Positioning and Currency Outlook

The US dollar bulls had ceded control for the better part of the first three weeks in June as corrective forces took hold.   They had regained the whip hand subsequently, but lost it again at the end of last week as markets responded euphorically to the EU summit. The dramatic reaction has resulted in a significant deterioration of the dollar's technical underpinnings.

In terms of fundamentals, much of Europe's "bad news" including the stalling of the German economy, easing of price pressures in the area, the likelihood of a 25 bp rate cut by the ECB, and new gilt purchases (GBP50 bln) from the Bank of England, have largely been discounted.  On the other hand, evidence is mounting that the US economy is slowing more in Q2 than previously expected.

The data suggests that Q2 was the fifth quarter of the past six in which quarterly growth is running at less than a 2% annualized pace.  The prospects of a weak US employment report may spur speculation of QE3.  A news wire poll found that the extension of Operation Twist did not change the perceived odds of QE3 among primary dealers.

While skeptical of the extent to which the EU Summit is really the game changer that Rajoy, Monti and Hollande suggest, we do recognize that the actions may help arrest the downward spiral of sentiment.  This will allow investors to shift their focus, at least in the short-term, back to the dollar and its fundamental support, or indeed the lack thereof.

The day after the BOE and ECB meetings, the US reports its market-sensitive employment figures.  Given the signals from the weekly jobless claims and the mostly disappointing regional surveys, the risk is on the downside.  A poor report will only push the expectations for QE3 in one direction.

Given the dramatic rally in the foreign currencies at the end of the week, the positioning data in the CFTC weekly report of the Commitment of Traders that covers the five sessions through June 26 may be somewhat less relevant than usual.  Nevertheless, the data is interesting in its own right, reaffirming the importance of looking at the disaggregated data, not just the net position, and see the direction speculative participants were moving prior,  to the EU Summit.

Euro: The net short speculative position increased by almost 19k contracts to 159.9k.  This cannot be explained by new shorts coming into the market.  Those rose a mere 1.3k contracts.  Instead, it was the longs that capitulated.  Recall that the previous two reports showed speculators had accumulated the largest gross long position in the currency futures in the euro itself, though the gross shorts were much larger still.  The gross longs were cut in the most recent reporting week by 17.5k to stand at 36.9k contracts.  This is a three week low.

The euro was testing the lower end of its Bollinger band early in the week, which is 2 standard deviations below the 20-day moving average.  It finished the week flirting with the upper end of the Bollinger band.

Even if there is some immediate consolidation as the market weighs the significance of the EU developments, the risk is that the euro finishes the week ahead higher.  The $1.2780-$1.2820 area is the first objective.  A break above here may encourage a return toward $1.30.  A move now below $1.2550 and especially $1.25 would negate the euro's more constructive technical outlook.

Yen:  The net long yen position was cut by roughly 2/3 to 4.5k contracts.  Again the disaggregated data is revealing.  The decline in the net long position did not reflect a cut in long positions as much as an increase of new shorts.  Gross longs were cut by 830 contracts to 43.9k.  Gross shorts grew 9.8k to 39.4k contracts.

The dollar recorded an outside-up-day against the yen, meaning it traded on both sides of the previous day's range and closed above the previous session's high.  In addition to this, the other dominant technical feature is that the uptrend line drawn off the early and mid-June lows caught the pre-weekend low to almost the tick.  Provided this trend line holds, the dollar could firm toward the recent high near JPY80.60 and JPY81.00.

The euro and yen tend to move in the same direction against the dollar.  However, with the exception of 2009, every year since 2006, there has been a period in which the 60-day correlation between the yen and euro has been inverse.  This is one of those times.  The correlation at the end of H1 has been turned slightly negative.  This lends support to our view that the euro can strengthen against the dollar and the dollar may strengthen against the yen.

Sterling: Even before the EU Summit, speculators were reducing short exposure.  The net short position fell to almost 760 contracts from 17.2k.  This was a function of shorts covering (gross short positions were culled by a third to 36.1k contracts), rather than the establishment of new longs (rose by 3k to 35.3k contracts).

While there may be some initial resistance in the $1.5730 area, the $1.5770-$1.5800 area is likely to be more formidable.  If this area is successfully overcome, the next target is near $1.5900.  Support is seen in the $1.5600-30 area.   It would not be surprising to see the euro lead sterling higher in this corrective phase.

Swiss franc:  The net short position rose sharply after being reduced dramatically in the previous week.  The net short position stands at 23.8k contracts compared with only 7k the week before.  This was a function of franc bulls capitulating and slashing their gross longs by 19.5k contracts to 4.6k, which is the smallest gross long position since late April.  Gross shorts were trimmed by 2.6k to 28.5k contracts.

While there may be some scope for the euro to trade higher against the franc, the franc's technicals against the dollar are similar to the euro.   The dollar's action around CHF0.9420 may be pivotal.  A convincing break would suggest another 1-2% decline.  If it holds, it may mark the bottom of a new range.

Canadian dollar:  Speculators were largely sidelined, with the net long position increasing 1.1k contracts to 9.3k. Yet as small of an increase as it may be, it is the first since late May.   Longs were essentially flat (-30 contracts) and leaving the small trimming of the shorts to account for the shift in the net position.

The head and shoulders pattern we had been monitoring may have been negated, but it still looks as if a larger US dollar topping pattern is being carved out that points to potential back toward CAD1.0000.  The CAD1.0200-30 area should offer resistance now as it acted as support previously.

Australian dollar:  Speculative interest faded in sessions leading up to the European Summit.  The net short position slipped to 2.2k from 3.5k contracts.  Longs were shaved by 1.1k contracts, while 2.4k short contracts were covered.   The Aussie long position stands at 40k, putting it just behind the yen, as the currency futures that speculators have established the largest gross long.

The technical outlook is favorable.  It finished June at its highest level since early May.  After what proved to be a false break near the middle of June, the Australian dollar appears now to have convincingly violated the downtrend line drawn off the late-Feb and late-April highs.  There looks to be potential toward $1.0370-$1.0400 area.   This technical outlook is consistent with a set of fundamental developments that would include no rate cut at the July 3 RBA meeting and a sufficiently neutral statement that would give the market second thoughts about an August cut.

Mexican Peso:   The net short peso position was cut roughly in half to 7.6k contracts.  Longs rose by 9.4k contracts to 32.2k, the largest since mid-May.  The gross shorts increased by 2.4k contracts to 39.8k.

On the eve of the Mexico's national elections, (does anyone else think of Nancy Botwin whenever it comes to south of the border politics? No okay maybe that is just my webmaster). the dramatic market response to the EU Summit saw the dollar fall to the MXN13.30 area, which is where a trend line drawn off the mid-March and early May lows intersects.  A convincing break of it could signal a move toward MXN12.90-MXN13.00.  A move now back above the MXN13.56-60 area would likely neutralize the dollar's bearish technical tone.