Currency Positioning and Technical Outlook: Dollar Heavy, Losses Loom

We have been looking for a downside correction to the US dollar and last week recognized that the anticipation of central bank meetings and US employment data were clouding the technical outlook. 

The fireworks all took place at the end of the week and the Dollar Index reversed lower on April 4th after posting new highs since last August.  The subsequent sell-off has been sufficient to send the 5-day moving average below the 20-day average for the first time since the first week in February. A break now of the 81.70-82.00 band would suggest a deeper correction has begun that could carry it to around 80.70, initially.  

The Dollar Index is heavily weighted toward the euro, so it is not surprising that technically, the euro looks constructive.  The 5- and 20-day moving averages are likely to cross early next week, for the first time since mid-February. and has resurfaced above the 200-day moving average (~$1.2895), having been driven below it by the Cyprus developments.

The next upside target comes in near $1.3115.  Although it is common this year for the euro to move in the opposite direction on Monday from the previous Friday, this constructive technical tone is likely to be maintained, provided the $1.29 area holds on the down ticks.  

We also note that the US-German 2-year interest rate differential continues to track the euro-dollar exchange rate.  After peaking in late March near 27 bp premium in the US favor, the spread has narrowed to below 21 bp, which is the lowest since mid-March. 

The dollar-yen rate has tracking the US-Japanese 10-year interest rate differential.  The spread widened from about 85 bp in the middle of November, when the Japanese election was called, to 140 bp by the middle of March.  That corresponded roughly to the dollar's peak against the yen (prior to this week) on March 12 near JPY96.70.  The differential then narrowed as the dollar slipped against the yen, reaching a multi-week low this past Tuesday (April 2) near JPY92.60.  

The rise in dollar against the yen following the BOJ's aggressive measures, which in effect doubled their QE efforts, did not correspond with a widening of the interest rate differential with Japan.  In part, JGBs reversed on Friday, with yields actually rising, while the US employment data disappointment weighed on US Treasury yields.  The interest rate differential finished the week near 115 bp, the lowest since early February. 

Without structural reforms, we are skeptical that the bank reserves the BOJ is creating will be lent out, for investment or consumption.  Nevertheless, technical indicators give skeptics, like ourselves, nothing to hang their hats on.  Momentum indicators and the MACD's warn that additional dollar gains are likely against the yen.

Moreover, there appears to be new flows using the yen as a funding currency to buy emerging market currencies, like Mexican pesos, Brazilian real, Turkish lira and the Russian ruble.  The Ministry of Finance weekly portfolio flow report suggest that this is not a function of Japanese investors (at least yet) as they have been net sellers of foreign bonds over for the past three weeks and have, in fact, only bought foreign bonds in three weeks so far this year.  

We have been arguing that sterling has been carving out a bottoming pattern against the dollar, but it has been particularly frustrating. Sterling has gained traction and broke through the $1.5260 resistance area.  The technical indicators we look at bottomed a couple of weeks ago, and show room for further price gains.  While we have been looking for a move toward $1.56, we see initial resistance now near $1.5425.    The constructive outlook would deteriorate if sterling fell back through the $1.5200-30 area. 

The Australian dollar is disappointing the bulls.  As the Commitment of Traders table below shows, there is a very substantial long Australian dollar futures position, which is regarded as representative of momentum and trend followers, and speculators more generally. The Australian dollar is trading heavily despite a favorable string of economic data and central bank that is in no apparent hurry to reduce rates again after delivering 175 bp in cuts.

The Australian dollar has broken the neckline of a double top pattern on the daily bar charts.  The neck line was $1.0380-$1.0400.  The measuring objective is near $1.0280-$1.0300, which corresponds a retracement of the move off the spike low in early March that had brought the Aussie to almost $1.01.

Ironically, it seems that it was the euro's recovery and the yen's sell-off that weighed on the Aussie.  On one hand, many participants were long Australian dollars and short euro cross positions.  The correlation (60-day percentage change) between the two has broken down from above 0.8 early last year and 0.75 as recently as August, to less than 0.2 now, which is near the lowest in at least a decade.

On the other hand, the prospects of a sharp depreciation of the yen that many expect, would put Japanese competitors at a disadvantage. In conversations with investors, we find an increasing willingness to consider the Australian dollar as a proxy for Asia.  Most Asian currencies are managed to some extent and have numerous restrictions.

The Australian economy is integrated into Asia through China, which is for many, including Australia, their biggest trading partner.  It is not a perfect proxy, of course, and it has its specific factors and sensitivities, but it is liquid and accessible.

We share these observations about speculative positioning the in futures market.

1. The adjustment to positions were largely four-fold: add to short euro, cover short yen, reduce sterling exposure and buy more pesos.

2.  Ahead of the BOJ meeting this week, speculators were reducing short yen positions.  The gross shorts peaked in mid-March near 145k and have fallen 20k over the past two reporting periods.  Some of yen's sell-off following the announcement of "qualitative and quantitative easing" appears to be the re-establishment of these shorts and the re-establishment of short yen positions (directly or as hedges).

3.  After the yen, the euro had the largest gross short position.  It was almost as large as the yen.  However, in the next reporting period, we are likely to see a decrease in euro shorts and an increase in yen shorts.

4. The gross long Mexican peso position is larger than the gross longs of the euro, yen, sterling, Swiss franc, and Canadian dollar put together.   It is crowded but the carry trade against the yen may hold off the corrective forces.