The US dollar's technical tone improved markedly especially during the second half of last week, and this is not picked up in the latest Commitment of Traders report on the speculative positioning in the CME currency futures.
The cause of the dollar's rally paradoxically lies in the future as opposed to the past. That is, the price action suggests the demand for dollars was not so much a function of what had appeared to be an imminent bombing of Syria in retaliation for use of chemical weapons, as the greenback extended its gains even after an attack seemed considerably less imminent. Nor was it a function of safe haven in the sense that the dollar's gains were also scored during the roughly 2.8% recovery in the MSCI Emerging Markets equity index off the midweek lows.
Anticipation of Fed tapering next month is probably a better explanation of the dollar's strength. In this sense it was probably just as much a function of time as price. Many, like ourselves, understood the summer rally in the euro, for example, to be temporary in nature as international investors made a largely one off portfolio adjustment to recognize the reflation story. Like others, we had thought the euro correction could have been extended into the $1.35 area. In terms of time frame though, this is what was anticipated.
Ironically, the Federal Reserve is the only major central bank not meeting next week, but it is not simply the key: Its policies are anticipated to diverge with the others. The Bank of Canada is likely to retain a medium term tightening bias, but with the economy having contracted in June and headline and core inflation below 1.5%, the bias does not mean very much. The BOJ is unlikely to change its aggressive quantitative easing. The BOE and ECB are expected to persist with their forward guidance. With an election next week, no one is expecting the RBA to cut rates again now. However, we expect it to deliver another 25 bp rate cut in Q4. The Riksbank is neutral as the chances of a rate cut have diminished.
Our concern has been that the market is likely to be disappointed by the FOMC. There are many moving pieces and each is a potential source of disappointment. If the broad consensus is right and the Fed tapers in September, there can be a buy the rumor, sell the fact, behavior in the dollar and the opposite in US Treasuries.
The market may be disappointed if the Fed reduces its monthly purchases by $10 bln rather than $20 bln. The market may be disappointed by the allocation of its tapering between Treasuries and MBS. Lastly, of course, the market would be disappointed if the Fed waited to taper.
However, such disappointment, if it is to come, is likely after additional dollar gains. During this phase, we initially anticipate the euro to move into the $1.3000-$1.3100 area. We anticipate sterling to break below the $1.5380-$1.5400 area to signal a move into the $1.5150-$1.5250 area. Initially, the greenback may struggle in the CHF09380-CHF0.9400 range, but there is potential toward CHF0.9500.
The dollar-yen rate appears to be governed by two lines. There is the downtrend line drawn off the late May and early July lows, which turned back the late July and late August advances. It comes in near JPY98.80 at the end of the week ahead. There is an uptrend line drawn off the mid-June and the two mid-August lows. It had approached that trend line last Thursday. It comes in near JPY96.70 at the end of the week ahead.
There are two other observations about this pattern. First, often there is a false break of one side. Second, it is also often regarded as a continuation pattern rather than a reversal. The dollar had rallied into this pattern and this encourages many of the bulls.
Our idea that the Australian dollar could have one more leg up proved for naught. The Aussie finished the month within striking distance of the three-year low set at the start of the month near $0.8850. The next technical target is near $0.8780 and then $0.8550.
Technically the Canadian dollar looks better than the Aussie. Typically in a relative strong US dollar environment, the Canadian dollar does well on the crosses. The US dollar held last week's highs against the Canadian dollar, despite the disappointing GDP figures before the weekend provides a chance that a high was recorded. Initial support for greenback is seen near CAD1.0460 and then near CAD1.0400.
The nearly 3% decline of Mexican peso last week eclipsed all the other notable emerging market currencies save the Indian rupee that lost 3.6%. Although it stabilized in the second half of the week, there is no convincing technical evidence that an important peso low is in place. The greenback held below the late June high near MXN13.46, but pullbacks were particularly shallow. If the dollar's offers in this area are absorbed, the next target is seen near MXN13.80.
Observations from the speculative positioning in the CME currency futures:
1. Participation is picked up. Generally speaking, speculative gross long and gross short currency futures positions rose. There were also three gross position adjustment larger than 10k contracts. These included a 10.3k rise in gross short yen positions, a 24.2k rise in gross short Canadian dollar positions and a 19.5k contract decline in long Mexican peso positions (a notable exception to the first generalization). There were only eight gross adjustment less than 5k contracts compared with 10 during the previous reporting week.
2. The net adjustment of the seven currencies we track was increasing the exposure to the US dollar. This was mostly driven by the new short yen and Canadian dollar futures positions.
3. There are several trends to note. This was the fourth reporting period in which the net speculative position was long euros. The price action after the reporting period ended likely reflected the liquidation my late longs. The increase in the net short yen positions broke a 4-week decline. The net short Canadian dollar position is the largest in two months. The net long peso position is the smallest since early July.