Deja Vu All Over Again?

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There is an eerie sense we have been here before.  The dollar rallied following the announcement of QE2 in early November 2010.  The strength continued into early 2011.  Then Trichet began threatening rate hikes.  At first it seem ludicrous--that his tough talk was going to get the market's to do his heavy lifting, though as we know, the ECB did hike rates in April and then again in July.   

In addition, the US economy, which had seemed to be on the mend in Q4 10, noticeably began to weaken at the start of 2011.  At the start of 2011, the US 2-year yield was 20 bp below Germany.  The combination of a hawkish ECB and weak US data pushed the US discount to Germany to 132 bp by early May.  The dollar sold off hard.  The euro rallied from about $1.2850 in January to almost $1.50 in May.

While the details are different now, there are some interesting parallels.  

ECB tightening of course is not in the cards, but the Federal Reserve did ease monetary policy by pushing out by around a year the likely time frame of the first hike.  In addition, the odds of a ECB rate cut in February have been reduced by the economic data that suggests that the euro area economic downturn is not accelerating.  

The US reports Q4 GDP on Friday and most look for it to be around 3% (annualized), which would be the fastest since Q2 2010.  However, we do not expect this pace to be sustained in Q1 and look for the economy to slow toward 2.0%.  

One significant difference between now and a year ago is in terms of market positioning.  The net speculative position at the IMM was long euros a year ago, even after the November-December slide.  Now, however, or as of last week, the net speculative position was short a record amount of euro futures contracts (notional value ~$20 bln).  

I have suggested since earlier this month that there was potential toward $1.32.  It moved within spitting distance earlier today.  While there is a reasonable chance that that area holds, what if it doesn't?   From a technical perspective a convincing break of $1.3200 suggests a deeper correction that could extend toward $1.3400-$1.36.  

To be clear this is not what I think is the most likely scenario, but one for which the risks have increased.