The new decoupling: Why smart money is starting to bet on USD

A pdf version of this report with graphs is available for free at the ForexDatasource blog ([url]www.forexdatasource.com/Blog/fxblog.aspx[/url]) or through the Forex Datasource FX Hound ([url]www.forexdatasource.com/widget/ProtraderReg2.aspx[/url]) [B][U]EURO Report [/U][/B] [B]Current Environment[/B] The testimony that Bank of England Governor Mervyn King delivered before Parliament on Tuesday unsettled euro and sterling bulls. King warned of high inflation rates lasting several more months and of the need to set aside a rainy day fund for similar bank failures to that of Northern Rock. The release of the BofE minutes on Wednesday showed that 1 of the 9 voting members argued for a rate increase – this gave a boost to sterling. The internal debate in the UK MPC gives hope to some that a 0.25bp rate rise may occur before year-end. The majority of the economic data out the UK and EU on Thursday was poor and worse than anticipated, particularly the German IFO and UK retail sales. Suddenly, the odds of an EU/UK recession have increased while the real return from European assets is bound to be poor for a long while. The theory of EU/UK decoupling is (again) out of favor. Even though the US remains in dire shape, “smart money” appears ready to usher in a period of cyclical dollar strength. [B]What the FMV is telling us[/B] In our previous report, the actual EURUSD was trading 0.2% above the EURUSD FMV – a weak bullish euro sign. Going into the weekend, the actual EURUSD was trading 0.7% below the FMV EURUSD – a euro bearish signal. With the EURUSD FMV down around the 1.5800 level, we doubt whether the actual EURUSD can or should break that FMV level – hence, a bearish EURUSD trend is likely to persist. From a wider FMV perspective, the euro is in a 1.0% oversold position against the sterling, but holds overbought positions against the swissie and yen, 0.4% and 0.6%, respectively. The notion where the yen and swissie are seen as safe-haven currencies is seriously questioned at the present time. [B]Scenario Analysis[/B] Last week we indicated that EURUSD would most likely trade in a 1.5700-1.6050 range (1.5650-1.5940 actual). For this week, we see a trading range of 1.5500-1.5800. The euro will test a support line dating back to mid August 2007. A drop below the 1.5500 line could usher in a rapid drop to 1.4950 within 4 weeks. Major Forex banks like Deutsche Bank and UBS issued reports last week pointing to the start of USD strength. It is not the first time we’ve heard this, but this time around there is a better chance that these forecasts may take hold. Nobody is claiming that the end of US weakness is within sight, but it is clear that even though the EU region does not have a sub-prime problem, the ECB has limited room for interest rate increases due to what looks like a rapidly deteriorating EU economic situation. [B][U]STERLING REPORT[/U][/B] [B]Current Environment[/B] The good start for the week seen for GBPUSD came to an abrupt end with BoE’s King warning of high inflation for months to come. But the sterling fall against the US dollar was not as pronounced as that of the euro. EURGBP fell from a intra-week high of 0.7970 on Monday to 0.7840 on Wednesday (a 1.7% drop), after the BoE minutes were published. Part of those EURGBP gains were reversed after weak UK retail sales numbers came out on Thursday. The dramatic drop in crude oil prices – down 17.7% to $123.26/bbl in 10 days – is a reflection that at least the energy price rally may have peaked. The ongoing CFTC crack down on speculators is a factor in the drop, but there are concrete signals that global demand for oil in the second half of the year might be much weaker than initially thought. [B]What the FMV is telling us[/B] Last week, the actual GBPUSD was trading flat with the GBPUSD FMV (a neutral sterling signal). At the close of last week, the actual GBPUSD was trading 0.4% below the GBPUSD FMV line – a bullish sterling signal. The GBPUSD FMV for close on Monday is 1.9860. The big drop in GBPUSD FMV value to 1.97 from 2.00 reflects the fundamental impact from the negative UK retail data. From a wider FMV perspective, the sterling is now in a overbought FMV position against the euro (1.0%), the yen (1.6%) and the swissie (1.4%). We have not seen this level of sterling bullishness in some time. [B] Scenario Analysis[/B] Last week we indicated that GBPUSD would most likely trade in a 1.9820-2.150 range (1.9820-2.0070 actual). Our forecast was right on target for the downside, while the upside target was about 0.4% off. For the coming week, we see GBPUSD trading in a 1.96-2.00 trading range. Our view for this week is that GBPUSD will likely test support as low as 1.96. The strength demonstrated by sterling is apparent in a couple of ways. First, GBPUSD held up to the support line dating back to the middle of June, something EURUSD could not do. Second, the FMV signal points to sterling strength, whereas all other six major pairs point to US dollar strength from an FMV perspective. We suspect that continued USD strength and the close correlation of sterling to the euro will ultimately bring GBPUSD below the mid-June support and towards the 1.96 support. [B]About Forex Datasource[/B] ForexDatasource.com (forexds.com) is a content-rich website serving the Forex market. The firm offers interactive features that allow traders to prepare for upcoming price volatility and also counts with proprietary tools and weekly reports for swing and position traders. Forex Datasource also licenses its FX Hound widget technology to major Forex websites and Forex brokers.