Week of March 23, 2008

Highlights:

• The Buck bounces, but outlook remains uncertain.
• Is the credit crunch over?
• Japanese gloom deepens, JPY is vulnerable.
• Key data and events to watch next week.

The Buck bounces, but outlook remains uncertain

It was an eventful week to put it mildly: the fifth largest US investment house effectively vanished overnight; the Fed cut rates another 3/4%; US stocks fell to new lows but then recovered sharply; commodities fell back to earth in the largest weekly decline since 1956; and even the lowly USD managed a solid bounce. For the USD, the recovery looks to be mostly based on profit-taking on short dollar positions after the FOMC cut rates by 75 bps, in a classic 'sell the rumor, buy the fact' reaction. The Fed statement also suggested that additional rate cuts are unlikely to be as aggressive, leading to an overall reduction, at least for now, in expectations of how low US rates will ultimately fall. The USD was also supported by the chicken-and-egg relationship with commodities-as the USD strengthened, commodities came under profit-taking pressure as hedges for a weaker USD were taken off. Finally, the USD also gained support as the US slowdown increasingly looks set to drag down other major economies in the months ahead, a re-coupling I have been expecting for a while now.

In short, the USD rebound looks to have been mostly driven by short-term market positioning adjustments and assorted inter-market relationships after a likely excessive decline, rather than any sudden improvement in the fundamental US outlook. That conclusion makes the USD recovery highly suspect, but at the same time there are significant technical indications that the USD rebound may have some more room to go. Keep in mind that US data next week focuses on housing (existing home sales, new home sales) and personal spending (durable goods and personal spending), neither of which are expected to be USD positives any time soon. Turning back to the technicals, The EUR/USD drop through 1.5600 broke below trendline support that guided EUR/USD higher since the break over 1.5000. Daily and weekly candlestick charts also show 'shooting star' patterns representing the sharp rejection from just below key psychological/round number resistance at 1.6000. Momentum studies have all crossed over to the downside from overbought territory, validating the price reversal lower. On Ichimoku charts, EUR/USD has fallen below the fastest line (Tenkan/conversion line), last at 1.5593, which should now act as resistance, and opens up potential for a move to the rising Kijun/base line, last at 1.5257. EUR/USD weakness below there opens up potential all the way back to the cloud down at the 1.4630/50 level. But let's not get ahead of ourselves just yet. For next week, I'm content to expect EUR/USD to be toppish in the 1.5550-5600 area and bottom-ish in the 1.5200/50 area, and I prefer to sell EUR/USD on strength until 1.5700 is surpassed. Traders will need to closely monitor commodity market developments next week to gauge the extent of the USD-upside. Further sharp declines in metals and oil could provoke a larger than anticipated recovery in the USD.

Is the credit crunch over?

The short answer is: No, not by a long shot. But, is the worst likely past? There, the answer is a cautiously optimistic 'yes' and that shift may hold the keys to a larger improvement in the USD outlook. It's clear to me that a large part of the USD's decline in recent weeks was due to fears of a systemic failure in the US financial sector. Various bullets were dodged along the way-bond insurers maintained their ratings, banks raised sufficient capital-but the outlook now is rapidly improving. US investment banks reported better than expected 1Q earnings this past week, suggesting that key firms have managed to get a handle on toxic debt and restructure holdings. The Fed has introduced multiple programs to increase financial market liquidity, with the latest initiative, the Term Securities Lending Facility (TSLF), set to debut on March 27th. The decision by the Fed to allow financial firms to post mortgage-backed securities as collateral is a key step to getting financial markets back in working order. Also, OFHEO (Office of Federal Housing Enterprise Oversight) this past week reduced the reserve margins that Fannie Mae and Freddie Mac are required to hold, freeing up $200 bio that can be used to purchase mortgage-backed securities, further lightening the load of banks down the road. The sooner the financial sector begins lending again internally, the sooner Main Street consumers and firms are likely to see an easing of credit conditions. We are by no means there yet, but it appears that the lending gears may finally be unstuck, which is the first step to ending the credit crunch.

Restoring financial market conditions to normal is a process that will likely still take many weeks and months, and the next few weeks are particularly sensitive. The end of the calendar quarter at the end of March is the nearest hurdle and European money markets seized up this past week as liquidity remained strained over that period, prompting the ECB and the BOE to inject billions more in liquidity operations. Much of the demand was for USD borrowing, which also likely contributed to better USD spot performance, as borrowers would fund in other currencies, sell them and buy USD's to satisfy USD obligations. I am also aware of the minefield of surprises markets have been exposed to over the last few months and the risk remains that additional unknowns will surface. But I think it's time to begin shaking off the paralysis of doom that has dogged the market since last year.

In terms of the overall market environment, I think we are on the verge of a significant improvement in risk appetites. For currencies, that means a return to buying the JPY-crosses (EUR/JPY, AUD/JPY and NZD/JPY) and otherwise focusing on higher yielding currencies. The short-term risk is that the USD rebound obscures or delays a recovery in the JPY-crosses. The way to work around that is to focus on buying USD/JPY on further weakness ahead of 95.00 or on a breakout to the upside.

Japanese gloom deepens, JPY is vulnerable

The USD staged a significant recovery against all major currencies with the exception of the JPY, which remained buoyant as risky trades were taken off in a relatively illiquid, pre-holiday market. The economic outlook in Japan, however, has deteriorated rapidly in recent weeks, with the latest monthly Tankan readings falling further. The US slowdown will eventually affect other major economies, and Japan is among the most vulnerable in relative terms to weaker US demand. Domestically, the Japanese government is facing an embarrassing episode where the opposition party has rejected the government's two nominations to replace retired BOJ Gov. Fukui. The Bank of Japan is currently headed by acting Gov. Shirakawa, this at a time when global financial markets remain in disarray. The MOF is unlikely to tolerate additional JPY-appreciation at this juncture, which would further de-stabilize domestic stock and bond markets. In addition, JPY-repatriation flows, where Japanese asset managers sell foreign-denominated assets and buy JPY for financial year end (March 31) window dressing, have likely come to an end. In the Week Ahead of Feb. 24, when USD/JPY was around 107, I headlined a section "JPY-repatriation has begun" and suggested the JPY would be bought through the third week of March. That window has now passed and it's time to start looking at selling the JPY on remaining strength toward 95-97, or on a break higher in USD/JPY over roughly the 100.50 area. Please see the Weekly Strategy for further discussion of this.

Key data and events to watch next week

Last week I cautioned that liquidity conditions would worsen toward the end of the week due to the Easter Holidays and price action was pretty jumpy from Wednesday onwards. Monday of next week will remain exceptionally thin and overall liquidity for the week will remain sub-par as UK and European markets remain short-staffed. Traders should expect further erratic price behavior next week and should adjust their trading strategies accordingly.

US data begins on Monday with Feb. existing home sales as the sole release of note. Tuesday sees the Jan. S&P/CaseShiller home price index, March consumer confidence, March Richmond Fed manufacturing index and the OFHEO Jan. house price index. Wednesday sees Feb. durable goods orders and Feb. new home sales. Thursday will see the final 4Q GDP estimate along weekly jobless claims and continuing claims. Friday finishes up with Feb. personal income & spending, Feb. core-PCE inflation, and final March Univ. of Michigan consumer sentiment. Multiple Fed speakers are on tap-please see the Economic Calendar for exact times.

Eurozone data begins on Wednesday with March French business confidence and March German IFO business climate. Thursday sees the April German GfK consumer sentiment survey. Friday sees Feb. German import prices, March French consumer confidence, and preliminary March German CPI.

UK data begins at midnight GMT on Monday with the release of the March Rightmove house price index. The next data is on Thursday which sees final 4Q total business investment, BBA home loan data for Feb. and the March CBI distributive trades report, a private measure of retail sales. Friday sees March Nationwide Building Society house prices and the final 4Q GDP estimate.

Japanese data begins on Monday morning in Tokyo with the release of 1Q BSI Large All Industry index. Wednesday sees the Feb. merchandise trade balance and Feb. corporate service prices. Thursday afternoon sees March small business confidence. Friday's data schedule is heavy with Feb. jobless data, Feb. household spending, March Tokyo CPI, Feb. national CPI, Feb. large retailers sales and Feb. retail trade.