FX And Oil Week Ahead: Broken Expectations? What's Next?

| About: The United (USO)

Summary

ECB inflation and monetary policy key for next week's risk sentiment.

AUDUSD & USDJPY affirm downward trends.

Oil and CAD very oversold and should bounce at anytime from current levels.

To say the last week was tough would probably be an understatement given the strong bearish momentum that took hold of the market. Whilst we are currently underwater on our inverse S&P500 (NYSEARCA:SPY) volatility trade (NASDAQ:XIV), we continue to view it as a trade to hold onto despite numerous opportunities to exit during the week for two reasons:

1. We think the S&P 500 and oil are at a bottom or have very limited downside left at this point. (Our target is 1844 on the S&P500)

2. The natural roll yield and number of standard deviations the VIX is above it's 1yr. average is probably unsustainable and a mean reversion of sorts should happen sooner rather than later.

One key catalyst for next week to turn risk sentiment around we think would be the Eurozone inflation data ahead of the ECB. Personally, we hope that number is bad and with oil at current levels we think that wish could very well come true. This should then kick the ECB into serious discussions about more easing in the future, even if they do not act this coming meeting which would boost risk sentiment. Despite rhetoric from the previous week from certain ECB governing council members expressing their displeasure with the current ECB easing program, we think that the ECB's hand will be forced sooner rather than later for another round of easing.

Key economic data and events for the coming week:

Monday, 19 Jan. 2016:

*US Public Holiday (Martin Luther King Jr. Day)

0130 GMT - China House Prices (Dec.)
0430 GMT - Japanese Capacity and Industrialization numbers (Nov.)

Tuesday, 20 Jan. 2016:

0200 GMT - Chinese Q4 GDP (Dec.)
0200 GMT - Chinese Industrial Production (Dec.)
0200 GMT - Chinese Retail Sales (Dec.)
0700 GMT - German Inflation numbers (Dec.)
0900 GMT - EZ Current Account & Net Investment Inflow (Nov.)
1000 GMT - EZ INflation numbers (Dec.)
1330 GMT - Purchases of Canadian securities (Nov.)
2100 GMT - US TIC flow numbers (Nov.)
2330 GMT - Japanese Reuters Tankan Index (Jan.)

Wednesday, 21 Jan. 2016:

0700 GMT - German PPI (Dec.)
1330 GMT - US Building Permits (Dec.)
1330 GMT - US Inflation Numbers (Dec.)
1330 GMT - US Housing Starts (Dec.)
1330 GMT - US Real Earnings (Dec.)
1330 GMT - Canadian Manufacturing and Whole sale Sales (Nov.)
1355 GMT - US Redbook
1500 GMT - Canadian Interest Rate Decision
2350 GMT - Japanese foreign bonds and stocks buying

Thursday, 22 Jan. 2016:

0000 GMT - Australian New Home Sales (Nov.)
1245 GMT - ECB Rate decision (Jan.)
1330 GMT - US Initial Jobless Claims
1330 GMT - US Philly Fed numbers (Jan.)
1500 GMT - EZ Consumer Confidence (Jan.)
1600 GMT -US EIA Oil Inventory numbers

Friday, 23 Jan. 2016:

0135 GMT - Japanese Manufacturing PMI (Jan.)
0830 GMT - German Manufacturing and Services PMI (Jan.)
0900 GMT - EZ Manufacturing and Services PMI (Jan.)
1330 GMT - Canadian Inflation Numbers (Dec.)
1330 GMT - Canadian Retail Sales (Nov.)
1445 GMT - US Manufacturing PMI (Jan.)
1500 GMT - US Existing Home Sales (Dec.)

Trading and Technical Strategy for the week ahead:

EUR/USD

The EUR retraced back above 1.0900 as expected, though the move up was a little more aggressive than we had initially expected with Friday's high at 1.0980 and the down move thereafter proving elusive in the previous week. This was largely due to the more bearish than initially expected movements in the S&P500, as well as economic data surprises to the downside which have now pushed out rate hike expectations for the Fed.

We think this week should bring EUR downside given the slightly overbought conditions and the potential for more QE or QE talk by the ECB on 21 Jan 16 (Thursday) given the absolute dismal Eurozone inflation so far, which should weigh on the pair for next week especially if the Eurozone inflation data comes in worse than expected.

In the larger picture, the rebound and structure of the move from the 1.07s to the 1.09s continues to look like a complex variation of scenario 2 may be playing out in the EUR instead of the primary scenario 1 expectation. Key level for the EUR to stay under remains at the 1.1090/1.1100 level to avoid our bullish scenario 3 possibility. For now though, we will take the view that scenario 1 is playing out.

Medium- to long-term trading strategy (1-6 months):

With the Fed in a rate hike cycle, we still think the next one to three months should see our primary scenario (Scenario 1) playing out with the pair making one final down move to the 1.0250-1.0300 level. However, we do want to give a fair warning that other than a complex scenario 2 playing out, the scenario 1 move to the downside is likely an ending diagonal pattern of some sort meaning trade will be choppy and overlapping, making it difficult to trade. Given the bearish sentiment in the S&P 500 we decided to wait to re-establish a short in the EUR with the 1.0970/80 level as our preferred level at this point in time. Our stop on this trade would be at 1.1025 given how the EUR structure has developed in the last week.

Short-term trading strategy (Intraday, 1-3 days):

Our short term strategy, would probably suit traders who do not wish to take excessive risk given the potential for disappointment at the ECB meeting next week, given the rhetoric by some of the ECB governing council members so far. As such, one can look to play the 1.0911 to 1.0970 range with a bias to sell at the top of the range vs. buying. Should the pair break below 1.0900, the range to play again with a sell bias would be the 1.0840 to 1.0895 range.

USD/JPY

The USDJPY continues to find lower levels with a projection target of 114 for the pair. With the BOJ not hinting at additional stimulus for the foreseeable future, the pair will probably find it difficult to move back above the 120 level. Upside bounce expectations so far have proven disappointing with the pair now targeting 115.80 before the next bounce followed again by a sell down to the 114 level. Whilst it is tempting to go short the USDJPY now, the potential threat of a surprise announcement from the BOJ or change in risk sentiment willmake any short trade a risky one, so do manage this risk carefully.

Medium- to long-term trading strategy (1-6 months):

Given the reluctance of the BOJ to increase the size of its QE program for the foreseeable future, we think upside for the USDJPY is limited for now even with the Fed tightening. Moreover, the risks of the S&P 500 falling further continues to be a major risk factor for longs in the pair. The recent COT FX futures report also suggests that market participants continue to increase their long JPY positions given the break of some key technical support levels in the USDJPY. As such, we prefer to wait on the sidelines until a fundamental or technical break shows itself to take a position for the medium to longer term. Our bearish scenario could see the pair move to the 114 level and lower if the downside scenario plays out. We currently think that anything above 110 for the USDJPY would be acceptable to the BOJ at this time, so downside risks certainly prevail.

Short-term trading strategy (Intraday, 1-3 days):

Despite the downside momentum for the pair, short term traders could consider short term buying opportunities for the pair if the 115.80 level is hit, looking for the high 116s to exit these long positions. Moreover, there is a potential that the S&P 500 (SPY) has reached a bottom or will soon reach a bottom at 1844, which should give some upside reprieve for the pair.

AUD/USD

The AUD was much more bearish than we initially expected with the pair breaking below the key 0.6900 level. This has effectively invalidated the upside potential for the pair now with downside momentum likely to persist to the 0.66-0.68 level as we laid out in our strategy piece here.

Medium- to long-term trading strategy (1-6 months):

The medium and long term bias remains to the downside for this pair. However, current oversold conditions on the long-term time frames would make us nervous sellers at current levels for long-term short positions. Given that the bearish momentum has invalidated the potential larger bounce scenario to 0.7380, we think any rallies to 0.7100 should be considered now as selling opportunities for a break of the 0.6800 level.

Short-term trading strategy (Intraday, 1-3 days):

Unfortunately, any short term long trades last week would have met quick deaths and admittedly, the bearishness in risk assets was much worse than we had initially anticipated. In order to adapt to the current short term volatile conditions, short term traders can consider playing a 0.6900 to 0.7100 range with a bias to the sell side from the 0.7050/0.7100 levels, taking profit just ahead of the 0.6900 figure. Chinese GDP and housing data are due next week, so any upside surprises may provide the spike needed for short term selling opportunities in the pair.

USD/CAD

The USDCAD moved up to the top of our topping zone and exceeded it slightly, whilst this looks bad, it is not uncommon for the market to exceed primary trend targets by 100-150pips, unlike corrective movements that tend to end at their stipulated projection points. However, as we laid out in our original piece, and have been emphasizing so far, short positions for the pair should only be considered when the pair shows a daily bearish reversal close to signal that a change in trend is at hand. Moreover, the USDCAD is now overbought on several time frames, indicating a down move should be round the corner.

Medium- to long-term trading strategy (1-6 months):

We continue to look for signs of a long term interim top with a daily bearish reversal close in the USDCAD from current levels to sell short with a potential longer term target at the 1.2000-1.2130 region. However, our first target is found at the 1.2900 level. This suits our longer term view that oil is potentially at a technical bottom which should lead to a bounce that would be bullish for the Canadian Dollar.

Short-term trading strategy (Intraday, 1-3 days):

Given the bearish momentum in oil prices, short term traders can consider playing the 1.4300-1.4500 range in the pair with a bias to sell at the 1.4500 level or higher given how overbought the pair is at this time. A break below the 1.4100 figure would also indicate the downward reversal we have been looking for in the pair has come, so do watch for this whether you are trading for the long term or short term.

WTI OIL (USO)

*Note on our price chart:
Before we dive into the WTI technical analysis, we have decided to use the WTI continuous futures price as a chart instead of the original spot price posted in our article. This price will match the nearest dated WTI Crude futures contract which will switch automatically once the contract settles moving on to track the next nearest dated futures contract. We will also be only analyzing the technical aspect of the WTI price, given the fundamental aspect of WTI oil is well covered by many subject matter experts in the energy commodities section. At this time, the nearest dated futures contract being tracked by the above price chart is the Feb. 2016 contract.

WTI Oil has exceeded our target zone slightly at this juncture, though we think the energy commodity is very oversold at this juncture and a bounce should be seen anytime now. Only a strong break of $28.30 would have us reconsider at this point our potential bottoming zone. But as a guide, should oil break below $28.30, the next target on WTI would be around $25. However, this is not our primary scenario at this time, and we do think a recovery back above $31 would be made into February. The big question at this time of course continues to be the catalyst, which the market is searching for at this moment. Potential Middle East tensions continue to be the most probable of all the catalysts at this stage.

Medium- to long-term trading strategy (1-6 months):

Despite WTI Oil slightly exceeding our bottoming zone target, long term technical indicators are in oversold territory, which should fuel the next bullish bounce in the not so distant future. However, given that the bounce timing is less certain until a catalyst triggers it, we prefer to use oil ETFs like USO or longer dated WTI futures to go long crude at these levels. Whilst the USO and other oil ETFs are far from perfect, it will suffice for us given the hassle of rolling over WTI futures contracts.

Short-term trading strategy (Intraday, 1-3 days):

Our short term strategy does not differ from our medium to long term strategy at this point, with current levels being an opportunity in our opinion to go long WTI crude oil futures or through the use of an oil ETF like USO. Those looking for shorter term range trades can play a $29 to $31 range with a long bias.

Thank you for your time, and we hope that you have enjoyed this weekly strategy piece. We look forward to your constructive feedback.

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Disclosure: I am/we are long XIV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.