Gain Capital

The US dollar lost further ground this week as the G7 failed to make any reference to USD weakness/EUR strength and incoming housing data highlighted only bleakness. Tellingly, the only time the USD experienced any strength was on Monday when a larger than expected write-off by Merrill Lynch triggered a stock market sell-off, which sent JPY-crosses (carry trades) plunging. The collapse in the JPY-crosses spilled into the USD pairs, triggering stop loss selling of the non-JPY dollar pairs (EUR/USD, GBP/USD, and AUD/USD, buying of USD/CAD). In other words, only an abrupt market dislocation sparked USD-buying, which only serves to highlight the lack of support for the USD from any fundamental source.

That hiccup also serves to highlight the primary risk to expectations for a steadily falling USD: extremely high levels of USD-short positioning. Going forward, traders need to keep in mind how short of USD the market is and how profit-taking will continually emerge on fresh USD lows. Selling USD on bounces against all but the JPY remains the preferred strategy going forward, but profits should also be taken on subsequent USD declines. Overall, markets remain on edge, with on-going credit market surprises likely to continue popping up, roiling an otherwise gradual decline in the greenback.

Interest rate futures markets went one step further beyond pricing in ¼% Fed rate cut next Wed. and began to price in chances of a ½% rate cut. As of Friday afternoon, Fed fund futures indicated a 90% likelihood of a 25 bp cut, and 10% for a 50 bp cut. On the fundamental side, there remains a remote possibility that the Fed decides to hold rates steady next Wed., an outcome that would be catastrophic for US equities and carry trades. Prior to the housing data that started in mid-Oct., US economic reports since the Fed’s Sept 18 rate cut were largely upbeat, which as recently as Oct. 12 resulted in market expectations of a 90% probability that the Fed would hold steady in Oct. If the Fed takes the longer-term view and looks beyond recent housing data, believing it got out ahead of the curve with the 50 bps in Sept., it may decide to wait for additional information before making further adjustments. Sharp gains in oil and other commodities point to rising inflationary pressures, which could be used as additional justification to hold off until the picture is clearer. I’m inclined to favor a ¼ point cut as the most likely outcome, which would allow the Fed to say they’re taking steps to support growth without being seen as completely ignoring inflation or bailing out investors. If the Fed only cuts by 25 bps., the USD is likely to see a brief sell-off, followed by profit-taking ahead of Friday’s NFP report. A 50 bp. rate cut is likely to result in much heavier USD selling as well as a euphoric equity market rally, which would then see JPY-crosses sky rocket. A steady rate decision is the Black Swan, which would see US equities plummet alongside JPY-crosses, and spark a very ugly round of USD short-covering.

The very high positive correlation between equity markets and JPY-crosses remained intact, but the overall stock market outlook remains hampered by 3Q earnings surprises, lingering economic concerns, and surging oil prices. This led to a choppy week for both stocks and carry trades, which should continue next week. Absent outright equity market strength, USD/JPY has had a lid kept on it, preventing the carry trade from returning in full force. Next week, the Bank of Japan will hold an interest rate setting meeting, and expectations remains for no change in Japanese benchmark rates, suggesting fresh JPY-weakness across the board may be the result. USD/JPY is also facing technical resistance in the form of Ichimoku cloud resistance, which very neatly capped the upside over the past week. The base of the cloud begins to rise from Friday’s 114.63 level to 114.90-115.03 for next week, with further rises to 116.40/50 by mid-Nov. A daily close above the base of the cloud suggests a more aggressive attempt to rally to the top of the cloud, which will be at 117.00-10 next week, and potentially break out above it, signaling an overall shift to an uptrend. USD/JPY upside potential remains favored while above last Monday’s 113.25/30 spike reversal low.

Turning to the data/event calendars, it’s the end of the month/beginning of the new month and data will be heavy. US data starts on Tuesday with the Aug. S&P/CS home price index, which is expected to show a further YoY decline in US home prices, and the Conference Board’s October consumer confidence reading. Wednesday sees weekly mortgage application data, ADP national employment report, 3Q advance GDP estimates, which are expected to be solid in the 3.0-3.5% area, Oct. Chicago PMI and Sept. construction spending. The main event will come on Wednesday afternoon when the FOMC rate announcement is expected at 1415EDT/1815GMT. Thursday sees Sept. personal spending and income, Sept. PCE inflation, weekly jobless claims, and Oct ISM manufacturing. Friday sees October NFP data, with expectations currently centered on a NFP gain of +80K and a steady unemployment rate of 4.7%. No Fed speakers are scheduled next week and US Treasury Sec. Paulson will be in India attending a conference.

Eurozone data kicks off with preliminary Oct. German CPI on Monday. Tuesday sees German Oct. unemployment data and a series of Eurozone retail PMI’s. Wednesday sees Sept. German retail sales, Oct. Eurozone consumer and industrial confidence reports, and Oct. Eurozone CPI estimate. Thursday has no data of note. Friday finishes out with Oct. Eurozone manufacturing PMI’s.

Japanese data begins on Monday morning Tokyo-time with Sept. retail trade and large retailers sales. Tuesday morning sees Sept. employment data and household spending, followed by Oct. small business confidence in the afternoon. The BOJ MPC meeting will begin on Wednesday morning and the decision is expected to be announced later Wednesday afternoon. Sept. labor cash earnings, overtime earnings, and Sept. construction orders are the data of note on Wednesday.

UK data sees final Sept. money supply data to start on Monday. Wednesday sees Oct. Nationwide building society house price gauges and Oct GfK consumer confidence. Thursday sees Oct. manufacturing PMI and Oct. CBI distributive trades report, a private measure of retail sales. Friday finishes out with the Oct. construction PMI. BOE MPC member Blanchflower, the lone dissenter to the steady rate decision at the beginning of Oct. favoring an ease, will speak on Tuesday evening UK time from Manchester.