The US dollar extended its advancing streak for the third consecutive week to close out the month and quarter. Federal Reserve officials have tried to clarify policy by noting that tapering is not tightening and the decision remains data dependent.
That may be fair and good, but it does not appear to have altered the calculation of investors. The US 10-year yield, for example, rose from 40 bp in response to FOMC statement, the updated forecasts and Bernanke's comments. The assurance of the Fed officials saw the 10-year yield surrender about 20 bp, leaving the benchmark yield at still elevated levels, though other market segments have not corrected as much.
Yields rose more than the Federal Reserve expected. Officials implicitly and often explicitly assumed that the market misunderstood what the Fed was trying to do. Efforts to clarify could not return prices to status quo ante. That would seem to suggest the Fed's hypothesis is wrong. Rather than the market misunderstanding the Federal Reserve, it may be the Fed that misunderstood the markets.
Fed officials (and many observers) appear to be relying on some kind of fair value model of interest rates to deduce that the market has over-reacted. However, there is another model, albeit less formal, that offers insight into the price action. It is not fair value, but internal market dynamics, such as positioning and liquidity, that explains the dramatic market response more than the discounting of net present value of some future expectation.
Even if the fair valuation model is valid over the longer term, it seems perfectly reasonable and rational that in the shorter-term it is overwhelmed by position adjustments. Sometimes, such is in the Treasury's Inflation Protected Securities (TIPS) and other thinner markets where the lack of liquidity and capacity on dealers balance sheets and internal risk limits can exaggerate the price action. This has even become evident in the ETF space.
Since the crisis began, there has been speculation about which country can normalize policy first. Even taking on board the Fed's clarifications, the investment community now recognizes that the US is likely to be first, even if not immediately.
Yes, the ECB's balance sheet is shrinking faster, as banks repay earlier borrowing from the ECB, which in part, reflects the lack of private sector demand for credit. However, the risk remains that the ECB will have to do more, especially given that excess reserves are falling to levels that may not be consistent with near zero overnight rates and the tightening of monetary conditions caused by the sharp rise in interest rates.
The new governor of the Bank of England was chosen to a large extent because he promises to deliver a more activist monetary policy. The BOJ's massive QE program is not even three months old and has much room to run. Should yields begin rising in Japan again, additional measures cannot be ruled out.
As a consequence, the dollar's role as funding currency is being unwound and as this process unfolds, it takes a life on of its own. Recall that as recently as the June 17-19 period, the US dollar was at 4-month lows against the euro and sterling (which was also reflected in the Dollar-Index). In the week ending June 18, the net speculative position in euro futures at the CME switched to long side for the first time since early March.
Before the weekend, the Dollar Index set new highs for the move, while sterling and the Australian dollar recorded new lows. The euro and Canadian dollar came within ticks of the lows set earlier in the week. While there may be some consolidation ahead of the key events next week, which include several central bank meetings (RBA, Riksbank, BOE and ECB), the monthly PMIs and US employment data, the US dollar is likely to continue to strengthen.
The euro's attempt to recover in the second half of last week fizzled near $1.3100 and closed below the 200-day average (~$1.3075) for the third consecutive session. This area will likely contain upticks. We look for the euro to test the trend line drawn off the early April and mid-May lows. It comes in near $1.2850 at the end of next week. This translates into dollar gains into the CHF0.9540-70 area.
Sterling finished the North American session lower for four consecutive sessions. The trend line drawn off the mid-March and late May lows comes in near $1.5080 at the end of next week and additional support is seen near $1.50. Corrective bounces are likely to be capped in the $1.5285-$1.5320 band.
The greenback appears to be breaking out to the upside from a wedge or pennant chart formation against the yen. The retracement objective we have discussed was near JPY100 and this still seems like the immediate target, but the pattern break suggests potential toward JPY102.
The technical tone of both the Canadian and Australian dollars is poor. The US dollar held above the top of its previous range against the Canadian dollar on a closing basis over the past week. It is found by connecting the early March and late May highs. It comes in near CAD1.0450. On the upside, the CAD1.06-CAD1.0650 is the next technical target.
The key reversal that the Aussie posted at the start of last week failed to stick and the beaten up currency fell to new multi-year lows at the end of last week. The next objective is $0.9000, while prior support near $0.9200 becomes resistance.
The Mexican peso was best performing currency (major and emerging market) last week, gaining almost 2.7% against the US dollar. We continue to like the fundamental story in Mexico, and while the peso suffered during the initial position adjustment phase, the generally favorable macro story, including attractive interest rates and a reformist government, underpins the positive sentiment. Support for the dollar is seen in the MXN12.88-MXN12.93 area. Additional support is seen near MXN12.80.
Observations of the speculative positioning in the CME currency futures:
1. The past reporting period was largely characterized by the reduction of speculative positions than taking on new risk. There were a few exceptions. Gross long and short yen positions grew, though minimally. Together they rose by less than 2.5k contracts. Gross long Canadian dollar positions were extended, practically doubling to 27.2k contracts. Gross short peso positions were grew by a minor 4k contracts.
2. The other main characterization of the position adjustment was that it was largely minimal. There were 8 of 14 gross positions were track that changed by 5k or less contracts. There were 4 gross position adjustments that of above 10k contracts. These include gross long and short sterling positions were cut, the gross long Canadian dollar position, as we noted, was increased, and the gross long peso position was pared.
3. There has been a dramatic clearing of positions in the peso. It had been the largest gross long speculative currency futures position. For most of the last several months, it has been the only currency futures we track that remained in which speculators remained net long. The overcrowded positioning has now been alleviated. The net long position was 121k contracts in late May. At the end of the most recent reporting period it stood at 5k contracts.
4. Part of the sell-off in the euro since the reporting period ended likely reflects speculative longs liquidating. At the end of the last reporting period, the gross long euro position was more than twice the size of the gross long position in any of the other currency futures.