Gain Capital

The USD staged a strong rally late in the week, largely on the back of higher PPI and CPI readings and a stronger than expected Nov. retail sales report. At the same time, the outlooks for other major economies continued to deteriorate, with Germany’s IFO economic research institute lowering its 2008 German GDP forecast from 2.2% to 1.8% (2009 only 1.5%), Japan’s Tankan survey pointing to weaker corporate sentiment ahead, and the UK’s RICS housing price balance (price gains minus price declines) plunging to its lowest level since June 2005, while house price expectations fell to 1998 levels. Along the way, the USD broke several major technical levels, most notably 1.4520 in EUR/USD, suggesting this move is for real, but at the same time the overall outlook for the USD remains highly uncertain.

To start with, the US data that inspired the latest push higher in the greenback should be taken with a few grains of salt. The retail sales report was solid through and through (core-core retail sales ex-gasoline, autos and building materials was up 1.1% MoM, it’s fastest gain since May) but all may not be as its seems, or at least sustainable . November retail sales were pushed higher by heavy discounting by retailers eager to lure shoppers, which shifts demand forward, and may see some give-back when Dec. retail sales are reported. Also, due to Thanksgiving coming earlier than usual, there were more post-Thanksgiving shopping days in the month than normal, which also likely skewed results forward to November. On the higher inflation reports, the first-blush sentiment is that higher inflation will keep the Fed from easing rates as aggressively as markets had been expecting. That view was reinforced after the fact by the Fed’s less than hoped for 25 bp rate cut on Tuesday. But I have little doubt that the Fed will continue to ease rates as necessary to support the economy, if the incoming evidence warrants it.

In terms of the overall skew of data, traders should note that we have just passed the mid-point in the month, which means that the focus of data over the next two weeks shifts back to the housing market, the US economy’s sore thumb. Normally this would have me expecting the USD to return to weakness, but lately the market has increasingly shrugged off further signs of housing market weakness. Surprise increases in pending home sales in Sept. and Oct. (leading indicator of existing home sales) has even led to nascent speculation that the US housing market is stabilizing. The balance of evidence, however, suggests that the US housing market remains in a deep funk and it will continue to cloud the US outlook in the near-term. As such, next week’s housing data is likely to temper the USD advance, but should it surprise to the upside, be prepared for further sharp gains for the USD.

The most compelling explanation for USD strength at this juncture is that the USD’s decline was excessive and that hedgers and speculators have begun to cover short-USD exposures. Inter-bank flow activity over the last 48 hours strongly supports this view, with systematic models among the heaviest buyers of USD. Speculators have by no means gotten long USD to any great extent and short-covering USD buying has further to run. Because of the shift in positioning, which for the moment is supported by a better outlook based on recent data, I remain positive on the USD over the next several weeks. But I also think it’s important to take profit on long USD positions as the moves unfold, as the risk environment remains extremely fragile.

With that in mind, I prefer to focus on buying USD dips against European currencies (selling rallies in EUR/USD and GBP/USD). Because of the potential for bad news from the credit markets to re-surface, I remain leery of buying any of the JPY-crosses and USD/JPY as well. Given the risks to the outlook, I would prefer to be selling JPY-crosses on strength, but USD/JPY’s inexorable rise has made that strategy difficult to maintain. Interestingly, most of the JPY-crosses spent the better part of this week testing upside Ichimoku cloud resistance. GBP/JPY remains well below its cloud and capped by the 230 area. AUD/JPY has so far been unable to break into the bottom of its cloud, while EUR/JPY and NZD/JPY, currently within their clouds, have so far failed to sustain their attempts to break out of the cloud and shift the trend higher. USD/JPY has just today come close to testing the base of its cloud at 113.72. The cloud levels for all these pairs descend sharply early next week, which suggests similar downside price potential, even including a Sunday opening gap lower. Looking at this set-up makes me think that some very negative credit-related or other highly unsettling piece of news is going to come out shortly, sending investors fleeing into the JPY. The alternative—that the world wakes up Sunday/Monday morning and concludes that the investment environment is suddenly outstanding and decides to strap on major risk into the end of the year— just does not seem fathomable. As such, my preference is for a sharp set-back in USD/JPY and the JPY-crosses next week.

EUR/USD made a significant technical break lower with the move under 1.4520, which constituted the neckline in a classic Head and Shoulders topping pattern. The measured move objective on the break-down is 1.4070 (see Weekly Strategy), with 1.4400 as the immediate downside support, followed by 1.4350/60, which marks the 38.2% retracement of the move up since August. I favor selling strength, if seen, into the 1.4550/4650 area, with stops above 1.4710/20.