Underlying Dollar Uptrend Intact, Consolidation Ahead
The recent US dollar uptrend began in mid-June, encouraged by anticipation of Fed tapering and the resulting wider interest rate differentials. Comments by Federal Reserve Chairman Bernanke last week were interpreted by market participants as indicating that the reduction of asset purchases in the Sept/Oct period, which had solidified as the consensus view, was not a done deal. This sparked a sharp dollar sell-off.
Most of that sell-off took place in thin market conditions, after the NY session ended but before the Asian session began in earnest. Leaving aside the Australian dollar, the other currencies have held in better than one might have expected given the lack of participation. This is illustrated, for example, by the Dollar Index which has thus far not even retraced the minimum 38.2% of the nearly 2.8% Bernanke-induced slide, which is found near 83.30.
Bernanke delivers the first leg of the Fed's semi-annual report to Congress Thursday July 18. Given Bernanke's recent track record for injecting volatility into the foreign exchange market, we suspect that the dollar is likely to broadly consolidate as participants await clearer signals of the Fed's intent. The price action suggests that the short-term market positioning is not as extended now and this may mean it is less vulnerable to another Bernanke shock.
Our longer term bullish dollar outlook has not been impacted by the near-term volatility or the possibility that the Fed's exit strategy is more prolonged than the market had come to anticipate. We have argued that the tapering may begin later than the consensus expected. This view was based on 1) ideas that the economy would stay weak in Q3 and that underlying employment growth was not accelerating; 2) that low core inflation might not be able to be ignored if there is no serious pick up in the coming months, and 3) that game theory insight suggests the Fed has more to gain in terms of anti-inflation credentials by creating the conditions for the next Fed chairperson to pullback from the full throttle monetary policy.
The $1.2930-80 area may be the key to the euro's technical outlook. A break through here and it would suggest that the upside correction was sharp but brief and that the downtrend is set to resume. On the upside, a move back above $1.3100 would suggest another upleg is likely. that could extend toward $1.3400.
Sterling was squeezed nearly 4 cents higher in response to Bernanke. It has retraced almost 38.2%, which comes in near $1.5065. Below there are the 50% retracement around $.15020 and the 61.8% retracement near $1.4970. A break of these areas is needed to signal the resumption of the bear tend. On the upside, resistance is see near $1.5200 and then $1.5280.
The dollar's dropped more than three yen to about JPY98.25. This represents a little more than 38.2% retracement of the dollar advance from mid-June (~JPY93.80) to the July 8 high just above JPY101.50. The JPY100.00-25 area is likely to cap greenback gains until at least the US 10-year yield stabilizes. Some of the technical indicators are generating conflicting signals. The Relative Strength Index is dollar supportive, while the MACDs are warning of dollar weakness. The contradiction is likely to be resolved in consolidative trading.
The Australian dollar had a more muted reaction to Bernanke's comments, failed to sustain even minimal upticks and recorded new multi-year lows before the weekend, dipping briefly and slightly through the $0.9000 level. The weight on the Aussie comes from rising expectations of a rate cut in August and as a proxy for Asia and in particular China. China's GDP (and other data) are to be reported before the markets open on Monday and there is concern about softer data. There is also some talk of sovereign supply. The Aussie can recover into the $0.9100-50 area without really improving the technical tone.
It appears Bernanke's comments helped the greenback complete a downside correction against the Canadian dollar, which had actually began a few days before the Chairman spoke. In the sell-off in response to Bernanke, the US dollar cam within a whisker of the 61.8% retracement of the gains score since mid-June. That area, around CAD1.0320, should offer the greenback support and we envisage a near-term test on the CAD1.0450-CAD1.05 area.
The Mexican peso finished last week near its best levels since mid-June. The overcrowded positioning has been alleviated and we suspect short and medium term participants are getting back involved. We see scope for further dollar slippage toward MXN12.60-MXN12.70 in the days ahead. Resistance is seen near MXN12.90.
Our trade of the year is long Mexican pesos against the Australian dollar. At the end of last week, it recorded a fresh three year low. The rationale for the trade remains valid. It seems that trade strategies can be put into three bucket: trend following, mean reversion and carry. This trade can be seen as all three. It presently enjoys good momentum (trend following). It is mean reversion in the sense that the OECD's PPP model still have the peso as the most under-valued currency (~67%). The Australian dollar has depreciated, but by the OECD's reckoning, it is still 25% over-valued. Mexican interest rates are above Australia's, giving the trade a (modest) carry component as well.
The Aussie finished last year near MXN13.36. It slipped below MXN12.00 by the end of May and generally traded between MXN12.00 and MXN12.50 through the end of June. It briefly traded below MXN11.60 before the weekend. Bounces toward MXN11.80 may offer a new opportunity to participate tin the trend move that we now project can extend toward MXN11.15.
Observations on the speculative positioning in the CME currency futures:
1. The net position swung from long to short in the euro and Swiss franc in the reporting week ending July 2.
2. The general pattern was for the gross long positions to be reduced and the gross short positions to increase. There were a few exceptions. Speculators slightly added to their long Swiss franc, Canadian dollar and Mexican peso position. Short Australian dollar and Mexican peso positions were reduced.
3. In the five sessions prior to Bernanke's speech on July 10, there were minor position adjustments in the currency futures (less than 10k contract adjustment in gross positions). The only exception was 17.7k contract expansion of gross short euro position. Nine of the 14 gross positions we review here changed by 5k or few contracts.
4. However, this obscures the large change in positions over the past few weeks. The late shorts were in weak hands. We suspect that Bernanke's remarks triggered a short squeeze, which, coupled with the thin markets at the time helps explain the dramatic price action. Gross euro shorts had grown by more than a third over the past two reporting periods. Gross yen shorts had expanded by 25%. Gross short Canadian dollar futures rose by two-thirds.
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