Gain Capital

Range conditions prevail
The USD has remained largely confined to ranges over the past several weeks. In EUR/USD, that range has been roughly 1.53-56; in USD/JPY, 102.50-105.50; in GBP/USD, 1.94-97; and in USD/CAD 0.9950-1.0250. To a large extent, these range-bound trading conditions reflect the current inertia of monetary policy at key central banks, with most interest rate policy setters now seen to be on hold. Given the offsetting effects of slowing growth in major economies and high inflation rates, the stalemate looks set to continue in the weeks ahead. Other markets, such as US stocks and Treasuries, are similarly range-bound owing to ongoing uncertainty and the lack of a clear directional theme to trade on. Even oil, which has caught a great deal of attention in recent weeks, looks to have reached a plateau, closing last week just below $126/bbl, and looks set to finish out this week only slightly higher at $126.60/bbl.

With interest rates likely on hold at G-10 central banks for the foreseeable future, FX direction seems destined to come from other markets and individual data reports. We have just passed the mid-point of the month and that means US data ahead will focus most heavily on the housing market, a sector that remains exceptionally weak. (Higher-than-expected building permits and housing starts on Friday were skewed by multi-family dwellings and are not an indication of stabilization.) In addition, commodity prices continue to rally, with gold playing catch-up to oil in sharp rebound, even as oil appears to be stalling. Most of these developments (weak US housing data, higher commodities) tend to favor USD weakness and sure enough the dollar is finishing out this week toward the lows of recent ranges. To be certain, ranges are made to be broken, but it just doesn’t feel like the situation on the ground has changed sufficiently to justify a breakout and a return to pronounced USD weakness.

To justify a breakout, I would look for sharply weaker US data or another series of sharp gains in commodities. Absent those indications, I prefer to fade the tests of USD-range lows and buy USD selectively. In particular, USD/JPY looks attractive to buy between 103.00-50 (stop below 102.50) and EUR/USD to sell between 1.5600-1.5700 Also, while range conditions continue to prevail, volatility declines and risk appetites improve. Barring major stock market volatility, range conditions will favor long JPY-cross positions, such as buying EUR/JPY or GBP/JPY on weakness. Should the USD recover from here and return to recent range highs, I’ll look to fade those moves, too, and sell on strength.

Bank of England signals inflation concern
One currency I will not be selling on strength is Sterling (GBP/USD). This past week, the Bank of England’s quarterly inflation report indicated that MPC members see inflation rising sharply in the year ahead, likely eliminating anticipated interest rate cuts. Normally, GBP/USD would have vaulted 3 big figures or more on such news, but incoming data has been so alarmingly weak, Sterling couldn’t stage a rally until Friday saw more widespread USD weakness. I have been negative on the UK and GBP since last fall, but this is the first time since then that I have recommended buying GBP (see The Weekly Strategy). The data that has been most dismal out of the UK involves housing, but the housing market declines are less likely to affect UK consumer spending since there has been less home equity withdrawn compared to US households. GBP/USD has also not fully adjusted to reflect the removal of between 75-100 bps of additional expected BOE easing, so I think Cable remains a buy on dips while recent lows at 1.9350/400 remain intact. Strength over 1.9700 opens up potential to further gains to 1.9875/00. I would also look for GBP to recover on the crosses, with a likely top in place in EUR/GBP while below 0.8000. Weakness below 0.7875 will be the trigger to a larger downside move to 0.7720/40.

USD hobbled by high oil, but…
In last week’s report, I suggested the relationship between oil and the USD should not be followed blindly, but it appears to still be infecting USD trading on the margins. I remain wary of following oil prices too closely to divine the USD’s direction, but absent more dominant news or data it seems that is what the market is focusing on. Follow the data and the news, but keep one eye on oil. Remember, the USD can drive oil as much as oil drives the USD.

In terms of the near-term outlook for oil, I think it’s interesting to note that even with a key US investment bank’s most recent note today forecasting 2H 2008 oil prices of $141/bbl, oil was unable to sustain even a minor new high. For all the news and noise about oil, it is closing only about 50 cents higher than the prior week. Also on Friday, US Pres. Bush was rebuffed for a second time by the Saudis in his quest for more oil output. Yet oil prices still failed to register significant disappointment and could not even reach the intra-day highs. Tuesday of next week (May 20) sees the expiration of the June oil futures contract and that typically sees a fair amount of position liquidations. All in all, oil is looking increasingly toppy, and that dovetails with a USD holding the bottom of recent ranges.