Speculative Positioning and Technical FX Outlook

The intensification of the European debt crisis continues to overwhelm all other considerations in the global capital markets. The corrective bounce we anticipated on May 17 largely fell shy of the technical objectives as the European officials appeared to continue to drift toward a Greek exit. In addition, the flash PMI readings from the euro zone and the German IFO warned that the regional economy cannot count on German locomotive here in the second quarter.

Regardless of the particular policy response by officials, stronger growth in the core (fueled by domestic demand) and a weaker euro would provide a more conducive environment for addressing the crisis. Although the wishes of officials do not drive currency prices, weakness of the euro should be understood as both the symptom of the crisis and also an attempt to cure, like a fever in person.

We remain concerned that market positioning and sentiment are stretched. Equities, emerging markets and most commodities have fallen sharply. Core bonds markets have rallied. The dollar and the yen have been the best performers in the foreign exchange market.

The latest Commitment of Traders report covers the week through May 22 and covered the short-lived bounce in the foreign currencies. Speculative players generally added to short foreign currency futures (euro and Swiss franc) or cut long positions (sterling and Canadian dollar). Of note the net speculative positions in the Australian dollar and the Mexican peso switched from long to short.

Before turning to the analysis of the positioning in the currency futures, a reminder is in order. The foreign exchange market is overwhelmingly an over-the-counter market. The most recent survey by the Bank for International Settlements puts the average daily turnover at around $4 trillion. The futures market is a small component.

We analyze the Commitment of Traders report (here is a link to last week's analysis) because we find it offers insight into a segment of the market whose activities provide directional views, unlike say corporate hedgers or some money managers who see the foreign exchange market as a transactional vehicle (necessary to buy foreign assets). 

Speculators in the futures market may be a microcosm of trend followers and momentum players in the larger foreign exchange market. This means that although there is a record short euro position, there is no “natural” limit. The current gross short position has a notional value of about $30 bln. The over-the-counter market’s average daily volume of the euro-dollar currency pair is around $1 trillion.

Euro: The net short speculative position increased to 195.4k contracts, which is an increase of 21.5k contracts. Approximately 3.8k longs capitulated, while the shorts gained 17.7k contracts (to 230k contracts). Long commercial positions rose to another record of 308.3k contracts. Commercials are thought to largely be hedgers. That they have a growing long position in the futures market suggests commercials may be increasingly short euros in their underlying businesses.

The fundamental news stream gives the euro shorts no cause for concern. The new lows recorded in the euro were not confirmed by the relative strength index or the slow stochastics. This divergence should discourage new shorts from entering, but bounces look to be limited. The $1.2600 area offers initial resistance. The recent high near $1.2830 seems too distant to be relevant in near-term. The $1.25 level was breached only sufficiently to trigger some option structures and stops, but assuming it goes, the next immediate target would be near $1.2380.

Yen: The net short yen position was nearly cut in half from 34.3k contracts to 18.0k. This was mostly a function of shorts being redduced by 13.3k contracts. Some bottom pickers emerged and the longs grew by 3k.

The dollar looks to be caught in the JPY79.00 to JPY80.50 trading range. It has not closed above its 20-day moving average against the yen since late March. It was near JPY79.80 on May 25 and is falling a few pips a day. The yen is the only G10 currency to have gained against the dollar here in May, though it was by an inconsequential 0.18%. 

A note of caution is in order as the dollar’s 5-day moving average is poised to cross above the 20-day average. Although this simply cross over “system” is not immune from being whipsawed, it has caught both the dollar’s rally from mid-Feb to late-March and its sell-off. The downside momentum appears to be faltering and the downtrend line drawn off the March high above JPY84 comes in near JPY80 and will likely be respected by trend followers.

Sterling: Last week we suggested that the late sterling longs were vulnerable. Unlike the euro, Swiss franc, and yen, a net long sterling position had been built in recent weeks. They were culled in the reporting period that ended on May 22. The net long position was more than halved to 11.3k from 25.0k contracts. This was primarily longs leaving; they fell by 16.6k contracts. Shorts were trimmed by 2.9k contracts.

Sterling’s 3.5% loss this month through May 25 makes it’s the second best performing currency against the dollar (behind the yen). The $1.5640 area represents a 61.8% retracement of the rally off the mid-Jan lows. This has been taken out on an intraday basis, but sterling has not closed below it. The $1.5600 offers backup support. The new lows in sterling, unlike, what we saw with the euro, were confirmed by the relative strength index. The $1.5725-50 area may offer initial resistance.

Swiss franc: The Swiss National Bank’s determination to put a cap on the franc’s appreciation is being tested in the spot market as safe haven is sought. The SNB does not appear to be fighting speculators as much as savers fleeing the euro zone. In the IMM futures, the net speculative short position continued to grow. Now at 34.9k contracts, it is the largest in several years. This was produced by a 4.2k cut in long franc contracts and a rise of 6.9k short contracts. The gross short position stands at a little less than 40k contracts and has essentially doubled this month.

Given the SNB’s refusal to allow the Swiss franc to find a price that clears the market, one’s franc view solely determined by one’s euro view. Yet perhaps in some ways the franc’s chart is clearer. A convincing dollar close above CHF0.9600 would encourage players to target CHF1.000. If the dollar move to parity with the Swiss franc and there is no real movement in the franc against the euro, that would put the euro near $1.20.

Canadian dollar: The net long Canadian dollar position fell to 38.6k contracts from 51k in the previous reporting period. Not only does the Canadian dollar suffer in a risk off environment, but we have warned that the market is likely getting ahead of itself in pricing in a rate hike this year. The speculative players cut longs by 8.7k contracts, but at 55.6k, the gross long position remain the largest in the futures market. Top pickers in the Canadian dollar continue to creep in as shorts rose by 3.7k contracts

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Neither market positioning nor technical indicators suggest the greenback’s advance against the Loonie is over. Initial support for the dollar is pegged near CAD1.0200. The near-term upside extends toward CAD1.0420.

Australian dollar: The longs capitulated and drove the net speculative position to the short side for the first time in three years (March 2009) and at almost 17k contract, it is the largest net short position since September 2008. Longs were cut by 42% to 30k contracts and shorts rose by a mere 565 contracts (to almost 47k).

The risk-off environment, sell-off in commodities, concerns about the pace of slowdown in China, and expectations of additional aggressive easing by the Reserve Bank of Australia makes for a poor fundamental backdrop for the Aussie. Yet at the end of last week, as the euro fell to new lows and equities struggled to sustain uptick, the Australian dollar did not make new lows after briefly dipping below $0.9700 on May 23. If this stability can be sustained over the next few sessions, some technical readings may turn in its favor. The $0.9830 area will likely be the initial cap.

Mexican Peso: The net speculative position switched from long to short pesos in the reporting week that ended on May 22. It is the first net short position since mid-January. The flip to 16.1k net short contracts form a net long 14.4k contracts was a function of both longs getting out (13.4k contracts) and shorts coming in (17.1k contracts).

The peso has lost about 7.25% against the dollar thus far this month. It has suffered in this risk-off environment. There does not appear to be a significant chart point until MXN14.30 now. If the dollar does not continue to rise in the coming days though, the relative strength index will likely show some (dollar) bearish divergence. Initial support is seen near MXN13.92.