-risk strategies linked to equity market jitters in China and default fears in the Middle East caused a surge in volatility, but may present a buying opportunity in a (still) ample liquidity environment. With buyers considering more attractive levels and finding cover in generally risk-supportive central bank policies, we see no compelling reason to shift to a less bearish USD stance as long as the Fed stays sidelined. Over the week ahead, a further improvement in US non-farm payrolls in November may 'recharge' pro-risk momentum, though we recognise that the spike in volatility may favour a more defensive set-up. The RBA rate decision on Tuesday provides addiotional uncetainty for near-term direction of high yield currencies. Balancing risk/reward, we are cognisant of bearish scenarios extending if the Shanghai composite breaches key 3,000 psychological support. The visit to China by ECB president Trichet along the EC's Juncker and EU's Almunia is also on our radar and calls for tight stops in EUR crosses. For GBP, the November PMIs could test narrow trading ranges through JPY and CHF crosses, with stronger PMI surveys set to favour a relief bounce on speculation of a pause in QE.

Quantitative Analysis:

• USD oversold - risk of reversal now building
• USD-commodity correlation now broken down
• Volatility curve steepens as short-end falls

Macro Outlook

A wobble in pro-risk strategies linked to equity market jitters in China and default fears in the Middle East caused a surge in volatility, but may present a buying opportunity in a (still) ample liquidity environment. With buyers considering more attractive levels and finding cover in generally risk-supportive central bank policies, we see no compelling reason to shift to a less bearish USD stance as long as the Fed stays sidelined. Over the week ahead, a further improvement in US non-farm payrolls in November may 'recharge' pro-risk momentum, though we recognise that the spike in volatility may favour a more defensive setup. The RBA rate decision on Tuesday provides addiotional uncetainty for near-term direction of high yield currencies. Balancing risk/reward, we are cognisant of bearish scenarios extending if the Shanghai composite breaches key 3,000 psychological support. The visit to China by ECB president Trichet along the EC's Juncker and EU's Almunia is also on our radar and calls for tight stops in EUR crosses. For GBP, the November PMIs could test narrow trading ranges through JPY and CHF crosses, with stronger PMI surveys set to favour a relief bounce on speculation of a pause in QE.

USD

• Selling USD rallies has delivered good rewards since June and remains our favoured medium-term play. The Fed went on record in the November FOMC minutes to describe the dollar decline as 'orderly' and with the Bank in no hurry to raise rates and FOMC members mulling additional MBS purchases, we look for the USD to stay weak in the near term.
• Pro-risk strategies were partially unwound this week but provide more attractive levels to gain exposure to a longer-term depreciating USD trend. A decline in the USD index below 75.0 was followed by a break below 74.50 to a 74.17 low. We favour selling a relief bounce up to 75.50- 60 resistance area.
• An impressive 36k drop in weekly claims to 466k in the week to 21 November and a fall below 5.5mn for continuing claims draw confidence for next week's non-farm payrolls (November data). Adjusted for the Novemeber- 08 blip (-198k miss), the average forecaat error since 1998 is -25k.
• Other key data releases next week include the November ISM surveys, pending home sales and the Fed Beige Book.

EUR

• Two-way volatility is poised to stay elevated going into next week, with 1m/1y EUR/USD vol spread set for a potential compression ahead of the ECB meeting (Thursday) and US NFP (Friday). Risk reversals still overwhelmingly favour EUR/USD puts (see chart).
• ECB president Trichet's planned visit to China raises a red flag. Though calls for more flexibility with respect to the yuan may fall on deaf ears in Beijing, the discussion along with EU and EC representatives is on balance compelling for us to favour near-term downside in EUR/USD compared to upside potential towards the 1.51 area. Key support runs along 1.4835, the 50d MA.
• Upside potential in EUR crosses is associated with the ECB press conference next week Thursday and a reassertion of pro-risk asset and currency flows. We look for upward revisions to the ECB staff projections for 2010 GDP and CPI from the September estimates of 0.2% and 1.2% midpoints, respectively. We also expect Trichet to announce a premium at the one-year tender scheduled for 16 December.
• Final EU-16 PMIs and the flash CPI estimate for November along with the second estimate of EU-16 Q3 GDP head up a fairly busy data calendar. German CPI came in at 0.4% y/y, a touch below the 0.5% y/y consensus forecast. EU-16 CPI is expected to have turned positive for the first time in seven months, climbing from -0.1% in October.

GBP

• With the exception of GBP/JPY, GBP/CHF and, to a lesser extent, EUR/ GBP, sterling crosses show no urgency to test the trading ranges in the G10 currency space. Solid outcomes for the two PMI surveys will fuel talk of a pause/end of QE in February and could lift GBP/USD back towards the upper end of the trend channel around 1.6750-1.68. Negative data surprises for US ISMs and a retreat in the Shanghai composite below 3,000 risk extending a corrective move towards the 1.6250 area.
• Flight-to-quality buying in JPY and CHF triggered a correctionbelow 1.66 in GBP/CHF and below 140.0 in GBP/JPY. Further downside looms if risk appetite fades, with 1.6382 and 139.0 standing out as critical support levels. For EUR/GBP, a first close above 0.90 since October 27 should inspire GBP bears to push for a break towards 0.92. EUR/GBP risk one-month reversals are trading at a two-week high of 0.95, favouring GBP puts. GBP/USD one month RR are steady around -1.17 also favouring GBP puts

CAD

• USD/CAD has been trading in a 300pip range since the start of the month, with the cross returning to the upper end of the boundary around 1.0750 on narrowing CA/US rate differentials and a drop in Nymex crude below $75pb.
• US and Canadian employment figures for November are due next week and will provide temporary distraction from trends in the commodity markets, though a collapse in crude towards $70pb could overwhelm CAD bulls. Key technical support for Nymex January delivery runs at $72.43. A break of 1.0753 in USD/CAD, the 100D MA, calls for targets to be raised to 1.0870.
• A breakout in GBP/CAD from the technical flag pattern appears imminent as the trading range narrows to 1.7370-1.7690. A resumption of pro-risk trades in conjunction with solid UK PMIs favours a move towards the November 17 high situated above 1.78. Downside protection runs at 1.7335.

JPY

• The MoF is venting increased frustration at the strength of the JPY against the USD and its other G10 counterparts for reasons linked to the competiiveness for Japanese exporters. The Nikkei has so far this month underperformed the S&P-500 by 12% and the FTSE-100 by just over 11%. Foreign selling of Japanese stocks hit the highest level last week since March-20 as investors snap up MM securities (see chart).
• We favoured short USD/JPY positions to 88.0 on USD aversion/pro-risk but now consider selling USD/JPY dips following this week's overdone sell-off below 86.0. Our near-term target is for a bounce to the 88.30 area, the 10d MA.
• A light week for Japanese economic data will be overshadowed by a speech by BoJ governor Masaaki on Monday and possible MoF comments on the JPY. Q3 capital spending data are expected to show a moderation in the rate of decline to 16.3% vs 21.7%. We also on alert for the EU/China meeting.

SCANDIS

• Both NOK and SEK have remained fairly range bound versus the US dollar (and also sterling) over the past two weeks. NOK/USD has oscillated in the 5.5405-5.7043 range while SEK/USD has ranged in between 6.80-7.00. Both currencies, however, have lost ground versus the euro as reserve diversification and equity markets keep the euro supported.
• Next week's Q3 GDP numbers are the main highlight of the economic calendar for both Norway and Sweden and the market expects a robust improvement from both. Despite comments from the Riskbank that suggest they will keep rates low until well into next year, further signs of a recovery from the labour market could well lead to rate hikes being brought forward. In the shortterm, the currencies continue to be driven by risk sentiment. Given the scaling of risk in recent days, we would continue our strategy of buying on dips, preferably versus the euro which we think has been overextended somewhat. We look for EUR/SEK to target 10.17 and EUR/NOK 8.34.

AUD

• The upward momentum in the AUD (and the NZD) has waned somewhat over the past few trading sessions. Although AUD/USD managed to print a new high for the year at 0.9406 two weeks ago, it has struggled to test that since. That said, the currency pair remains above the upward trend line (from the March 2009 low) and until we see a clear break below, we remain bullish.
• The major upcoming risk event is the RBA meeting next Tuesday (1st December). We are in line with the consensus in that we expect a further 25bp hike in the cash target rate. Interest rate futures, however, have an 80% probability of this priced in and as such we would expect a rally in AUD on this outcome. Given AUD is currently trading close to it's upwards trend line, there is scope for a decent rally - unless a major shift occurs in the risk environment.
• We continue to look for the AUD to rally up to 0.95. We see resistance at 0.9406. On the downside, a significant close below 0.9115 would violate the March '09 upward trend line and could see a sharp move to the downside. Support lies at 0.8058 (the 50day MA) and then 0.8907. A move to this level would suggest a double-top and could potentially see a move down to 0.8650. Technical risk aside, however, we remain bullish and expect the interest rate differentials and the increase in output to keep the currency well supported.

Quantitative Market Analysis

• USD oversold - risk of reversal now building
• USD-commodity correlation now broken down
• Volatility curve steepens as short-end falls

Contrarian Indicators Relative Strength Index (see page 6 for explanation), Risk Reversal Skews (based on options prices, see page 7) and IMM data (highlighting speculative positioning, see page 5) are used to analyse foreign exchange to understand how stretched currencies may have become.

The IMM data show that speculators have an extremely short position in USD/CHF - when examining speculative positioning over the past three years, the current position lies around the 3rd percentile. This suggests that the risk of a squeeze higher remains in tact - we continue to look for a potential trigger for this squeeze.

The RSIs are close to neutral (50) for most G-10 currencies against the USD. The main exception is USD/ JPY, where the 14-day RSI is now consistent with previous episodes of trend reversal. Hence the risk of a move higher (especially given that speculators already hold a sizeable short USD position) is building.

Risk reversal skews (I analyse them by ranking the data over a rolling year) have become stretched in EUR/USD, USD/CAD, USD/CHF, USD/SEK and USD/ NOK, in favour of USD calls. This suggests that a high proportion of market participants have become concerned about the level of USD weakness and fear the risk of a correction. Hence they have heavily invested in USD calls.

On balance, the USD is now oversold. The risk of a move higher is building, especially if risk appetite were to fall (the news surround Dubai are making investors nervous).

FX correlations

Market correlations are shown on pages 10-12. 1-month rolling correlations are plotted for G-10 FX against interest rate spreads, S&P500 and commodities (represented through the CRB index).

The correlation between G-10 FX (against the USD) and interest rate spreads is quite high - partly explaining the recent USD negative movement. Interestingly the underlying interest rate spreads are showing some divergence (within the G-10 community). Whilst the EZ/ US and US/SZ spreads are still trending against the USD, the AU/US, UK/US, NZ/US and US/CA spreads are beginning to turn in favour of the USD. If this turn in interest rate spreads is sustained, then the basis for a USD rally could be forming.

The correlation between G-10 FX and the CRB (our favoured broad based commodity index) has fallen over the past week. Whilst the trends in currencies have continued, commodities have been broadly stable this month. There has now become a noticeable divergence between commodities and the S&P500 (equities continue to grind higher). However, with momentum in equities beginning to wane, we are cautious that commodities could lead the move lower. In this context the USD would likely gain traction.

Finally, the correlation between most currency pairs vs. S&P500 remains quite high.

FX Implied Volatility

The charts on page 8 show 1-month and 1-year implied volatility for G-10 currencies, against the USD. 1-month volatility is drifting lower, partly reflecting mature and stable FX trends. Additionally, the Thanksgiving and Christmas holidays have reduced the trading days left for 2009, helping to further drive down short-term volatility. Barring a risk aversion led event (where the USD rallies strongly), a continuation of the USD negative trend or a stabilisation in the USD is likely to lead to further weakness in 1-month volatility.

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