Market Outlook:

GBP has been the star performer this week as short covering and speculation of a pause in QE by the BoE have helped sterling to catch up with other pro-risk currencies. The rally in GBP spot has been accompanied by a spike in short dated volatility and a jump in GBP risk reversals to a two-month high. We believe market conditions are likely to stay choppy over the coming weeks with GBP crosses subject to two-way volatility as uncertainty reigns over what the MPC will decide on QE next month. G10 currencies are likely to be characterised by elevated event risk over the coming weeks as we approach a busy schedule of G20 and central bank meetings during the first week of November and ECB president Trichet prepares to visit China. Negative US/G10 interest rate spreads provide fuel for ongoing USD weakness, though this has to be balanced with the emergence of new initiatives in Congress to support the US economy in 2010.

Technicals:

Dollar oversold?
Pound rallies as expected - more to come
Commodity currencies' trends to interrupt?

Quantitative Analysis:

Sterling volatility breaks higher
Interest rate spreads become dominant driver for G-10 FX

Macro Outlook

GBP has been the star performer this week as short covering and speculation of a pause in QE by the BoE have helped sterling to catch up with other pro-risk currencies. The rally in GBP spot has been accompanied by a spike in short dated volatility and a jump in GBP risk reversals to a two-month high. We believe market conditions are likely to stay choppy over the coming weeks with GBP crosses subject to two-way volatility as uncertainty reigns over what the MPC will decide on QE next month. G10 currencies are likely to be characterised by elevated event risk over the coming weeks as we approach a busy schedule of G20 and central bank meetings during the first week of November and ECB president Trichet prepares to visit China. Negative US/ G10 interest rate spreads provide fuel for ongoing USD weakness, though this has to be balanced with the emergence of new initiatives in Congress to support the US economy in 2010.

USD

The drop in the dollar index below 75.50 vindicates our short USD view and with appetite for risk assets generally showing good support, the threat of a USD reversal beyond a relief bounce is still remote.
The looming G20 finmin and trio of Fed/ECB/BoE meetings in early November alongside non-farm payrolls may bring some respite for the USD and argues for cautious positioning as central bank officials on both sides of the Atlantic extol a strong dollar for the global economy.
The first US data releases for October have disappointed and the chance of a weaker outcome for the Conference Board consumer survey next week could overshadow a strong advance Q3 GDP estimate.

EUR

For EUR/USD, ECB efforts to slow a move up to 1.50 have clearly failed as, USD diversification in Asia and EU/US interest rate differentials support EUR demand. A major resistance zone is situated at 1.5050-83.
EUR strength has to date failed to dent manufacturing optimism in the euro zone and it is in the context of overseas demand that the PMIs and German IFO will be scrutinised. Weaker data and profit taking in stocks could knock EUR/USD back towards support around 1.48. A widening in EU/US 2y spread to 50bps looms if the PMIs and IFO don't disappoint.
We are surprised at the scale of the pullback in EUR/GBP from the 0.94 area but see some justification for the retracement in a 14bps compression in EU/UK 2y benchmark yields to 40bps. Speculation of a pause in QE by the BoE should protect EUR/GBP from downside below 0.90.
German CPI and unemployment as well as the monthly EC confidence surveys will be key pointers for economic data next week. A 15% surge in crude oil prices (12% in EUR terms) may have translated into higher consumer prices in October, but annual CPI is likely to stay close to zero

GBP

The uncertainty with regard to the BoE's position on QE argues for long volatility strategies to be maintained. Vol spreads in GBP/USD and EUR/ GBP have narrowed considerably this month and are likely to stay fairly tight in the run-up to November 5th.
GBP/USD has gone some way over the past week, with the move over 1.66 supported by short covering and the omission of sterling commentary in MPC speeches. The outlook becomes more complicated from here with two-way volatility and lighter trading volumes likely to emerge as we move closer the November MPC meeting.
Economic data releases next week will be second-tier. The CBI distributive trades survey for October, mortgage approvals for September and consumer confidence head up the calendar, but will only play a peripheral influence on the wider QE debate.

JPY

We lean towards additional USD/JPY near-term gains following the bounce over 91.0. A test of the October 16 high of 91.32 argues for the rally to up to 92.0 as short USD/JPY positions are covered.
September industrial production data is due on the 28th and should bring more evidence of a slow recovery, though we take a more pessimistic view on the export orientated sector. The G20 finance ministers meeting in early November urges caution in JPY crosses, especially in GBP/JPY following the aggressive bounce from 141.75 above 151.0. Key support runs at 147.59.
Net investment inflows into JGB's and equities turned negative (Y88bn) for the first time in three weeks and backs up the rally in JPY crosses. Including MM instruments, flowed turned positive for the first time in four weeks (Y501bn).

CAD

We urged for caution going into the Bank of Canada (BoC) meeting and have not been left disappointed as the CAD backed off from widely publicised calls for a move to parity vs the USD. The BoC revised down its inflation outlook and warned about the strength of the CAD.
Based on the compression in CA/US 2y yield spreads below 60bps, a further unwinding of short USD/CAD positions cannot be ruled out. A move up to 1.06 Fibo resistance favours a back up towards 1.0694.
Stronger UK Q3 GDP data would add fuel to the rally in GBP/CAD from the 1.6236 low. We favour adding to long positions on a test of 1.7387. Resistance runs at 1.7469. Within the G10, GBP's biggest gains since October 16 have come vs the CAD.
The BoC publishes its monetary policy report on Thursday. Retail sales for August are forecast to show a 0.4% m/m rise, partly reversing the 0.6% drop on July. Since 1st October, Canadian equities have underperformed the S&P 500 by two percentage points (3.3% vs 5.2%).

SEK

With the immediate threat emanating from the Baltics having subsided in recent weeks, the focus for the SEK has returned to the domestic economy and monetary policy. Despite upgrading GDP growth forecasts, the latest Riksbank minutes were on the dovish side – the forecasts for 2009 and 2010 CPI were both downgraded while the first rate rise remains planned for Autumn 2010.
In the short-term, this is likely to continue to add to the upside risk for EUR/SEK. Although the currency pair has so far failed to convincingly break resistance at 10.3945, our target for 10.60 remains in play ,especially given the sustained strength in EUR.
This said, the minutes contained evidence of small shifts within the committee with two out of the six members calling for rate hikes before H2. On a more longer-term outlook, we look for the SEK to appreciate and would choose to express this via a short USD/SEK position targeting 6.0.

NOK

USD/NOK remains pinned below 5.60 and on track for our target of 5.50. With oil prices having breached $80/bbl and continuing to make new highs for the year as well as the Norges Bank expected to be only the second central bank in the developed world to raise interest rates next week, the NOK should find itself well supported.
The economic data calendar remains fairly quiet for Norway until the interest rate decision next week after which follows unemployment and retail sales data. We expect a 25bp hike next week, however, we think the tightening cycle priced in by the market is too aggressive and remain wary of an initial sell-off in NOK when the Monetary Policy Report is published (28th October).

AUD

The RBA have clearly set out their stall in recent weeks by first surprising the markets somewhat by hiking interest rates early and then announcing that loose monetary policy was “possibly imprudent” - clearly signalling further rate hikes in November. We are not convinced that the RBA will hike by 50bp in November although the market is pricing in a significant probability.
We continue to look for AUD/USD to rally up to 0.95 on the back of this and the sustained rally in commodities. The CRB index has rallied a further 2.9% so far this week buoyed by Chinese economic data.
With little sign of Chinese growth slowing or commodities turning, we would be hesitant to be anything but long AUD. Our favoured trade remains long AUD/USD however a target of 90 in AUD/JPY would also be consistent with this view.

Technical View

Dollar oversold?
Pound rallies as expected- more to come
Commodity currencies' trends to interrupt?

The technical strategy from last week highlighted two main themes. On-going USD weakness (and how sentiment is running excessively bearish) and potential unwinding of sterling's oversold status (which has corrected somewhat since then - but has more to go). For this week, the indecision that has plagued equity markets may gain some clarity as 1,100 resistance in the S&P 500 puts the brakes on the bullish theme for US stocks and European stock futures oscillate around key support levels, taking some of the heat out of the bull trend. This, coupled with the support zone being hit in the DXY (again mentioned last week as a potential turning point) makes a dollar rally look increasingly feasible, although confirmation of a correction is needed in the commodity markets. Oil and gold continue to hold the majority of gains and base metals seem ready for another push upwards, but where the dollar has been weakest, (i.e. against the commodity and EM currencies) I am anticipating a reversal of trend. Resistance at 76.00 is being monitored closely in the DXY. This is close to a downward trendline from February. Whilst below this point, calling for a dollar rally is risky, but through this area could initiate a sea-change in market sentinent.

Has the sterling rally run out of steam? I don't believe so. From a short term perspective, gains are bound to attract further short selling and profit-taking, but the extent of sterling's underperformance over the past few months makes further gains an attractive proposition. The sterling TWI index below has hit last week's target at 80.00 - a very strong resistance level, but after the initial reactionary pullback, the trend should continue to 82.00. This suggests 1.6743 in cable with be breached. The continued unwinding of sterling shorts should propel EUR/GBP below 0.9000 with objectives at 0.8800.

Weakness in the Japanese yen is becoming broader and I would expect this trend to gain momentum in the coming weeks. The Japanese TWI has been range-bound for most of ths year, highlighted by the 50, 100 and 200 day m.a.'s converging in a tight range of 151.04, 148.99 and 150.52 respectively. Despite the balanced nature of the chart, a move towards the July low of 143.00 is expected. Admittedly the driver behind the yen is difficult to pinpoint as equity strength has had little impact, but the arguments for holding the japanese currency appear limited.

Chart of the week: Sterling TWI- highlighted last week.