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Market positioning, amid thin conditions, appears to be the best explanation for the seemingly inexplicable price action in the foreign exchange market. The consensus has been bullish the dollar on ideas that the Fed will be the first of the major central banks to begin pulling away from the extraordinary policies pursued in the aftermath of the end of the credit cycle.

However, this story has been increasingly eclipsed by the reflation story in Europe, and to a less extent, China. The resulting increase in interest rates, in turn, adds to the pressure on many emerging markets.

We often find it helpful to recognize two types of explanatory models for price action. The first is fair value model and is driven by economic fundamentals and their anticipation. The second is more flow and liquidity driven. We think that many observers may be emphasizing too much the former presently and not giving sufficient due to the latter.

We are also suspicious of explanatory variables that are used to explain both a rising dollar and falling dollar. Yet this is precisely what much the financial press and many observers are doing at the moment. When the dollar rises, anticipation of tapering is often cited and the compelling logic outlined: Fed tapering underpins the dollar through wider interest rate differentials.

When the dollar falls, it is also attributed to tapering speculation as well: Tapering reduces the demand for Treasuries from the biggest buyer, pushing down bonds, and have a negative knock-on effect on stocks. Beware that anticipation of tapering has become the go-to-explanation for all price activity. Moreover, we note that in the past week, UK assets also performed poorly, with yields rising rates and the equity market was among the worst performers among the major markets, and sterling was the best performing currency against the dollar.

Euro: We continue to favor the euro's upside over the near term. The $1.3400-20 area represents the immediate cap and a break may spur a move toward $1.3500. The $1.3170-$1.3200 area is the lower end of the trading range.

Yen: The US 10-year premium has risen above 200 bp for the first time in two years. Japanese investors have bought foreign bonds for six weeks running and the most recent weekly data showed the heaviest buying since August 2010. For their part, foreign investors have been net sellers of Japanese shares for three consecutive weeks, the longest such streak of the year. However, the dollar remains in within the downtrend seen since early July. That trend line is found in the JPY98.60-80 area by the end of next week. On the downside, support is seen near JPY96.00.

Sterling: Persistently better than expected data has helped sterling extend its recent gains. The rally has now extended to nearly 7 cents from the early July low. After flirting with it recently, sterling finally managed to close above the 200-day moving average (~$1.5525). This area should offer support now. The next target is late June highs near $1.5750, incidentally, near where the 200-week average is found and near a 61.8% retracement objective of the decline off the year's high set on the first trading day of the year near $1.6380.

Swiss franc: The price action reinforces the importance of the CHF0.9400 cap for the dollar. The lower end of the recent range extends to around CHF0.9175. It is difficult to get excited by the franc. The euro-Swiss cross has been largely confined to a CHF1.23-CHF1.24 trading range with a few exceptions in recent week. The franc is also trading in relatively narrow ranges against the yen.

Canadian dollar: Neither the rise in oil prices nor the gains in the Toronto Stock Exchange (making it the second best performer over the past week among the G7 markets behind Italy) was sufficient to lift the lethargy surrounding the Canadian dollar. It was the weakest of the dollar-bloc currencies. Look for the CAD1.0275 area (near the 100-day moving average ~CAD1.0285) to stem the US dollar selling pressure, while the CAD1.0380-CAD1.0400 may cap gains.

Australian dollar: We do not think the upside correction in the Australian dollar is over. A break of the $0.9220 area will boost our confidence in seeing another cent advance. The OIS market appears to have moved away from expecting another rate cut this year by the RBA and this swing in the pendulum of expectations, coupled with extended short positions, provides the fuel for the constructive near-term outlook. We peg initial support near $0.9125 and the $0.9060.

Mexican peso: The US dollar advanced against the peso for six consecutive sessions, rising from around MXN12.56 top MXN12.97 Technical indicators we look at do not indicate a dollar top is in place, though the pre-weekend advance seemed exaggerated. Risk extends toward MXN13.06, and potentially MXN13.15.

Last week, we suggested that a long Aussie/short yen position captured our technical views. The Aussie gained about 1% against the yen. We still like this position, though the lower end of the our initial target range (JPY90.00-20) was met. Our secondary target near JPY92.00 still seems reasonable. In addition, we also like the Australian dollar against the Canadian dollar and look for the cross to move toward CAD0.9600-50 provided the CAD0.9450 support holds.

Observations about the speculative positioning in the CME currency futures:

1. The net speculative Swiss franc position swung to the long side, following the euro, which switched the previous week.

2. Position adjustment remained small, echoing the thinner spot markets. The 18.0k contract decline in gross short Australian dollar positions is the first gross position adjustment larger than 10k in two weeks and is the largest adjustment in over a month. In the previous reporting period, there were only three gross adjustment larger than 5k. During this latest reporting period, there were only 2.

3. The net effect of the small gross positions was to reduce long dollar exposure. The net short currency positions were reduced and the net long currency positions grew. Sterling was the sole exception. The net speculative short sterling position edged higher as the gross short position grew more than the gross long position.

4. Despite the firmer tone in the foreign currencies, at the end of this reporting period, there are substantial gross short speculative currency positions. In particular, the continuing gains in sterling probably forced more to shorts to cover. On the other hand, the late peso longs are in weak hands and some likely were forced to liquidate.

week ending Aug 13

Commitment of Traders

(spec position in 000's of contracts)

Net

Prior

Gross Long

Change

Gross Short

Change

Euro

16.1

6.1

90.0

4.7

73.9

-5.3

Yen

-74.5

-80.2

17.4

-2.0

91.8

-7.7

Sterling

-46.5

-46.0

22.2

0.1

68.7

0.6

Swiss Franc

2.1

-0.3

10.6

1.9

8.4

-0.6

C$

-9.1

-10.4

21.7

-0.9

30.1

-2.2

A$

-62.7

-76.8

12.6

-3.9

75.3

-18.0

Mexican Peso

36.3

32.1

66.9

4.7

30.6

0.4

Source: Noise To Signal Increases