Euro was under relentless assault in early morning European trade today, after reports on the website http://www.benzinga.com suggested that Austria may be the latest trouble spot for the credit crisis spreading throughout the region. The Austrian regulators have already nationalized Carinthian Hypo Alpe Adria Bank AG and speculation is mounting that Austria’s fourth largest bank Oesterreichische Volksbanken AG (OeVAG) may be the next to be rescued.

OeVAG which reported an accumulated loss of 607 million euros in the first three quarters of this year has a balance sheet of 53 Billion euros. Investors are concerned that credit writedowns could skyrocket to 20 Billion euros on the loan book of Austrian banks putting massive stress on the European financial system.

The euro tumbled below the 1.4600 level for the first time since October 5th as the single currency suddenly became a toxic asset of its own, with traders loathe to buy it until further clarity in Austrian banking sector can be established. The unit has now come off more than 500 points from its yearly highs as concerns over the fiscal integrity of the European financial sector along with better than expected US economic data have markedly changed the dynamic in the FX market in favor of the dollar.

FX traders will now look to the ZEW survey due at 10:00 GMT for latest data point on the state of the Eurozone economy, but if the report disappoints, the combination of weak economic data and heightened fears over another possible credit crisis in the European financial system could easily drive the pair below 1.4500 figure before the day’s end.

WHY THE SHIFT IN USD POSITIONING IS VERY SIGNIFICANT

The price action in the currency and equity markets suggests that investor sentiment has improved. However considering the magnitude of the news that Citigroup plans to repay TARP funds, Abu Dhabi’s $10 billion support to Dubai World and Exxon Mobile’s $31 billion stock deal to acquire XTO Energy, we would have expected a more significant reaction in the financial markets. Instead, U.S. stocks ended the day virtually unchanged while the dollar gave back a small portion of its recent gains. The consolidation in the forex markets reflects the lack of U.S. economic data and hesitancy of currency traders to add to their long dollar positions ahead of the Federal Reserve’s monetary policy announcement on Wednesday.

Reining in Inflation Week

Based upon the latest labor market and consumer spending reports, there has been enough improvements in the U.S. economy to warrant a more hawkish stance from the Federal Reserve. However as recently as December 7th , comments Fed Chairman Ben Bernanke suggests he is not convinced that the improvements are here to stay. Although we are also skeptical about whether the U.S. economy has really taken a turn and question the possibility of positive job growth next month, at bare minimum, FOMC members will need to acknowledge the improvements. Their degree of hawkishness will also be partially contingent about the upcoming inflation numbers. It is inflation week across the globe with producer and consumer price figures due for release from many of the G20 nations. Tomorrow’s producer price report will provide an updated look at the latest inflationary conditions in the U.S. With import prices rising by the strongest amount in 5 months, inflationary pressures have accelerated and we expect this trend to be reflected in the upcoming PPI and CPI releases. Higher inflationary pressures should encourage more hawkish comments from the Fed but knowing that once they turn optimistic, they cannot pare back as readily they will try to stick to their cautious optimism as much as possible. How the Fed sways should determine how the dollar trades for the rest of the year.

Significance of Turn in Dollar Positioning

On Friday, the CFTC released their weekly Commitment of Traders Report, which measures positioning in the commodity markets. According to data from the Chicago Mercantile Exchange, future traders have reduced their short dollar positions across the board. In fact, speculative positioning in the EUR/USD turned net short for the first time since May. This shift from net short to net long dollars against euros is extremely significant. Since 2005, there has only been approximately 4 times (not including this time) that EUR/USD positioning has flipped to net short after being net long by more than 20k contracts. Each time, this shift in dollar positioning was a precursor to a more significant rally in the U.S. dollar. According to the following chart, the last time that speculative EUR/USD positioning (white line) flipped from net long to net short was in the first week of August 2008 and interestingly enough, that was the very week that the breakdown in the EUR/USD began, with the currency falling more than 3,000 pips or 20 percent over the next 3 months. W are certainly not saying that the EUR/USD will fall 20 percent from current levels because the move in the EUR/USD following each shift in dollar positioning has varied in terms of magnitude. However, the yellow vertical lines on the chart show that a flip consistently foreshadows a sell-off in the EUR/USD. If the Fed grows more hawkish on Wednesday, we could have a fundamental trigger for a more meaningful decline in the EUR/USD.



EUR: INDUSTRIAL PRODUCTION TURNS NEGATIVE

The Euro strengthened marginally against the U.S. dollar in quiet trading. German investor and business confidence are the key economic releases from the Eurozone this week which is why the drop Eurozone industrial production is so significant. For the first in 6 months, manufacturing activity in the Eurozone contracted. After rising strongly throughout the second and third quarters, industrial production fell by 0.6 percent in October. This was primarily due to slower manufacturing activity in Germany and France. Given the persistent rise in manufacturing PMI and the increase in the trade surplus, we do not expect this decline in industrial production to continue. The German ZEW survey which measures investor confidence is due for release tomorrow. We do not expect a major change in investor sentiment as stronger trade and retail sales activity offset weaker factory orders and industrial production. Don’t forget that this week’s 12 month tender will be the last and therefore the degree of demand will be particularly important. Meanwhile the Swiss franc also held onto its strength against the U.S. dollar and euro despite flat producer prices. Swiss industrial production and the SECO December economic forecasts are due for release tomorrow and based upon the Swiss National Bank’s hawkish comments last week, we expect the forecasts to entail a positive tone. The SNB announced that they will stop bond purchases at their last meeting, which is a step towards tighter monetary policy.

GBP REACTS TO CADBURY AND KRAFT DRAMA

The mild improvement in risk appetite has helped to drive the British pound higher against the U.S. dollar. However the drama surrounding U.S. based Kraft Foods’ hostile takeover bid for British chocolate maker Cadbury has triggered sharp intraday volatility in both the GBP/USD and EUR/GBP. Cadbury has been forced to step up its defence against Kraft’s $16.9 billion cash and stock offer. Such a large M&A deal will undoubtedly impact the forex markets because if the deal is passed and approved by shareholders and regulatory bodies, it would create a large near term demand to buy British pounds and sell U.S. dollars. Aside from Rightmove House Prices which was mixed, there was no market moving economic data from the U.K. last night. The RICS house price balance, the DCLG house price index and consumer prices are due for release tomorrow. The rise in the BRC shop price index suggests that inflationary pressures on the consumer level accelerated last month. However, we do not expect any acceleration to affect the Bank of England’s monetary policy stance. Last week, the BoE left the door open for additional easing and only employment or consumer spending figures (which are due for release later this week) could alter their plans.

AUD: ALL EYES ON RBA

U.S. dollar weakness drove all three of the commodity currencies higher. The Australian and New Zealand dollars appreciated by approximately the same amount while the Canadian dollar trailed behind. Whether or not the Australian dollar can sustain its gains will be partially contingent upon the tone of the RBA minutes, which are due for release this evening. Earlier this month, the RBA raised interest rates three months in a row. The minutes will help to explain why they decided to make such an unprecedented move. If they tightened because they cannot afford to wait and more is needed, we could see a sharp rally in the U.S. dollar but if they signal any hesitancy about future rate hikes, expect the sellers of Australian dollars to return. Meanwhile service sector activity in New Zealand accelerated dramatically in the month of November, supporting the recent hawkishness of the Reserve Bank. The PSI index jumped from 49.9 to 56.0 on stronger new orders and sales. House prices continued to grow, albeit at a slower pace. The Canadian dollar was unfazed by the drop in capacity utilization. Leading indicators and new motor vehicle sales are due for release tomorrow and based upon the rise in employment, housing starts and equities last month, we anticipate a round of CAD bullish numbers.

JPY: BUSINESS CONFIDENCE IMPROVES

The Japanese Yen strengthened across the board as business confidence improved in the fourth quarter. According to the latest Tankan survey, both manufacturers and non-manufacturers grew more optimistic in the last 3 months of the year. This is the third straight quarter of improvement in Japan and reflects the stabilization in the global economy. However a bleak outlook on capital expenditure suggests that Japanese companies still plan on spending cautiously. Also, this optimism was not shared by small businesses who expect to be negatively impacted by weak demand. There is big divergence between big firms and small firms in Japan with larger entities benefitting from corporate hedges and export flows and smaller entities trailing behind. Japanese companies have also reduced their average forecast of exchange rates from 94.50 to 92.93 for this fiscal year which ends in March. This suggests that their tolerance level for Yen strength has increased but given that their forecast is well above the current level of USD/JPY, Japanese firms are still suffering from Yen strength

GBP/USD: Currency in Play for Next 24 Hours

The currency in play for the next 24 hours is the GBP/USD. The UK will release their Consumer Price Index at 9:30GMT or 4:30AM EST. The U.S. will release producer prices and the Empire State survey at 13:30GMT or 8:30AM EST.

For the past 4 trading days, the GBP/USD has found support above the 1.62 level. However it remains to be seen how much longer the currency pair can hold below this level given that gains are capped by Fibonacci and moving average resistance. The 38.2 percent Fibo retracement of the 1.57 to 1.6880 rally sits right at 1.6435, which also coincides with the100 and 50 day SMA. The GBP/USD is also trading in the sell zone, which we determine using Bollinger Bands. As long as the currency pair holds below 1.6435, the downtrend remains intact. A break below 1.6155 would open a move down to 1.60.