A clash of fundamentals, key events this week and massive stop-loss positions will inevitably trigger a further surge in currency volatility. Buying the dollar on dips remains the most attractive option by far given the medium-term outlook, but patience remains a key requirement given the risk of a shorter-term correction weaker for the still overbought currency. Look to sell EUR/USD on any approach to the 1.3150 region and buy USD/JPY in the 97.50 area.
The argument for further longer-term dollar strength remains compelling. In relative terms, the U.S. economy will continue to outperform on growth and the structural position is improving sharply as shale energy boosts competitiveness and continues to improve the trade account. A turn in the global credit cycle and international stimulus fatigue, together with a contraction in inter-bank lending, will also draw fresh funds into the U.S. dollar. From a longer-term perspective, with defensive support when global risk appetite crumbles, the dollar is in a win-win situation.
Shorter-term indicators, however, are continuing to warn that the currency has moved to price in too much strength and over-anticipated any Fed move to slow quantitative easing.
The latest IMM positioning data recorded an increase in the net long dollar position for the fourth successive week. The net long position now stands at close to $44 billion, the largest since at least June 2008. There are substantial net short positions in all major currencies, and this positioning will maintain the risk of a sharp correction.
The dollar gained strong support during the first half of May on yield grounds as markets speculated over a scaling back of the Fed quantitative-easing program. Confidence in an early tapering of quantitative easing has eroded slightly and the dollar's two-year yield advantage over German equivalents has narrowed back to March/April level, which will make it much more difficult for the dollar to make fresh 2013 highs against the euro.
This is an extremely important week for fundamentals with two stand-out events in particular. Any disappointing U.S. payroll release this Friday would almost certainly rule out any action at the June Federal Reserve meeting to taper bond purchases and would also undermine the dollar.
The ECB holds its latest policy meeting on Thursday with major pressure and tensions surrounding the possibility of further action. It is clear that there is a vigorous and almost certainly acrimonious debate within the ECB over policy actions and the scope for much more radical action. A minority within the council will certainly be pushing for the adoption of a negative deposit rate in an attempt to stimulate lending and force the use of cash reserves. There is also certain to be a high degree of opposition from the Bundesbank in particular and its allies.
Within the next few meetings, there is a high probability that the ECB will be forced to take additional action to stave off peripheral collapse, but it will very difficult to reach a consensus at this meeting and the ECB will also want additional time to prepare markets if it is considering negative rates.
On the positive side of the dollar ledger, there have been serious warnings from key emerging markets. The South African rand has fallen sharply to four-year lows beyond 10 against the U.S. currency, while the Indian rupee dipped to 11-month lows last week. The PBOC also guided the yuan slightly lower late last week. Emerging-market vulnerability will be another crucial factor supporting the dollar in the longer term.