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The days ahead will help clarify whether the U.S. dollar's somewhat firmer tone last week was simply corrective in nature,before a new leg lower, or the carving out of a bottom of a downtrend that began in June against most of the major currencies and July for the euro.

The key may not lie with the economic data. The important steps announced by the ECB, Federal Reserve, and BOJ has stolen the thunder from the near-term economic performances. Instead, we suspect politics and positioning may be more important.

As we have noted, the signals coming from European officials indicate that there has been an important climb down from pushing Greece out of the monetary union and the indications from intrade.com, where the odds a country leaving the eurozone this year has fallen to the lowest in at least two years, suggest investors recognize this.

Exactly how the proverbial circle can be squared--how Greece's debt outlook can be judged to be on a sustainable path--is not clear. Yet this is not the top issue on the agenda. In fact, since earlier this month, European officials appear to be playing for time, and not just for the mid-Oct EU summit, which had previously seemed to be the case. Instead, expectations have been massaged and now a November decision is more likely.

Instead of Greece, the political spotlight in Europe is on Spain. There are two conflicting impulses. On one hand, Spain is reportedly engaged in negotiations to design a structural reform package that could be adopted prior to formally asking for assistance that would in fact meet the Troika's conditionality. These structural reforms, which may not include new taxes or spending cuts, could be announced toward the end of next week.

On the other hand, with the decline in yields and recent bond auctions that clearly demonstrate that Spain has not be frozen out of the capital markets, the sense of urgency has slackened. Germany's finance minister reportedly sees no need for Spain to request aid. Some press reports also suggest the pressure that Italy was applying to Spain to seek relief, to help stabilize Italian yields, has also lessened. We do not anticipate a formal request by Spain until mid-October at the earliest.

At the end of next week, the three month review of Spain's financial system is expected to be completed with the outcome being a clearer understanding of the banking system's recapitalization needs. Spanish officials insist that the 100 bln euro backstop already granted will prove more than sufficient. There is some desire to use the "excess" for other purposes, but this will prove contentious.

In the U.S., President Obama has enjoyed a significant post-convention bounce. If the poll numbers in the swing states is maintained over the next week or so, it would imply more than a post-convention bounce is at work. While we have suggested that Obama's re-election was the most likely scenario, we recognize that in terms of the fiscal cliff, the presidential race is only half the story.

The key issue is whether Obama's "coattails" will be sufficient for the Democrats to capture the House of Representatives. If this did happen, it would increase the chances of a compromise to resolve the fiscal impasse. The latest polls and projections suggest this is unlikely and that the Republicans will maintain a small majority. This in turn worries businesses and investors that the country is still moving headfirst toward the fiscal cliff.

In this ugly contest, we suspect that Europe remains uglier. The FOMC decision on QE+ was not spurred because the U.S. was in danger of slipping into recession, but because growth was not fast enough (to reduce the unemployment rate quick enough). The euro area (and Japanese) economies appear set to contract in the current quarter. The U.S. remains one of the few high income countries in which its growth rate is above, albeit slightly, bond yields.

We continue to suspect the position adjustment that weighed on the dollar in Q3 is over or nearly so. Many fund managers began the quarter underweight Europe and were forced to chase the market or under-perform benchmarks. As we note below, there has also been an adjustment by speculative participants.

Last week, we noted that the technical condition of the dollar against most of the major currencies was still poor. The exception was the Canadian dollar, and to a less extent the Australian dollar. The price action over the past week has seen the improvement of the dollar's technical outlook broaden to include the British pound and the Mexican peso.

Given the current correlations, a recovery in the U.S. dollar against those "risk-on" currencies, would likely occur in a weakening equity environment. The S&P 500 appear to be carving out a near-term top. The close before the weekend was poor (on the session low). A break of the 1450 level would support this "topping" view and could spur a move toward 1400. Of note, the S&P 500 has recently typically fallen at the start of the week. In eight of the past 10 Mondays (though used Tuesday Sept 4 due to the Labor Day holiday on Monday Sept 3), the S&P 500 has fallen.

Euro: The net short speculative euro position was reduced in the week ending September 18, continuing the trend that began in early June. At 73.5k contracts, down 22.k on the week. It is the smallest net short position since last November and has been cut in half in the past eight weeks.

This has been primarily a function of short covering. Another 14.5k contracts were reduced to a still substantial 122.3k. This is the smallest since April. However, bottom pickers and now momentum traders have also been accumulating a long position. The gross longest increased by 5.6k contracts and at 48.8k, is the largest since June.

The euro spent most of last week paring back gains. It was the worst performing major currency, slipping 1.1% against the dollar. However, on the pullback, a key area technically that we identified last week ($1.2900-20) held and off that the euro recovered about 50% on Friday what it had lost on the week until then.

While the technical tone has weakened, we still do not see a strong sell signal for short-term participants. Medium term participants may reduce euro exposure or short dollar hedges into euro strength. A move now back above $1.3080 would could see another cent advance.

Yen: The speculative net long position was sliced by more than half to 15.5k from 32.8k contracts. This was largely a function of long liquidation. The gross long position was cut by about a third to 41.5k contracts. The gross shorts were trimmed 2.1k contracts to 26k.

The Japanese yen was the strongest currency of the week, gaining about 0.25% against the dollar, despite the mid-week QE announcement by the BOJ that both increased purchases and extended the time of operations until the end of next year (as well as some other operational adjustments).

The dollar was rebuffed on the post-BOJ advance above JPY79 and the rule of alternation was followed and the yen finished the week near the lower end of the recent range near JPY78. Just like the dollar overshot to the upside briefly, it could undershoot to the downside, with JPY77.80 seen as support.

Sterling: The speculative market swung hard to the long side in the days before sterling made a new high for the year in the spot market on September 21. The net speculative position switched to the long side after being short for a couple of weeks and it is the largest net long position since May. About 15.5k short contracts were covered, leaving 38.2k contracts still short. The longs were increased by 3.7k contracts to 52.6k.

Sterling managed to eke out a minor gain against the dollar last week of less than 0.1%. With the rejection of the new high for the year, briefly above $1.6300 and the close near the low of the day on Friday, the technical tone weakened considerably. However, a break of the $1.6180-$1.6200 area is needed to give more credence to a downside correction that could lead to a return to the $1.6000-40 area (initially). New longs seem to be in weak hands, but some players may leg into a short euro-sterling cross position in anticipation of a euro top.

Swiss franc: The speculative net short position was halved to 4.5k contracts. Gross longs increased by 2k to 23.6k contracts. Gross shorts were cut by 2.5k contracts to 18.2k. The dollar has built support in the CHF0.9230 area, but unless it can advance beyond the CHF0.9420 area, a consolidative phase is unfolding rather than an outright correction.

Canadian dollar: The speculators in the futures market still cannot get enough Canadian dollars even though they had already a accumulated a record long net and gross position. In the most recent reporting period, the net long position rose another 10k to 112k contracts. Recall the speculative net position was short as recently as the end of July and it has doubled in the past four weeks. The gross longs rose another 10.1k to 126.7k contracts. Top picking was minimal as the gross shorts increased by a little less than 125 contracts.

Last week, we thought the Canadian dollar looked most vulnerable technically. We wanted to the see the U.S. dollar rise above the CAD0.9780-CAD0.9800. It stalled out near CAD0.9815 and pushed back to CAD0.9725 support area. Barring a convincing break of this area, the U.S. dollar still appears poised to trade higher.

Australian dollar: The net long position rose by less than 1k contracts to 69.2k contracts. The little changed net position was a function of both new longs and shorts coming into the market in roughly equal proportion. The gross longs rose 9.5k to 117k contracts. The top pickers increased the shorts 8.5k contracts to 47.8k.

The Australian dollar lost nearly 0.9% last week, but it managed to recover smartly off the $1.0370 low on Thursday to the $1.0530 area on Friday. However, technically the Australian dollar has to prove itself. It needs to rise above $1.0530 in the coming days or will likely experience another leg lower.

Mexican peso: The net speculative long position was trimmed by 4k contracts to 118k. Top pickers and trend followers saw opportunity. The gross longs rose by about 10% to 140.4k contracts. The gross shorts jumped to 22.2k contracts from less than 5k in the prior week.

The technical tone of the peso has deteriorated. Barring a break of the MXN12.80 area, the greenback appears poised to correct higher with initial potential toward MXN13.05.

Source: FX Outlook And Positioning: Getting Tired?