As the year comes to an end, the DailyFX research team looks to 2011 with interest and – of course –ideas on what we may see in the 12 months ahead. Find some of our top trades for the year and our opinion on the most important themes in the forex market for the New Year.
JOHN KICKLIGHTER
Currency Strategist
Those that Stick Their Neck Out the Furthest
Short: GBP, EUR; Long: USD
Fiscal responsibility is a good policy when it comes to the long-term health of a market and economy. However, when you are one of a few players that are looking to reign in the support when the rest of the globe is nurturing a still-weak recovery; it is asking for trouble. We have seen both the UK and Eurozone make considerable strides to cut deficits and reduce the threat of burdensome budget as well as sovereign credit rating pressure. And, over the long-run, these efforts will very likely help the economies and stabilize their markets. On the other hand, what happens in the event of a near-term slump in risk appetite and a stagnant period of growth? Those policy authorities that pursued austerity will pay for their efforts by amplifying the weakness of their economies. For the UK, the record budget cut and plans to cut 500,000 government jobs will reflect what impact it has starting in the 4Q and 1Q GDP numbers. Once that effect is noted, the sensitivity to risk trends will be leveraged. For the Eurozone, the application of austerity measures to already weak members will likely push these economy’s deeper into recession and further into financial turmoil – eventually spelling contagion for the entire region.
This will lead both the Euro and British pound to meaningful declines. And, where will the capital go? Naturally, investors will seek liquidity; but they will also look for support. They will find it in the US dollar. This development only speaks to the first stage reaction. The pain will be amplified in those austere currencies for sure. Yet when underlying investor fears level off; the survival of these economies able to maintain a conservative fiscal position will put long-term investors on the hunt for European and British assets. Both of these developments are likely to happen within 2011; with the first phase likely to come before mid-year while the second will take place sometime in the third quarter. When that second phase occurs, we can reverse that position to short Dollars and long Euros and Pounds.
A Collapse of Government-Sponsored Risk Appetite
Short: EUR, AUD, NZD, S&P 500; Long: Gold, USD, CHF
In contrast to 2009’s consistent advance in speculative and growth-dependent assets, this past year’s performance was far more volatile. What was the difference between these two periods? In late 2009 and early 2009, the governments of the world rushed in to guarantee risky assets, buy up toxic assets and pump liquidity into the markets. This was a rush of relief for a market that seemed on the verge of collapse. And in the subsequent reprieve, tremendous amounts of capital that was transferred into the most liquid and low risk assets had to make its way back into the market. That recapitalization lasted through most of 2009; but in 2010 the markets were once again topped off. Fundamentals would again come into play; but the side effects of government stimulus lingered and helped maintain to sustain risky positioning. And, in fact, additional stimulus was pumped into the system to prevent a European crisis from spreading, the US falling back into recession and Japan from a permanent state of deflation. This stimulus can certainly have positive effects on growth; but the benefits of additional support are increasingly marginal. Eventually the markets will have to make a natural correction to account for the anemic outlook for employment, growth, earnings, dividends and every other meaningful measure of activity and return. When this day of reckoning does come, the governments will find they are already over-extended and won’t have the necessary resources to fight a collapse in sentiment that is already acclimated to stimulus. That will only increase conviction in the subsequent unwind – especially in those assets that have reaped the benefit of stimulus.
Among the rank that will be hardest hit are the high-yielding currencies (Australian and New Zealand dollars), the euro which has seen cracks in the support of its 750 billion euro rescue fund and the S&P 500 which has been inflated by Fed stimulus. On the other end of this development is the market’s most liquid asset (the US dollar), the euro’s principle counterpart (the Swiss franc), and the asset that is considered an alternative store of wealth (gold). For a time frame, this will most likely happen in the first half of the year; but it is difficult to say how much stimulus will be pumped in to temporarily hold up the house of cards.
DAVID RODRIGUEZ
Quantitative Strategist
Crises Aren’t Done Just Yet
Long: USD, Short: EUR
At the risk of sounding like a broken record, I believe that the US Dollar has set an important low against the Euro through the month of November. My belief is based primarily off of more quantitative measures such as Futures positioning and FX Options risk reversals. Yet below all of that remains a compelling fundamental argument for Euro weakness and US Dollar strength—the ongoing Euro Zone fiscal debt crisis.
When all is said and done, I see very little scope for material improvement in the Euro Zone’s debt issues. As measured by proportion of GDP, Euro Zone countries are among the most indebted among all industrialized nations. This means that the topic of interest rates and government bond yields is especially significant, and the ongoing crisis in confidence will only inflate EMU country debt further.
Clearly the US Dollar side of the equations is not without problems. Yet I hardly think that the EMU nations have the appetite to bailout further members in the foreseeable future—that which is a growing risk and may be only a matter of time. Thus I think we can continue to see the Euro decline against the US Dollar going into the New Year. It may be especially important to watch price action in the month of January, as this typically sets the pace for the remainder of the year.
JAMIE SAETTELE
Sr. Technical Strategist
Shorting the Pacific Rim in 2011
Short AUD, NZD, JPY; Long: USD
ILYA SPIVAK
Currency Strategist
The Multi-Year Euro Downtrend Continues
Short: EUR, Long: USD
Broadly speaking, the Euro has been trending lower since July 2008 having peaked above 1.60 against the US Dollar. Consensus forecasts suggest the pace of GDP growth in the Euro Zone will lag that of the US by 1.2 percent on average through 2012, the largest disparity among industrialized economies. Accelerating growth puts upward pressure on interest rates even in the absence of monetary tightening; indeed, while central banks may err on the side of caution amid a still-fragile global recovery, a pickup in activity will see firms begin to engage idle capital, reducing the supply of loanable funds and bidding rates higher. Assuming this occurs faster in the US, the greenback is likely to rise against the single currency. The continuing evolution of the Euro Zone debt crisis promises to encourage this process, particularly if sovereign risk concerns engulf a larger member state like Spain or even Italy, eroding confidence in the region’s assets.
The US Budget Deficit Takes Its Toll on Bond Yields
Short: JPY, Long: USD
The US budget deficit hit 10.3 percent of GDP – the most in over four decades – in 2009 and is expected to average a still very high 9 percent this year. Filling such a tremendous hole will not be done through spending cuts and tax increases alone, particularly given the political hurdles facing either approach. The path of least resistance leads to an increase in borrowing, amounting to large-scale issuance new US Treasury bonds sending their prices lower while driving yields higher. Given the Japanese Yen’s long-established inverse relationship with US yields, this points USDJPY upside. Indeed, looking at data since 1978 (the first full year since the demise of the Gold Standard), regression studies suggest that well over 70 percent of the variance in the USDJPY exchange rate is explained by variance in 10-year US Treasury yields.
JOEL KRUGER
Technical Strategist
Violently Oversold Monthly Studies Are Too Compelling to Ignore
Long: EUR; Short: AUD
We have warned that we see risks for significant downside in the Australian Dollar over the coming months, with the single currency trading by record highs and looking very stretched on a cyclical basis. All of the fundamental drivers of the Aussie strength look to be approaching exhaustion and we believe that things will not be sustainable from here. RBA monetary policy has been extremely aggressive in the face of a global slowdown to produce attractive yield differentials, while booming commodity prices and a flourishing Chinese economy have also helped to propel the antipodean. However, at this point, the RBA is already starting to slow down with its tightening bias, while other central banks are starting to play catch up. At the same time, commodities prices are looking quite overdone and show plenty of room for a sizeable corrective pullback, while the latest Chinese measures to curb inflation, will likely weigh on the China dependent Australian economy.
With this in mind, we recommend a short Aussie position into 2011 via the Euro. We have chosen to short the Aussie through the Euro instead of the Dollar as we believe it is a safer play from here and also could offer a more attractive risk/reward. The cross sits at 20 year lows and by the bottom of a major range. Monthly studies are severely oversold (very rare) with the RSI by 25 and in desperate need of a healthy bounce. Up to this point, the Eur/Aud cross has been somewhat inversely correlated to Eur/Usd, particularly in periods of Eur/Usd strength. When the Euro rises, markets have taken this as a risk positive and the higher yielding Aussie then rallies even more on the favorable yield differentials. Meanwhile, when the Eur/Usd sells off, the markets have been inclined to take this as a risk negative and in turn look to liquidate the higher yielding Aussie more aggressively. But moving forward, we see the Australian Dollar at risk even in the event of more broad based USD depreciation. The basis for our argument is that with the Australian economic data finally starting to show a dent in its armor, the attractive yield differential in periods of USD weakness will no longer be quite as attractive, with market participants starting to price in a slowdown in the local economy.
JOHN RIVERA
Currency Analyst
“Loonie” Falls Inline as U.S. Yield Expectations Rise
Long USD; Short CAD
Heading into 2011 there are three major themes that will dominate price action and traders will need to account for them when deciding which positions to take. The first is the European debt crisis which is currently at the forefront of trader’s minds and has everyone looking to bail on the Euro as speculation grows that the single currency’s days are numbered. The second theme is will the U.S. labor market find traction and propel growth in the world’s largest economy, negating the need for additional QE from the FOMC. The third is how long will emerging markets in particular China continue to drive the global economy and will their governments step up their attempts to slow domestic growth as inflation risks grow.
Focusing on the latter two themes a strong case can be made for a long USD/CAD trade, if we see slowing demand for Canadian exports from emerging markets coupled with rising U.S. yield expectations. An improved outlook for growth and rising inflation concerns should drive U.S. yield expectations and provide bullish greenback sentiment. Parity continues to provide solid support for the pair as Canada’s dependence on its southern neighbor makes it a difficult case to place a greater value on the “Loonie” than the greenback. The 2010 high of 1.0851 is a reasonable target, with potential to 1.1500. However, we must guard against excessive pump priming by the Fed which could deter demand for U.S. treasuries, causing similar concerns to those that are weighing on the Euro-Zone.
MICHAEL WRIGHT
Currency Analyst
Fighting a Losing Battle
Short EUR; Long USD
Debt contagion fears in the euro zone will continue to weigh on the single-currency in 2011 as the market places the spotlight on Portugal and Spain after Greece and Ireland tapped into the EU-IMF life line. As of late, the credit default swaps (cost of insuring against a sovereign default) in Portugal and Spain have jumped approximately 400 and 300 basis points respectively and may continue their northern journey as both governments struggle to bring down their deficits. The recovery in the 16 member euro area is fragile and growth will come under pressure in the medium term as governments plan to implement tough austerity measures. Looking ahead, if appropriate action is not taken, the negative spillover effects of the recent developments will likely be an unemployment rate nearing 15 percent, a mild recession, and renewed housing concerns. As the bloc faces major headwinds in achieving a self-sustaining recovery, the European Central Bank is expected to remain on the sidelines for most of next year, with realistic thoughts of raising rates returning in the fourth quarter.
In light of additional concerns in the troubled euro area resurfacing, the safety-linked greenback will likely push higher. However, the catalyst needed for the dollar to uphold its strength will need to come on the back of positive fundamental developments, surrounding employment and inflation, with those developments likely to come to light during the middle of the year as compared to 2012 in the Euro-Zone. Moreover interest rate expectations in the U.S. may push higher next year due to the Fed’s second round of quantitative easing. All in all, market participants may witness the euro come under increased selling pressure in 2011 against the U.S. dollar.
