Weekly Forex Forecast - Week 40

Monetary uncertainty to weigh more than fiscal uncertainty

Federal Reserve uncertainty weighs on markets and the US dollar

One should not illude oneself: Mr. Bernanke's September 18 decision not (yet) to proceed with QE tapering reflects the serious concern that such move could still derail the recovery, based as it is on the highly interest rate-sensitive housing market. Inflation, furthermore, remains on historically low levels. On one hand this gives the central bank more room for manoeuvre. On the other hand, low inflation is an indication of the continuing deflationary threats in the economy, its threat to still high household debts, as well as the continuing weakness of the very recovery.

In this respect, we believe that the monetary policy concerns related to the QE tapering dilemma are more risky than the never-ending fiscal saga in Washington. At the same time, we concede that the combined effect of enduring uncertainty on both fronts could represent a major risk for the markets, over the next coming weeks. After all, if markets do not like uncertainty, they hate policy uncertainty. And, today, we are facing an unpleasant combination of monetary and fiscal policy uncertainty.

Labour market data key

September monthly job creation, more than the unemployment rate which is currently at 7.3%, will be important to give further clues about the strength of the economy and, consequently, the Fed's determination to pursue tapering. If the number would edge closer to 200k than to 150k, and if earlier in the week the purchasing manager figure (ISM) will remain above 55, it should be fair to expect some US dollar strength on the back of increased tapering prospects. If, on the other hand, the labor data would disappoint, the euro might further strengthen against the US dollar. And, this time, also equity markets would remain jittery.

Is Japan really on its way towards fiscal balance?

Japan is likely to take a first step towards more fiscal soundness

Mr Abe is expected go ahead with the first phase of the sales tax hike, implying a rise to 8% in April 2014 from the current 5%. The measure should be associated to a ¥5tn stimulus to cushion the blow on economic growth. Even though this is a first step towards balancing the budget, more steps should be taken to increase the odds of attaining this goal. In particular, the social welfare program needs to be revised and not only by raising the age of retirement, which was decided by the government before Mr Abe's. In 2011, the cost of Japan's welfare program was around 23% of GDP, which is in the average of the major economies. Sadly, Japan society is characterised by an aging population, which will lead to an inevitable increase in the cost of welfare. Therefore, should Abe fail to follow through courageous reforms in government spending, even an increase at 10% in October 2015 implied by the second phase of the sales hike is unlikely to be sufficient to balance the budget. Indeed, social welfare spending will reach a record ¥29.1tn this year while the government expect a yearly ¥13.5tn revenue with a tax at 10%. The resulting effect would be a loss of confidence among Japan's creditors, which could lead to upward pressures on government yields, leading to dire consequences for a country with a debt to GDP ratio of around 210%.

A technical overview on the Japanese Yen

As the Swiss franc, the yen has recently appreciated given its perceived safe haven status. However, we view this decline as temporary and we continue to expect EUR/JPY and GBP/JPY to hit their 2009 peaks (139.22 in EUR/JPY and 163.09 in GBP/JPY). USD/JPY is also attractive as it is close to a key support at 97.76 (see also the 200 day moving average) and that its longer term target lies between 105.50 (61.8% of the retracement of the decline from June 2007 peak) and 110.66 (August 2008 peak).

Uncertainties continue to weight on EUR/CHF

Uncertainties overshadow the recent EUR/CHF supportive news

EUR/CHF usually rises when investors are more risk seeker than risk averse. Therefore, the postponing of the tapering by the FOMC and the ongoing narrowing spreads in the Eurozone among core and peripheral countries should have lifted EUR/CHF. However, since the Fed decision to delay the start of the reduction of its liquidity injections, EUR/CHF has declined. This counterintuitive behaviour could be explained by the increasing uncertainties related to the US fiscal situation. Indeed, since the FOMC meeting, markets have focused on the threats implied by the short-term budget and the debt ceiling. Overall, the bigger risk lies in the debt ceiling as it is linked to the capacity of the US to service its debt.

The SNB continues to find the Swiss franc highly valued.

On the other hand, the Swiss National Bank reaffirmed on 19 September its commitment to defend a EUR/CHF floor at 1.20 and continues to consider the Swiss franc as highly valued. Given the lack of signs of inflation risk in Switzerland, we continue to see 1.20 as a credible backstop for EUR/CHF in the foreseeable future. Coupled with the potential mild recovery in Europe and the persistent global monetary accommodative policies among central banks, the medium-term outlook of EUR/CHF remains tilted to the upside.

Short-term uncertainties offer buying opportunities for EUR/CHF

Looking at the chart, EUR/CHF is moving below the key support at 1.2268 (06/08/2013 low). As the debt ceiling uncertainties could linger on until early November, it would be prudent to wait for the short-term uncertainties to be lifted before entering a long EUR/CHF. The way US lawmakers will manage the budget, and the potential government shutdown, is likely to give clues on the likelihood of a deal for the debt ceiling issue.

Long-term equilibrium broken in GBP/CAD

GBP/CAD is exhibiting an attractive technical configuration

The precepts of technical analysis mention that the upside or downside potential implied by technical patterns derives from two elements. The first component is the variation of the price inside the technical configuration or the height of the pattern. The second component is the time spent inside the technical configuration or the length of the pattern.

As a large pattern comes from wide price swings, the target is expected to be more significant as prices tend to offset the previous price extremes. Therefore, the greater the height, the bigger the potential target. Similarly, as a long pattern results of a persistent equilibrium between buyers and sellers, the break of this equilibrium is likely to lead to a significant move as many investors are wrongly positioned and have to close their positions, adding fuel to the new trend. Hence, the longer the pattern, the bigger the potential target.

Looking at GBP/CAD, the bullish breakout of the resistance at 1.6474 (26/08/2010 high) put an end at three years of consolidation. Given the length of the pattern (called a rectangle), we can expect a long-term rise in GBP/CAD. The height of the pattern (0.1225=1.6474-1.5249) implies a minimum target at 1.7699 (0.1225 added to 1.6474). Given the resistance at 1.7934 (09/11/2009 high), the minimum upside potential could be even pushed a little bit closer to that level. Furthermore, even if the September 2009 peak should be hard to break, the extended time length of the consolidation suggests that a move towards the next key resistance at 1.9304 is far from unlikely.

With a stop-loss slightly below the support at 1.6174 (28/08/2013 low), the minimum risk/reward ratio is above 2.5, which makes a long GBP/CAD position attractive for the medium- to long-term time horizon.

High short GBP positioning has been erased

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.

Except the Japanese yen, all currencies have been bought during the week ending on 17 September. The side-effect is an overall reduction in long USD positions. As the FOMC took place on 18 September, it is safe to assume that more of this erosion in long USD positions has occurred.

In particular, investors have almost closed all their short positions in GBP. Given the neutral readings, any rally in the British pound will not be lifted by GBP positioning. Investors have increased their long position in Euro back to levels seen in February 2013. The ongoing reduction in Eurozone liquidity could lead to a further increase in the long positioning. Finally, commodity currencies have recently experienced a reduction of their short positions. Further closings of short bets could lead to a longer appreciation in these currencies in the short-term, especially the Australian dollar which has recently broken its strong resistance at 0.9345.