Weekly Forex Forecast - Week 36

The US cycle remains key for the global economy

The return of optimism

A summer has gone by and, war worries notwithstanding, it is time to reassess where we stand with the global economic cycle. Whilst emerging economies seem to be under pressure, courtesy also of prospective QE tapering, the United States recovery still looks pretty stable while the prospects of a European recovery, where PMI indicators continue their slow but steady rise, seem now also more concrete. From our perspective it remains key to stress two aspects. First, QE tapering will result initially in a reduction of additional liquidity injection, and then an elimination of further injections. Tapering does not aim at a reduction of the outstanding pool of liquidity. Therefore markets may already price in its implications or, worse, have overreacted. Second, Europe, China and Japan appear vulnerable. As such, also continuing good news from Europe will rest on the US steady recovery to continue.

What to watch in the United States

One should in particular bear in mind that the US recovery has to a large extent been driven by the housing market and, as such, the July drop in US new house sales raises concerns. As can be seen from the chart, however, confidence remains relatively high. It is true that tapering concerns have raised the 30 year mortgage rate to 4.6%. It is also true, however, that that remains historically a low rate (and might paradoxically induce some people to buy in the expectation that rates have now firmly bottomed). As importantly, new house inventories are relatively low, which should deter downward pressure on prices. Next week's all important ISM and national labor data will give us further important clues as to the recovery of the US cycle, which we continue to consider sustainable.

The Fed steals the show among next central bank meetings

This week's central bank meetings should have a minor effect on FX

Between the 3 and 5 September, five central bank meetings on monetary policy are going too take place. However, the outcome from these meetings are likely to be uneventful. Indeed, the European (5 September) and the British (5 September) central banks have now tied their monetary policy to forward guidances, which are not expected to change as they have been published less than 2 months ago. A potential further wording down about the "unwarranted" rise in long-term yields should be mentioned, similar as what Mr Carney did during his 28 August speech, which could have a mild negative effect on the Euro and the British pound. In the Pacific, the Bank of Japan (5 September) is poised to leave its asset purchases programme unchanged, while the Reserve Bank of Australia (3 September) is unlikely to lower rates for a second time in a row. Finally, the Bank of Canada (4 September) is unlikely to move rates given their tightening bias and a still not normalised domestic economy. Overall, we do not expect a major effect on forex from these monetary policy meetings.

All eyes are fixed on the FOMC meeting on 17 September

On the other hand, the FOMC meeting could have a significant impact on FX crosses. For the time being, even if a tapering seems highly probable before the end of this year, the precise timing remains blurred. The US August job reports, published on 5 and 6 September, are likely to give more precise hints as to whether tapering will occur very soon, i.e. in September. It should be noted that the potential tapering should be very gradual, and would only be followed through should key economic data like job creation and growth exhibit persistent improvements.

The US dollar seems poised for a short-term rally

Short-term oscillators are oversold in US dollar

Looking at EUR/USD, GBP/USD, USD/CHF or simply the US dollar index, the long-term trend remains in favour of the US dollar. The summer decline in USD has brought all these crosses to short-term overbought (for EUR/USD and GBP/USD), respectively short-term oversold (for USD/ CHF and US dollar index) conditions. Furthermore, most of these crosses are close to significant resistance or support levels, notably 1.3417 on EUR/USD, 1.5752 on GBP/USD and 0.9022 on USD/CHF. The conjunction of these underlying long-term trends, the short-term overextended moves and the critical levels in the vicinity makes a compelling case for building a long USD position.

Investors positioning remains a supportive driver for GBP/USD

Given an already short GBP positioning among investors, the potential for a significant USD strength against the British pound appears less likely than compared to the Euro or the Swiss franc. On the other hand, the Euro long positioning is at levels consistent with a medium-term downward reversal (see page 7). Furthermore, the monetary stance of the Swiss National Bank and the potential loss of attractiveness of safe haven assets, should market perceptions of the risks in the Middle-East region ease, could offer some support to the Swiss franc. Looking at the EUR/ USD, the natural stop-loss for a medium-term long USD strategy is slightly above the February peak at 1.3711. Therefore, if possible, we would try to wait for EUR/USD to be close to 1.3500 to improve the risk/reward ratio of our strategy. However, in the case of a break of the key support at 1.3190 (02/08/2013 low), we would be less patient as the break of this pivot point would favour a medium-term bearish trend reversal. Then, the stop-loss would have to be lowered close to the recent high at 1.3452 (20/08/2013 high).

Market volatility should be a short-term drag for EUR/CHF

EUR/CHF caught between two opposite forces

In Europe, the recent improving economic data and the continuous reassuring presence of the OMT have narrowed yields spreads between the core of Europe (Germany) and the peripheral countries (Italy and Spain). This improved confidence among investors should favour capital inflows inside Europe while reducing the recent years' outlows in safe haven countries like Switzerland. EUR/CHF is therefore expected to benefit from the potential improving Eurozone outlook. On the other hand, the looming Fed's tapering, coupled with persistent rising longterm yields and overextended stock markets, could lead to an increase in volatility, favouring flows in safe-haven asset like EUR/CHF. Furthermore, the tensions in the Middle-East (Syria) is an additional source of volatility that could trigger a flight towards safe-havens.

Buy on weakness remains our favourite strategy

The second forces (Fed's tapering and Middle-east tensions) are likely to continue to grab the short-term attention, so EUR/CHF could remain weak in the next few weeks. A sustained recovery in the Eurozone, on the other hand, is likely to take more time to materialise, leading to a more gradual and medium-term support for EUR/CHF. Overall, given the 1.20 threshold put in place by the Swiss National Bank and the improving outlook of the Eurozone, we continue to favour a medium-term positive stance on EUR/CHF. Therefore, the potential short-term strengthening of the Swiss franc could lead to attractive entry point, especially should EUR/ CHF falls near 1.2120 (26/02/2013 low).

Euro long positions at levels seen on February top

The International Monetary Market (IMM) non-commercial positioning is used to visualise the flows of funds from one currency to another. It is usually viewed as a contrarian indicator when it reaches an extreme in positioning.

No real change in positioning since last week, except in Euro, whose long positions continue to expand. Although not at historical extremes, the EUR long positions have almost reached the level of the previous peak in February for EUR/USD. Admittedly, EUR/USD is not as high as in February, when some European political leaders started to raise concerns on the negative effect of a strong Euro on their domestic growth. However, coupled with a looming tapering from the Fed, we expect a limited upside potential for EUR/USD.

Short positions in British pound have marginally been reduced, but remain well anchor in negative territory. As mentioned in our last report, the conjunction of a less dovish BoE's forward guidance, the persistent short GBP positions among investors and the improving technical configurations (especially against AUD, CAD and JPY) favour a more constructive stance on Sterling.

Long Swiss franc positions have been reduced to neutral. However, this move does not bare any conclusive hint about the future evolution of the Swiss franc.