Same Drivers, New Targets, Be Careful of Turn Around Tuesday

Thin market conditions and extended positioning is producing a most dramatic reaction in the foreign exchange market. The initial targets suggested here for the correction have been either achieved or neared much sooner than expected.

Here are the next objectives. A move above $1.3700 in the euro would target $1.3850 and then possibly $1.40. A move above $1.5725 in sterling would target $1.5860 and possibly $1.60. The Australian dollar have moved above parity. The next target is about $1.0075 and then $1.0240. The Canadian dollar is also recovering. The greenback can test the CAD1.0170-CAD1.02 area and then possibly parity.

These are near-term targets and does not alter the bigger picture or our forecasts for the euro to finish the year near $1.29 and sterling near $1.50. The market appears to have been positioned for the apocalypse. The news stream, including the promise held out by Sarkozy and Merkel of new deal in the works; ideas that when a plan is place, large pools of foreign capital, may be interested in European bonds (e.g. Russian comments about Spanish bonds) and the stronger than expected US jobs data, has helped encourage the position squeeze.

However, the facts on the ground in Europe have not really changed substantively. While countries led by Germany are thought to be seeking greater haircuts than the plans announced on July 21 allowed for (21%) has now been formally opposed by the ECB. Germany and France also appear to be divided on bank recapitalization efforts. The former want national authorities to take charge, while France is reportedly pushing for a multilateral effort, including EFSF funds. With France and Germany indicating a new plan by early Nov, European leaders pushed back the planned Oct 18 summit until Oct 23.

Ironically, although most European sovereign bonds sold-off on Monday as risk appetites returned, 5-year CDS prices for most European countries fell. Greece appears to be the major exception. Belgium's CDS price was a fraction firmer following news that it would take over part of Dexia.

Given the magnitude of the currency moves, short-term participants should be on-guard for "turn around Tuesday" style of price action. Some backing and filling for this upside correction in the foreign currencies seems likely before the correction continues. So to reiterate and simplify--medium-term dollar to get stronger; near-term foreign currencies are correcting higher and within the correction, there is scope for a modest pullback.