FX: Speculative Positioning and Technical Outlook

The heightened risks to the European monetary union following the election results in both Greece and France earlier this month continued to drive the foreign exchange market. In the week through May 15, speculative participants in the currency futures generally either added to shorts or cut longs.

Although the fundamental drivers have not changed, the technical condition of the market has. We began warning of the risk of an upside correction for  the major currencies in the middle of the week. On May 18, the euro and the Swiss franc posted what is technically a potential key reversal. Both currencies traded below the previous day’s low (and when doing so, made new lows for the move) and then rallied above the previous day’s high and managed to close above those highs.

Sterling did not record a key reversal, but after selling off sharply earlier in the session and then rallying to close at its highs, a bullish hammer pattern in Japanese candle sticks was recorded. To be sure, both the key reversals and hammer require some follow through action for confirmation. However, a key take away is that our reading of the technical condition of the market is more constructive than our fundamental assessment.

While medium term investors may be best served to continue to focus on the underlying fundamentals, technical indications suggest a better opportunity to position for those fundamentals may be seen over the near-term. Medium terms investors need not chase the market.

Euro: The net short speculative position jumped to a record of almost 174k contracts in the week that ended May 15 from 144k the prior week. This was purely a function of the establishment of new shorts, which grew by a little more than 32k contracts. At 212k, the gross short euro position is also a record. Those apparently trying to pick a bottom in the euro rose 2.4k contracts.

Anticipating the extended nature of market position, the fact that the Greek election is a month away, and that officials would likely try to pull sentiment away from the edge of the abyss, led to our expectation for a technical recovery in the euro. A move now above $1.2805 could spur a move toward $1.2850-$1.2900 initially.

Japanese yen: With increased speculation that EMU may be on the verge of dissolving and German 2-year interest rates half of what they are in Japan, it is not very surprising that the net speculative short yen position was trimmed. The net short position fell to 34.3k contracts from 41.1k the previous week. Long yen positions grew by a 1.1k contracts. The shorts were cut by 5.7k contracts.

Cross rate demand for yen against the euro, sterling, and the Canadian and Australian dollars weighed on the greenback against the yen, despite talk that Japanese officials were preparing for intervention. The dollar may see some support in front of JPY79, while a break will encourage a move to JPY78.30. Important resistance is now seen in the JPY80.00-50 area.

British pound: Sterling fell through most of the week covered by the latest Commitment of Traders, but the net speculative position hardly changed. Sterling has fallen for 10 of the 14 sessions this month thus far. Yet, in the latest reporting period, the net long position fell about 300 contracts to 25.0k. Longs were shaved by 2.2k contracts and the shorts were trimmed by 1.9k. The subsequent slide in sterling after the end of the reporting period warns that more of the gross longs were likely cut. They remained substantial on May 15 at almost 57.5k.

In the second half of last week, the combination of soft economic data, dovish comments by the Bank of England and speculation that gilt purchases (QE) may be resumed as early as next month, saw sterling slide in the spot market. If the recovery before the weekend sees follow through gains, the first real test for sterling is seen in the $1.5880-$1.5930 band.

Swiss franc: We recognize that the Swiss National Bank’s effort to prevent franc appreciation against the euro has generally been successful. The SNB succeeded in deflecting speculative attention away from the franc. Speculative participants have, at least for the moment, given up playing the franc from the long side, even though there remains a high level of anxiety. They are choosing instead to play the franc from the short side.

The net speculative short franc position jumped to 26.7k from 16.5k contracts. This is the largest net short position since September 2007. The gross shorts grew by 11.3k contracts to stand at almost 33k. This is the largest gross short franc position since Oct 07. The gross longs increased by 1.1k. The dollar is likely to encounter bids near CHF0.9385, but near-term potential extends toward CHF0.9310.

Canadian dollar: The net long speculative position was cut by about 15% to 51k contracts. This was a function of both longs getting out (-3.6k) and shorts getting established (5.5k). The net and the gross long Canadian dollar positions are the highest among the currency futures.

The Canadian dollar did not participate in the foreign currency bounce ahead of the weekend, and in fact the US dollar settled near session highs against the Canadian dollar, which is near the best level since mid-January. The underlying fundamentals remain constructive for the Canadian dollar. The strength of the recent employment report coupled with the firmer than expected CPI data on May 18 should help underpin expectations that the Bank of Canada is likely to be the first to raise rates within the G7.

Medium term participants should stay alert for a new opportunity to build Canadian dollar exposure. However, a recovery in the Canadian dollar would seem to require a stabilization of equities. While the decline in oil prices may not be doing the Loonie any favors, it is the performance of the S&P 500 that appears to be taking a bigger toll. Note that the over the past 60 days, the Canadian dollar’s correlation (percentage change) with the S&P 500 is near 0.80 while the correlation with oil is about 0.58. Over the past 30 days, the correlations are 0.84 and 0.61 respectively. Risk extends toward CAD1.03.

Australian dollar: One of the most notable aspects of the Commitment of Traders report was the despite the Australian dollar’s slide over the reporting period, the net speculative position remained long. To be sure, it was sharply reduced from 25.1k contracts to 4.7k, which is the smallest net long position since March 2009. The gross longs were culled by nearly a third to 51.1k from 72.2k contracts. The shorts were pared by a few hundred contracts to about 46.3.

The Australian dollar, like its Canadian counterpart, did not participate in the pre-weekend recovery against the dollar. It has not managed to close above its 5-day moving average since the end of April. Speculation that the Reserve Bank of Australia, which delivered a 50 bp rate cut earlier this month can follow up with another 50 bp cut in early June maybe a bit rich. It has declined nearly 5% already this month and if a corrective phase is indeed at hand, the Aussie should participate. The first hurdle comes in around $0.9880-$0.9910.

Mexican Peso: Risk aversion helped encourage a dramatic adjustment of position and the net long position was slashed by nearly 2/3 to 14.4k contracts. The longs were cut by 17.5k contracts, while the shorts grew by almost 5k. Mexico’s macro-fundamental outlook appears relatively constructive and the nearly 6% loss this month reflects the heightened anxiety throughout the capital markets, more than a Mexico-level development.

The peso, like the Canadian dollar, is higher correlated to the S&P 500 than oil and the first sign of stability in equities may see the peso recover. Initial support for the greenback is seen near MXN13.70 and then MXN13.50.