Currency Positioning and Technical Outlook

Last week was of two halves.  In the first part, the dollar remained strong as the European crisis dominated other considerations.  In the second part, the dollar had its recent gains pared as the seemingly bipolar market shifted its focus to the increased risk of a policy response.  In addition, evidence continued to mount that the world's largest economy is off to a sluggish start of Q3.  

Next week is jammed with key events, back loaded, if you will.  The keys will be the FOMC meeting that concludes on Wednesday and the ECB meeting on Thursday.  In addition, the US reports the market sensitive employment data on Friday.  The poor clue from the ADP estimate last month will make short-term participants less likely to give it much weight and, hence, it is unlikely to steal the thunder of the government's report.  

The Bank of England meets but as it is currently engaged in QE and the "Financing for Lending Scheme", this will likely be a non-event.  And unlike other central banks, when the Monetary Policy Committee doesn't do anything, it doesn't say anything.  The monthly purchasing managers surveys will also be released but are unlikely to provide much fresh insight or challenge current views.    

There are two important caveats to the following observations about speculative market positioning and the technical outlook.  First, as was the case last week, significant price action took place in the few days that follows the closing of the Commitment of Traders reporting period.  Last week, we were able to anticipate the general price action: Follow through selling of the foreign currencies early in the week and then a recovery later in the week.   

This week is more difficult, which brings us to the second caveat.  The investment environment is punctuated with event risks.   Nevertheless, having some sense of market positioning and psychology can be useful in anticipating how the market may respond to different fundamental developments.  In general, we anticipate some additional follow through gains in the major foreign currencies, except the yen,  in the early part of the week.   

Given that market participants seem divided about whether the Fed is prepared to act now or in September, the FOMC is unlikely to disappoint very much.  Given Draghi's recent comments, the risk of disappointment seems greater from the ECB.   While the market reacted favorably to what appears to be a hint at resuming the sovereign bond purchase program (SMP), which has been dormant for nearly five months, a review of the actual results of its past purchases, suggests it is not the game changer some have suggested.  

We worry European officials are not prepared to take any key decisions in the weeks ahead:  not about Greece, Spain, or the ESM.   Hope for some semblance of stability seems to be pinned on official jawboning and the ECB.  

Ideas that Germany or German interests dominate the ECB are belied by the very existence of the SMP in the first place.  Two German ECB members resigned over it.  Does any one really think that that exercise in futility will be repeated and that Weidmann and Asmussen would resign if they lost the vote on resuming the SMP?  

Draghi does seem to share with German officials the understanding that granting the ESM a banking license would be in violation of both the letter and spirit of the law.  However, given that the ESM does not exist, and won't until at least the middle of September, this argument need not be taken up at this week's ECB meeting.  

Nor does the decision about whether to offer a negative deposit rate have to be made this week.  A 25 bp cut in the refi rate need not require a cut in the deposit rate, which was cut to zero earlier this month.  The ECB could accept a narrower rate corridor, which would not be unprecedented and would potentially be less disruptive than a negative deposit rate.  

The ECB is reviewing its general collateral rules and was expected to unveil reforms in September. What ultimately is involved in the distribution of risks and the collateral is an important element.  However, if Draghi is ready to announce this sooner, it too risks underwhelming the market, especially if it is not part of a larger effort.    

Euro: The net short euro position was trimmed in the week ending July 24 to 155.1k contracts from 167.2k.  Gross longs grew 7.7k to 39.5k contracts and gross shorts were trimmed 4.5k to 194.6k contracts.  The speculative players were moving in the right direction ahead of the 3.5 cent rally off the July 24 low.  

There is scope for additional near-term euro gains.  The $1.2400-40 area offers a reasonable near-term target.  A convincing break would suggest additional potential toward $1.2550.   A break of the $1.2240-70 would be the first important signal that this is yet another short-lived bounce.  

Yen: The biggest change in the net positions in the currency futures took place in the yen, where the net long position more than doubled to 25.1k contracts from 11.1k.  This is the largest net long position since the middle of February.  It reflected a 15.3k rise in gross long positions, which at 52k is also a five month high.  Gross shorts edged higher to 27k, adding 1.4k contracts.

As noted, the dollar appears to be carving out a near-term low against the yen near JPY78.00.  Initial resistance is seen in the JPY78.80-JPY79.20 area.  The general advance anticipated here for other major currencies suggests that cross rate pressure help the greenback against the yen in the near-term.  

Sterling:  The net short position cut to 2.9k from 7.5k contracts.  Both longs and shorts were trimmed (4.6k and 9.1k respectively).  

The shift in the investment climate was the key to sterling's resiliency in the face of evidence that the economic downturn deepened.  Sterling recovered from a ten day low to finish the week at its best level in a month.  Initial resistance is seen in the $1.5785-$1.5800 area.  A break of $1.5650 would be an early sign that the recovery is faltering, but to be convincing now a loss of $1.56 may be needed.   

Swiss franc:  The net short franc position ended higher to 25.9k from 23.1k contracts.  This is the largest net short position in a month.  Longs were cut by 1.1k to stand at 5.1k contracts.  Shorts increased by 1.8k contracts to 31k.   The short-term speculative market was leaning the wrong way.  The dollar lost 3% against the Swiss franc after nearing parity for the first time since December 2010.

There is scope for additional near-term dollar losses.  The CHF0.9650 offers initial support, scope extends into the CHF0.9540-80 area.  On the other hand, a dollar recovery through the CHF0.9830-60 band warns of another run to parity.    

Canadian dollar:   The net short position doubled to 2.4k contracts in the most recent week.  It is the second week that the net position has been short, for the first time since February.  There has been a bit of a battle.  The gross longs rose 6.1k to 29.7k contracts.  The gross shorts added 7.3k to 32.1k contracts.  The sharp gains recorded in the second half of last week saw the Canadian dollar rise to its best level since mid-May. 

The Canadian dollar lagged behind the other dollar-bloc currencies in the move against the greenback in the second half of last week.   Still there is scope for additional near-term Canadian dollar gains  Near-term players have their sights set on parity, which has not been seen since the first half of May.  If this scenario unfolds, the dollar should hold below CAD1.01.   

Australian dollar:  The net long Australian dollar position doubled to 26.4k contracts and is the largest in more than two months.  Gross longs rose 15.8k contracts to 66.7k and shorts rose 3.2k to 40.3k.  The Australian dollar rallied more than 3.2% off the mid-week low.  

The Australian dollar's advance that started in early June from below $0.9600 reached new highs at the end of last week near $1.05 does not appear complete.  A convincing move above $1.05 targets $1.0600-20.  The low seen following the decline in Q2 CPI on July 25 successfully test the trend line drawn off the late-June and mid-July lows.  That trend line comes in near $1.0280 by the end this week.  

Mexican peso:   The net long position rose almost 15k contracts to 49.7k.  This is the largest net long position since mid-May.  Gross longs rose 5.2k to 66k, making it the second largest gross long in the currency futures behind the Australian dollar.  Gross shorts were cut by a little more than a third to 16.3k contracts.

The dollar can ease further to re-test the month's low near MXN13.07.  Additional support is seen around MXN13.00.  A move back above MXN13.40-43 may see the peso bulls begin reconsidering their stance.