Five Factors Impacting Position Adjustment

The main feature of the foreign exchange market remains the relentless pressure on the US dollar.

There are several forces at work and seem to reflect both short-covering and outright longs. The net speculative position at the IMM futures remains short euros and sterling. The euro’s net short position has been cut dramatically from a record 114k contracts in mid-May to 21.3k as off early last week. Sterling shorts have been reduced from 76.7k in early May to 18k early last week. The net speculative sterling position has not been long since Aug 2008. The dollar’s slide has been of sufficient duration and magnitude to have encouraged momentum traders and model-driven funds to get short.

There are a number of fundamental reasons for the position adjustment:

First, and probably most importantly, the European experiment of mnetary union without political union is not collapsing as many had thought a couple of months ago. While there are still a number of voices still expecting such an outcome, they have greatly diminished as European officials innovated and created greater institutional capacity.

Second, the US economic recovery appears to have slackened. There is a normal volatility in such a large and dynamic economy and it is still difficult to know with any degree of certainty whether the world’s biggest economy is experiencing this or something more malign. However, given the structural headwinds and the recent experience, many fear the worst.

Third, European economic data has surprised to the upside and this stands in stark contrast with the US data stream.

Fourth, the ECB has not objected in word or deed to the rise in short-term European rates, while US rates have fallen. Dollar LIBOR for example is near two month lows. As we have noted before the dollar-euro exchange rate has broadly tracked the developments of the two-year sovereign interest rate differential, which has swung from 34 bp in the US favor on May 27 to 25 bp against on July 29. The euro bottomed on June 7.

Fifth, the earlier fears of Europe left many fund managers under-weight European equities and there appears to have been some re-balancing in recent weeks. Some observers that would add to this list of factors concern that the US is lagging behind Europe in addressing its fiscal challenges. How fiscal policy is impacting the currency markets seems more complicated. After all, most members of the euro zone are not really adopting austerity this year. The notable exception of course is the periphery. And the US is not as expansive as some suggest. The state and local governments are cutting spending and raising taxes. There is a fierce debate now over allowing the “temporary” Bush tax cuts to expire and next year with see significant fall in Federal government spending.

These factors have put the dollar bears back into ascendancy. However, as is so often the case, the economic entrails are neither as good nor as bad as they may initially appear. The risk that the pendulum is swinging too far the other direction is increasing. But to be clear, there still does not appear much technical or fundamental incentive to pick a bottom to the dollar. While technical readings are getting stretch, there are not tell-tale signs like divergences or bullish chart patterns to hang one’s hat on.

The pattern of fundamental news and the market’s reaction to it remains intact: the market shrugs off disappointing European data and sees the US economic glass as more than half empty. In terms of sentiment, there are two events on the horizon that have potential to help. First, if private sector job creation is stronger than the 90k the consensus expects and maybe closer to March’s 158k, this would help ease concerns. Second, with renewed focus on what has been dubbed QEII, that is the possibility that the Fed announced renewed asset purchases at the August 10 FOMC meeting, a strong jobs report might ease this fear too. The talk on QEII has focused on reinvesting the proceeds from the maturing assets (mostly mortgage bonds).

Reports suggest that a little less than 10% of the Fed’s assets or $200 bln may be maturing next year. Without buying more assets, the Fed’s balance sheet shrinks and many see that as the tightening of monetary conditions, which given the deflation risks and on-going de-leveraging, the Fed may want to do more to support the economy. Yet, we suspect that with mortgage rates already near record lows, Treasury yields near record lows and the spread near record lows, the bar for renewing QE next week is higher than the media report suggests, even if there are contingency discussions.