Broad Dollar Sell Off

Relatively constructive US economic data in the form of a better than expected Feb Empire Manufacturing Survey and a stronger than expected capital inflows (Dec TIC report) has seen the dollar humbled under broad based profit taking. Although there did not seem to be a trigger for the price action, there are a couple things to note. First, as mentioned earlier, Greek debt was under pressure today. The market has taken it in stride. In fact, with the EU fin min meeting out of the way, it seems the topic may be an simmer from hot as positions now seem to have been staked out ahead of the mid-March review or pending the next effort by Greece to issue debt.

Second, Chinese markets will be closed for the next several days. Recall the PBOC hiked reserve requirements last Friday, effective at the end of the Lunar New Year holiday. Addressing seasonal demand for funds, the PBOC had been accommodative, but the pre announcement of the reserve requirement hike indicates officials do not want the seasonal injection to be used for investment or speculation. The PRC factor is off the table for the remainder of this week.

Third, US economic data suggests that the first revisions of Q4 09 GDP are unlikely to be major (due out on Feb 26th), while the US economy appears to be tracking around 3% for Q1 10 GDP. The US and Canadian economies are expected to be the fastest growing economies among the majors this year. But outside of further normalization of monetary conditions, that could include a discount rate hike in the coming months, a hike in the Fed funds rate or the in rate the Fed pays on excess reserves seems a ways off still.

These events come as short-term market participants--speculators, momentum traders and model-driven players have been building long dollar positions, illustrated by the latest Commitment of Traders data from the IMM that showed a record short euro positions (~$10 bln) and a nearly record short sterling position (~$5.7 bln).

One key question is how far can the foreign currencies rally on what appears to be largely a short covering bounce ? Both the euro and sterling have approached initial retracement objectives of the decline seen since Feb 3. For the euro the 50% retracement is found near $1.3780. The 61.8% retracement comes in near $1.3840. For sterling, the 50% retracement is seen near $1.5800 and the 61.8% retracement near $1.5865. Note that the 20 day moving averages are a bit further than the 61.8% retracements, coming in near $1.3875 and $1.5915 for the euro and sterling respectively. The yen is lagging behind the other majors as cross positions are unwound. Look for the JPY90.85 to cap greenback gains.

This assumes that only the last leg of the dollar's rally is being corrected. It is possible that this is not aggressive enough and that without a steady stream of poor news the the euro retraces the move since the last correction that ended in mid-Jan. This would project into higher bounces and a somewhat longer duration of this correction.

Given our expectation of a benign news stream, our understanding of market positioning, and our reading of the technical condition, warns that this dollar setback is unlikely to be a one day wonder. However, the price action itself will clarify whether is a 3-4 day phenomenon--a more or less typical short-term correction or a more serious and deeper correction.