Our assessment of macro fundamentals leave us inclined to favor the dollar on a medium term basis. However, we continue (see here and here) to recognize that near-term technical considerations favor the major foreign currencies, but the yen.
It seems many participants lack conviction about the price action. As our review of the Commitment of Traders shows, outside of the euro and yen, positioning by the momentum players and trend followers in the futures market was little changed. Moreover' the euro's rise appears to be driven by short-covering rather than the establishment of new longs.
The yen seems to be the exception. Here many participants believe a major turn has taken place. We are less convinced and are sensitive to the distinction between declaratory policy (what officials say) and operational policy (what official do). With the Japanese election still two weeks away, we recognize there is more opportunity to sell the yen on the "rumor" and later "buy the fact."
Increasingly, in the coming weeks, we anticipate US developments to eclipse events elsewhere. First, the recent economic data points to a marked slowing in the US economy here in Q4, with growth tracking about half of the 2.7% revised pace in Q3. As part of this, we see high risks of a poor employment report at the end of the week. This will encourage expectations of the second important event: the Federal Reserve will likely expand QE3+ by rolling into it the long-term purchases that have been conducted under Operation Twist. This will essentially double the Fed's monthly purchases to $85 billion a month.
This brings us to the third important development and that is, of course, the fiscal cliff. It strikes us as unreasonable to expect any deal until the very last minute, and even then, political considerations and brinkmanship tactics seem to suggest that a resolution may be easier after the fact than preventative. Perhaps a bit counter-intuitively, the knee-jerk market reaction to news of the lack of progress has been to buy the dollar, perhaps on safe haven ideas. Yet that reaction function seems to have reached the point of diminishing returns with such reactions becoming shorter and shallower.
Euro: New multi-week highs were recorded before the weekend. The $1.3000-30 objective cited in this space last week was met. Look for a move above here in the coming days and we suggest a $1.3140 target. A break of $1.2935-50 would call this constructive view into question.
Separately, we note that implied volatility has picked up from very depressed levels in recent days. It finished last week above its 20-day average for the first time in almost three months. The 60-day correlation between 3-month implied volatility and the euro has turned positive in recent days after being inversely correlated since early September. The correlation was positive in the Jan-Feb period, but turned inverse from late-Feb through late-July. It then remained positive until early September.
It appears that the euro's advance is being met with call buying (either for protection of underlying shorts or as a way to benefit from a euro advance rather than getting caught up in the vagaries of spot action). The risk-reversals (euro calls relative to puts equidistant from the forward strike) now show the smallest discount for euro calls (smallest premium of euro puts) since the Greek crisis first surfaced in late 2009. Anticipate additional near-term euro gains.
Yen: The main weight on the yen continues to come from anticipation that Japan is on the precipice of a more aggressive policy that purposefully seeks to debase the currency. There is plenty of time before the December 16 election for Abe's campaign rhetoric to continue to encourage new yen sales. The price action seems to reflect good yen selling into even modest bounces. Dollar support identified in this space last week in the JPY81.60-80 area was successfully tested. The dollar's gains ahead of the weekend, recording new highs for the week, appear to have begun a new leg higher. We are monitoring a trend line drawn off the 2011 high near JPY85.50 and this year's high near JPY84. It comes in just above JPY83 next week. Anticipate further yen weakness.
Sterling: Given the narrowness of the recent ranges, we are choosing not to emphasize the outside day recorded on Friday when sterling traded on both sides of Thursday's range. In the past week, it was confined to a one cent range. The initial support we identified last week near $1.5960 held on the midweek test. The resistance we anticipated near $1.6050 was frayed intra-day, but held on a close basis. Technical indicators are neutral. However, with euro-sterling bid, and looking poised to test the GBP0.8150-60 area, sterling may under-perform. Neutral outlook, but likely a laggard in moves against the dollar.
Swiss franc: The franc was dragged higher by the euro. The franc may under-perform the euro going forward as the euro had approached the SNB's floor. The dollar decline stalled out near CHF0.9250, though we see potential toward CHF0.9200. Resistance is seen around CHF0.9300. It is, frankly, uninspiring. The franc is function of the euro, but without the liquidity.
Canadian dollar: The US dollar traded within about half a cent range against the Canadian dollar. Trend line support we identified, drawn off the September 14 and October 18 lows has been frayed, but the violation has been minor and the CAD0.9900 level remains intact. No compelling technical signal. Neutral.
Australian dollar: The failure ahead of $1.05 disappointed Aussie bulls and the subsequent pullback saw it fall to the week's lows on Friday just above $1.04. Of the five central banks (ECB, BOE, BOC, RBNZ and RBA) that meet in the week ahead, the RBA is only one that is likely to deliver a rate cut. The Australian dollar could, counter-intuitively, rally on a stand pat stance or a 25 bp rate cut that would still leave Australia with the highest nominal and real rates among the major economies. A 25 bp cut is nearly fully discounted in the indicative pricing in the forward market. Signs of the Chinese economy stabilizing and talk of continued reserve managers' interest, leaves us inclined to buy the Australian dollar on pullbacks, provided the $1.0380 area remains intact. More constructive after rate decision.
Mexican peso: In subdued markets, the Mexican peso offered a good place to park funds. The dollar fell to its lowest level against the peso since late October, but the MXN12.90 support area we identified remained intact. A break of the MXN12.90 area should be respected as it would open the door for another 1% dollar slide. On the top side, the MXN13.07-MXN13.10 should contain dollar bounces. Like the yield pick up in quiet markets. Minimal spot appreciation expected near-term.
week ending Nov 27
Commitment of Traders
(speculative position in 000's of contracts)
* The euro's advance has been a function of short covering rather the establishment of new longs. Gross shorts fell by 20%, which is the largest weekly adjustment of the year. Note that gross long euro positions actually fell.
*Gross short yen positions rose by a third to the largest level in five years. The net short position is also the largest since the financial crisis began.
*The small net (LONG) sterling position conceals the fact that the gross long position is larger than the gross long euro.
*The reduction of net short Swiss franc positions was a function of new longs entering and more than twice as many gross shorts covering.
* Although the net long Canadian dollar position increased, the market continued to trim exposure, with gross longs and gross shorts falling slightly.
*Despite the efforts by the RBA to talk the Australian dollar lower, the gross long position continues to grow and is now 5% off the August record high.
* The net long peso position increased for the first time in two months as a function of both new longs and a covering of shorts.