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Contrary to what many, including ourselves thought, the expected divergence of monetary policy between the Federal Reserve tapering on one hand, and the European Central Bank (and Bank of Japan) which is likely to have to provide more monetary support next year on the other hand, has not spurred a US dollar rally against European currencies. There is little reason to expect this to change from a technical point of view.

That said, the dollar's losses have not been broad based. Sterling and euro (and the Swiss franc and Danish krone) are where the greenback's losses have been concentrated. In part, the market appears to be taking the Fed's guidance seriously. Tapering is not tightening. The premium the US offers over Germany on 2-year money has been nearly halved over the past week to 9 bp. The nearly 20 bp discount of the US compared to the UK is near the largest since late 2011.

Yet, when it comes to the yen, it does not appear that interest rate differentials were the key driver. Normally, we find the exchange rate is more sensitive to long-term rate differentials. The US 10-year rate premium over Japan widened to new multi-year highs of almost 224 bp on December 5, even as the dollar was recording six-day lows against the yen. We suspect the pullback in Japanese equities (~4.5% fall Dec 3-5) was a more significant factor. The combination of the bounce in the dollar against the yen after the US employment data, the rally in US shares, and the strong close in the Nikkei, warns that last week's gap found 15579 and 15661 will likely be tested early in the week ahead (pre-weekend close 15300).

This suggests that the dollar will have another run at JPY103.75 high set in late May. Support has been established near the JPY101.65-80 area.

The dollar's weakness against the European currencies does not appear exhausted. The only cautionary note from technical indicators is that the euro and Swiss franc are at the top of their Bollinger Bands, which are set +/- 2 standard deviations from the 20-day moving average. Although the returns (changes) in currency prices are not normally distributed, a break of the bands may still be seen as reflecting a stretched market. This should encourage buying on the next pullback.

The next technical target for the euro is $1.3800-30. A similar level for the dollar against the Swiss franc is found just below CHF0.8900. There is little chart-based support below there before CHF0.8500.

The US Dollar Index, which is heavily weighted toward the complex of European currencies, tested the 80.30 area which represents a 50% retracement of the rally from late October through the first part of November. The next retracement objective is near 79.90. A break of this area could signal a move to the year's recorded in February just below 79.00.

Sterling has been a bit disappointing after rising to new two-year highs at the start of last week near $1.6440, it has under-performed, but the advance does not seem to be over. Support is seen near $1.6260, which corresponds to the Oct highs. We target the $1.6600-$1.6750 on the next leg up. That said, the recent highs in sterling were not confirmed by the RSI or the MACDs.

We have been frustrated by the Australian dollar. Last week, we suggested the Aussie was set to bounce. The bounce was muted and the Aussie fell to lows since early Sept before the US jobs data. It subsequently rallied and finished the North American session above the previous day's high, setting up a potential key reversal. Initial resistance is seen near $0.9140 and then $0.9200.

The US dollar extended its recent gains against the Canadian dollar to the CAD1.07 level. It was tested Wed-Fri last week and the greenback failed to close above it even once. The technical indicators are not suggesting an important high is in place, but a break of CAD1.06 will likely spur a bout of profit-taking.

The US dollar began last week by extending its gains against the Mexican peso. It reached almost MXN13.27 on Dec 3 before reversing lower and finished the week near 3-week lows, having tested the MXN12.90 area. Technical indicators warn of potential of additional dollar weakness in the period ahead that could extend to MXN12.80 or a bit lower.

Observations on speculative positioning in selected currency futures at the CME:

1. The mixed spot performance of the dollar is reflected in the speculative positions in the currency futures. On a net basis, speculators are long the euro, sterling, Swiss franc, and Mexican peso. They are short yen and the Australian and Canadian dollars. This is almost the opposite of earlier this year, though the speculative market was short yen then too.

2. Gross long currency positions were generally added to, except in the yen and Mexican peso. Almost a quarter of the peso longs were squeezed out (10.9k contracts), but in the three sessions after the reporting period ended, the peso has come back strongly. Gross short currency positions were more mixed, but the larger adjustments came from adding to shorts (especially the Canadian dollar, 17.2k contracts and Australian dollar 13.8k contracts).

3. Gross sterling longs saw the biggest increase, 17k contracts. The gross long sterling position is the largest of the currency futures we track. At 18.4k contracts it is nearly twice as large as the second place euros (9.3k contracts).

4. At 134.7k contracts, the gross short yen position is at a new five year high. The gross short Canadian dollar position (41.6k contracts) is the largest in six months.

5. The net euro position swung back to the long side (9.3k contracts) after briefly and shallowly (0.4k contracts) to the short side the previous week. The net position had been near 72k contracts in early Nov. The shift was more about longs liquidating than new shorts entering. From Oct 22 through end of November, the gross long position fell 55k contracts, while the gross shorts rose by about 15k contracts in roughly a slightly longer period. The price action since the reporting period ended suggest this position adjustment was being reversed.

week ending Dec 3

Commitment of Traders

(spec position in 000's of contracts)

Net

Prior

Gross Long

Change

Gross Short

Change

Euro

9.3

-0.4

82.2

8.1

72.9

-1.6

Yen

-133.4

-123.0

21.3

-2.7

134.7

7.5

Sterling

18.4

0.4

74.0

17.0

55.6

-1.0

Swiss Franc

6.5

4.6

14.5

1.5

7.9

-0.4

C$

-16.3

-16.1

32.6

4.4

74.2

17.2

A$

-44.3

-33.5

20.2

3.0

64.5

13.8

Mexican Peso

8.9

12.5

27.7

-10.9

18.7

-7.3

Source: Dollar Outlook