Weekly Review and Outlook: Dollar Rebounded as Focus Turned to Eurozone Debt, China and Yields

By: Milla Shaw in Forex Consultant on Nov. 10, 2010

A couple of factors boosted dollar last week and sent the dollar index through near term resistance of 78.36. Firstly, there were persistent speculations on Eurozone debt crisis that gave much pressure to Euro and pulled EUR/USD back below 1.37 level. Secondly, weak bond auctions from US lifted longer term treasury yields and send USD/JPY through 82 resistance level. Thirdly, and seemed the strongest factor, risk sentiments were hit by additional tightening measures from China and markets believed that another rate hike is imminent to cool inflation. Commodities and equities were sharply lower towards the end of the week and the deep fall in gold helped stabilize the greenback even though Euro attempted a recovery. We’re using EUR/AUD and AUD/JPY to gauge the impact of the above three forces and the development showed that markets were in much deeper concern in the development in China.

Euro was under much pressure last week on speculation that Ireland was on the verge of a EUR 80b bailout from EU and IMF. The rumors sent CDS on peripheral Eurozone countries to record high, as well as respective bond spread with benchmark German bund. Nevertheless, the rumor was denied by Irish finance ministry on Friday. Investors were also worried that Germany will push forward measures to have bond holders sharing the burden in future bailout of countries in fiscal problems. But investors were then calmed down by a a joint statement by UK, France, Germany, Italy and Spain that “any new (bailout) mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements”. After all, the debt crisis situation is not going away soon. Also, GDP data from Eurozone showed deeper than expected slowdown in the recovery in Q3, as the result of governments’ austerity plans. Euro will likely continue to remain soft against Swissy and Sterling for a while.

Dollar, on the other hand, was lifted by surge in longer term treasury yields last week. The $24b 10-year Treasury auction showed weak demand, with bid-to-cover ratio of 2.8 comparing to 3.14 average at the past 10 auctions. Demand on the $16b 30 year bond auction was also less than impressive, with bid-to-cover ratio at 2.31, lowest since November 2009. Yield was at 4.32%, which was higher than market consensus of 4.288%. Fed had made it clear that the $600B QE2 will concentrate on purchases of 4-year to 10-year Treasuries and the bond auction results sent yield on 30 years and 10 years bonds up to as high as 4.335% and 2.783% respectively. Markets somewhat stabilized after Fed announced a busy plan to purchase $105b of treasuries over the next month from November 12 through December 19, in 18 market operations. But the development so far favors more upside in yields ahead, in particular if yield on 10 year note could break through 2.83% resistance level. And such developments will likely send USD/JPY further higher through 83 level.

China announced some new measures last week to curb inflation and guard the country against hot money inflow. The strong CPI reading of 4.4% yoy in October justified the government’s move. State Administration of Foreign Exchange announced new rules that included stricter management of quotas for use of short term foreign debts and oversight of fund repatriation by Chinese companies. In addition, there will be controls on equity investments by foreign companies in China. Besides, China lifted reserve ratio rates for some of its major banks to 18.5% and was seen as another evidence that China is normalizing its monetary policy. Also, China would limit investments by foreign companies in the domestic real-estate markets and would be barred from purchasing residential properties. It’s believed that another rate hike from China is imminent. The development sent global equities and commodity broadly lower. Gold dropped sharply from the new record high of 1424 and closed at 1365. Crude oil also reversed from 88.63 to close at 84.73. Aussie was hardest hit by the developments and was down against all major currencies.

Sterling was relatively steady as supported by BoE Quarterly Inflation Report. Other than stating inflation is likely to pick up a little further in the near-term, BOE’s November Inflation Report contains few surprises. The central bank forecasts ‘the chances of inflation being either above or below the target (2%) by the end of the forecast period are judged to be roughly equal. Moreover, UK’s recovery is expected to continue, supported by expansionary monetary policy, further growth in global demand and the past depreciation of sterling’. Although policymakers have left the Bank rate unchanged at 0.5% and the asset-purchase program at 200B pound, the report unveiled that there were’ wider than usual range of views’ among officials. More in BOE Expects Inflation to Overshoot in the Near-Term.

Technical Highlights

While everybody talked about Euro weakness last week, situation in Aussie was indeed worse considering the sharp reversal in EUR/AUD on Friday. A short term bottom is no doubt formed and we should seen some more rebound in the cross ahead. Nevertheless, the more important point to note is in the possibility of completion of a terminal triangle. There is not confirmation yet, but we’d like to point out that price actions from 1.5455 could indeed be a five wave diagonal triangle pattern that’s finished at 1.3641. Focus will be on 1.4370 and a strong break there will confirm medium term reversal, which would see EUR/AUD soars through 1.5455 resistance eventually.

Yen was rather mixed last week. It’s partly pressured by jump in US treasury yield and partly supported by risk aversion. While yen weakened against dollar, it did stage a strong rebound against Aussie towards the end of the week. The overall outlook in AUD/JPY remains unchanged. Price actions from 71.86 are treated as consolidation to fall from 88.04 only. It’s still a bit early to conclude that such consolidation is finished. But strong resistance should be seen even if it manages to extend the rise to above 82.83. Meanwhile a break of 78.17 support will be the first alert that such consolidation is completed and will turn outlook bearish for a test on 71.86/73.60 support zone. Also, ideally, such decline should be accompanied by a break of 4700 level in Australian All Ordinaries index.

Looking back at the dollar index, the break of 78.36 resistance confirms that a short term bottom is formed at 75.63. We’d stay cautiously bullish in near term as long as 77.44 minor support holds and expect stronger recovery to 55 days EMA (now at 78.79). However, note that break of 80.08 support turned resistance is still needed to confirm reversal. Otherwise, we’re not totally comfortable with the bullish scenario yet. On the downside, below 77.44 minor support will flip bias back to the downside for 75.63 low and possibly below.

The Week Ahead

The post QE rebound in dollar was late but did came last week as markets’ focus turned to Europe, China and G20. Fundamentally speaking, we’d expect dollar to stay supported as long as focus remains elsewhere other then Fed’s QE program. Development in Ireland and China will continue to have an impact on market volatility while treasury yield will determine whether dollar and yen would take lead in risk sentiments trades. Also, Sterling was so far quite resilient thanks to buying in EUR/GBP. The pound will face some tests from UK data as BoE minutes this week.

Sunday: New Zealand retail sales; Japan GDP
Monday: Eurozone trade balance, US retail sales, empire state manufacturing; business inventories
Tuesday: RBA minutes; UK CPI; German ZEW; US PPI, TIC capital flow, industrial production; NAHB housing market index
Wednesday: UK employment report, BoE minutes; US CPI, new residential construction; New Zealand PPI
Thursday: UK Public sector net borrowing, retail sales; Swiss ZEW; US jobless claims, Philly Fed survey; BoC review
Friday: Japan all industrial index; German PPI

USD/JPY’s sharp rebound and break of 81.97 resistance last week indicates that a short term bottom is already formed at 80.29. Further rise will now remains in favor as long as 81.54 support holds. Current rebound should continue towards key cluster resistance level at 85.92 (38.2% retracement of 94.97 to 80.29 at 85.89). On the downside, however, below 81.54 will flip intraday bias back to the downside for retesting 80.29 low instead.

In the bigger picture, at this point, there is no evidence of trend reversal yet and the long term decline in USD/JPY from 2007 high of 124.13 could still extend beyond 79.75. However, note that decisive break of 85.92 resistance will be the first signal of medium term bottoming and will turn focus back to 94.97 for confirmation on reversal.

In the long term picture, there is no indication of trend reversal yet and USD/JPY’s long term down trend could still extend further to 1995 low of 79.75. We’d anticipate some strong support from 79.75 initially to bring rebound. Focus will be on whether 79.75 would hold or USD/JPY is indeed resuming the multi decade decline that started back in the 80′s.