Waiting For The Dollar Correction

Includes: FXA, FXE, UDN, UUP
by: Tim Clayton

Patience will be required this week before jumping on the bullish dollar bandwagon. The timing of this week's economic diary is very important and will have a clearly defined market impact. The dollar is vulnerable for a correction until the end of Wednesday on event risk before the potential for fresh gains late in the week as eurozone and global doubts increase again.

Congressional testimony from Federal Reserve Chairman Bernanke is due on Wednesday, which will be followed by the latest FOMC minutes later in the day. The dollar will be vulnerable to selling pressure on Bernanke and the minutes as the tone is not likely to meet the market's hawkish expectations. On Thursday, however, there is the latest PMI flash PMI data for China and the eurozone. This data poses important risks for China, the eurozone and the global economy with evidence of fresh weakness, which is likely to trigger renewed U.S. currency demand.

The best underlying predictor for euro/dollar moves remains the U.S.-German bond yield spread. The good news for the dollar is that the yield structure has moved significantly in its favor. The bad news is that the shift in yields has not been enough to justify further gains. Indeed, the currency looks to have strengthened slightly too far. The yield advantage for 2-year U.S. Treasuries over equivalent German bunds briefly turned negative in late January, which coincided with EUR/USD rallying to the 1.37 area. There was a sharp improvement in U.S. yields over the remainder of the quarter and, after a brief dip, yields have again moved in the dollar's favor. The advantage, however, have not surpassed the April peak of above 0.25% when the EUR/USD rate hit a 2013 low of 1.2750

The dollar will, therefore, need fresh impetus to advance or even sustain the gains seen over the past few weeks. There will either need to be a further improvement in the yield gap of fresh fears surrounding the other major economies. In this context, a first pre-requisite for increased U.S. yield support would be a more hawkish tone from the Federal Reserve. The dollar gained important traction over the second half of last week from comments by San Francisco Federal Reserve President Williams, who suggested there could be a case for scaling back bond purchases this year, possibly even in June. The comments were slightly surprising given Williams' normally dovish tone.

An extremely important issue here is whether Williams was kite flying For Chairman Bernanke and looking to cushion the market reaction when Bernanke himself adopts a more hawkish tone. The most likely scenario is that he is not voicing Bernanke's thoughts.

Despite an improvement in consumer confidence, the economic data has not backed up the case for a more hawkish tone with disappointing readings in the latest regional PMI readings. The next Federal Reserve FOMC policy making committee meeting is just over four weeks away and the Fed Chairman will want to keep his power dry at this stage.

The latest IMM positioning data recorded the largest net long dollar position for 11 months with a modest extension in long positions against the euro. The dollar also registered a net long position against the Australian dollar for the first time this year, which will make it more difficult to push the Australian currency down even further and also poses important corrective risks for the U.S. dollar as a whole.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.