By Brian Dolan Chief Currency Strategist and Jane Foley Research Director Gain Capital

Strength of the global rebound remains the key

We’re expecting further challenging market conditions overall. The degree of uncertainty on the outlooks for individual and collective economic recoveries has only increased and the potential for another credit-driven crisis remains very real. Above all, we think the strength of the global recovery will remain the central element in the 3Q and will remain the basis on which all incoming economic data and policy developments will be interpreted. In short, if data is positive on growth, or policy initiatives are supportive for growth, risk assets will likely strengthen. On the other hand, if incoming data suggest weakness or backsliding, or if policy prescriptions are seen to be hurting growth outlooks, then risk assets should decline.

US recovery to stay anemic; unemployment to weigh

In the US, we expect incoming data to show a still anemic overall recovery. This will become more apparent throughout the second half of the year as the effects of US fiscal stimulus begin to fade more seriously. High unemployment will persist and continue to restrain consumer spending and the overall US recovery. In the sense that the US remains one of the primary pillars of the global rebound in economic activity, sluggishness in the US is likely to undermine the outlook for global growth, and that is at the heart of our view that risk markets are predisposed to further weakness in the months ahead.

Euro-zone fiscal retrenchment poses risks

In Europe, governments are quickly moving to impose austerity measures in the aftermath of the credit crisis. While most policy provisions, as in spending cuts and tax increases, will not take effect until next year, markets are increasingly likely to begin pricing in the expected outcomes, namely lower consumption, higher unemployment, and rising credit default risks. Here again, we would note the vulnerability of the European banking sector to renewed economic weakness and the attendant negative implications for economic growth in the Eurozone.

UK budget cuts may de-rail recovery

In the UK, as in continental Europe, the newly elected government is set to introduce fiscal consolidation measures, i.e. budget cuts/tax increases, later this month. The risks are clearly on the side of underperformance in the UK outlook in the months ahead. We think a return to fiscal rectitude will only provide GBP with a short-term reprieve, and that likely years of austerity lie ahead, keeping the UK growth outlook on thin ice.

Key central banks to stay on hold given uncertainty

The major central banks, meaning the Fed in the US, the ECB in Europe and the Bank of England and the Bank of Japan are all expected to remain on the sidelines in the months ahead. The minor currency central banks, namely the Bank of Canada, the Reserve Bank of Australia and the Reserve Bank of New Zealand, have all embarked on a policy of removing extraordinary policy accommodation, i.e. raising interest rates from emergency levels.

The RBA is clearly the leader here, but they all share the risk that heightened concerns over global growth will cause them to postpone further rate hikes until the outlook improves in a more sustainable fashion. That should serve to keep their policy preferences extremely fluid and therefore their currencies may be subject to heightened volatility.

China additional stimulus may be a salvation

China appears to be stepping back from a policy of imposing credit restraint due to heightened global growth concerns emanating out of the European debt crisis. In this environment of uncertainty and volatility, Chinese policy is most likely to be kept on hold and further credit tightening seems unlikely, as does any change to its currency management regime.

However, if the global growth outlook appears to be under more serious threat, the Chinese may be compelled to undertake another round of fiscal stimulus to support and defend domestic tranquility. If a second round of stimulus is undertaken, the impact could be quite positive, in the short run, for commodities and commodity currencies AUD, CAD and NZD, as well as stock markets in general.

Expected Ranges for 3Q

We primarily expect additional USD strength and look for EUR and GBP to see potential new lows for the year. We don’t think it will be catastrophic weakness, but our risk bias is for additional downside potential. USD/JPY may be relatively steady given the off-setting influences of carry trades as bets on the direction of risk and the role of the USD as ‘the’ safe haven currency.

The commodity currencies, Aussie, Canada and Kiwi are likely in our view to remain pretty stable around current levels against the USD. But the risk is to their downsides should the global recovery experience further setbacks and the USD is sought as a refuge. In EUR/GBP, we see the risks mostly to the downside owing to a likely weaker European outlook and the potential for GBP to recover. In EUR/JPY, our view toward further weakness is based on both our weak EUR outlook and the expectation that risk appetites are more likely to soften than strengthen as we head into the end of the year and a very uncertain 2011.

In gold, our primary expectation is that gold will remain supported by ongoing concerns over the value of national currencies. But we think the risks are that gold breaks down on the potential for a surge in risk aversion and with it the USD. We would also note a potential ‘double top’ pattern in gold at the 1250 level that may signal a larger reversal in precious metals. Lastly, in WTI crude oil we think prices should remain below US$80 /b and are at risk of falling to new lows for the year if the global recovery begins to slow more markedly.

In terms of trading strategies we think could be successful in the 3Q, we favor buying USD/JPY on weakness below 90.00 and looking for an eventual move to near 100. In EUR/GBP, we think a correction higher in the pair offers a selling opportunity to take advantage of further EUR weakness, which we also express with our short EUR/USD strategy.

In WTI crude oil, we similarly look to enter short positions on strength toward our expected upper range limit around US$80 /b. AUD/JPY is currently near levels where we would like to establish what is effectively a ‘short risk’ position and fits our view that risk sentiment is most likely to deteriorate as the summer wears on.

The last trading strategy, to sell NZD against the CAD, is a relative recovery play. Here we think the NZ recovery will be more muted and consequently make the RBNZ less likely to tighten as aggressively as markets are expecting. In contrast, we think the Canadian recovery will continue on solid footing and the Bank of Canada will continue to withdraw extraordinary accommodation, potentially raising rates more rapidly than markets currently expect.

The views expressed in this story are the authors' and not FNArena's (see our disclaimer).

GAIN Capital Holdings, Inc. is a global provider of online trading services, specialising in foreign exchange (forex or FX) and contracts for difference (CFDs). Customers and trading partners in more than 140 countries have utilised the company’s award-winning trading platform which transacts nearly US$200bn per month. For company information, visit www.gaincapital.com or www.forex.com.

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