The USD will continue to strengthen

By Brian Dolan and Jacob Oubina
Forex.com
The USD largely consolidated its recent gains this week, but not before making marginal new highs against the most beleaguered currencies (EUR, GBP, and AUD). Data continued to come in showing further deterioration in both current conditions and future outlooks in the UK and Europe. In contrast, US data continued to come in mostly better than expected (existing homes sales, consumer confidence, durable goods, 2Q GDP, and Chicago PMI all beat expectations). This is a theme we have been following for several months now, and it finally seems to have taken hold among analysts in the broader market. In contrarian thinking, that would suggest the bulk of the USD's moves are done for the time being. But I'll argue later that this is most likely simply a period of consolidation that will be followed by further USD gains. In the meantime, traders need to be prepared for more consolidation and relatively choppy conditions, subject to key levels I'll outline next.

Recent data has painted a very clear picture of deteriorating growth prospects in G7 economies outside of the US, while US data has shown increasing signs of stabilization. Still, nagging concerns remain about the US outlook. It's as if we're paddling down an uncharted river and we're not sure if the rocks we see up ahead are just shallow rapids or the edge of large waterfall. This uncertainty is the most likely driver of the current period of consolidation, and with major US data out next week (Beige Book and Aug. NFP, in particular) there are plenty of near-term risks to contend with. The data will eventually reveal itself to us, but as we have argued in recent weeks, US consumers have retrenched and look able to weather the storm, as long as it doesn't last too long. This view, contrasted with eroding outlooks elsewhere, keep us fundamentally biased toward further USD gains.

The other major USD support going forward stems not from currencies as a barometer of national outlooks, but rather from currencies as an asset class. Over the last five years as the USD weakened, US investors increasingly sent investments abroad. With stumbling economic outlooks in Europe/UK/Japan and fresh signs of slowing in Asia ex-Japan, US investors will increasingly be repatriating assets back to the US. The sudden rebound in the USD has likely caught many investors flat-footed, meaning the bulk of USD asset repatriation has yet to hit the market. These flows will be an ongoing source of USD support over the next several months, regardless of what the US data suggests for the here and now. (And we're not talking a few billion here, but rather trillions of dollars in off-shored investments.) Next Friday's Aug. NFP will likely be a case in point. We will be watching closely to see if the USD is able to shrug off another expected job loss, which would be another indication of the long-term nature of the current USD recovery. Should the USD react more negatively, we'll take it as an indication that consolidation is ongoing.

• European Central Bank
The European Central Bank is up on Thursday at 1145GMT with the usual press statement following at 1230GMT. The consensus is for the bank to leave rates on hold at the current 4.25% level. As such, the press statement will once again be in focus. Recent comments from ECB member Axel Weber that a rate cut is currently premature are likely to resonate in Trichet's post rate decision comments. That said Trichet will also have to acknowledge that economic growth has clearly slowed with 2Q GDP printing negative and recent business surveys like the German IFO -- which plunged to 94.8 in August from a prior 97.5 -- suggesting no speedy recovery in 3Q. While likely to be similar to the prior press statement which harped on inflation worries and downgraded growth slightly, we would expect a potential bounce in EUR/USD if Trichet suggests rate cuts are out of the question. In this case we would look to sell post-Trichet EUR bounces as reality sinks in that the Euro-zone economy remains on shaky ground.

• Bank of England
Last but not least, the Bank of England will decide on rates on Thursday at 1100GMT. The consensus here is unanimous that the bank will leave rates at the current 5.00% level. If this happens, the release will turn out to be a non-event as the BOE does not provide a press statement unless they make a change to rates. The meeting will likely prove to be contentious as per the latest musings from BOE member David Blanchflower who noted the very real risk of the UK plunging into a recession. Indeed he said that he expects "negative growth" for "several further quarters.'' While the risk of a rate cut is an extremely low probability event, this would be the only thing to shake up GBP/USD in a big way. On such a surprise we would expect Sterling to see a sharp leg-down towards the 1.8000 area.