Currency Positioning and Technical Outlook: Dollar Breaks Down

The re-opening of the US government after a 16-day shutdown sparked a sell-off in the US dollar that has deteriorated the near-term technical outlook.  The combination of setting the stage for a repeat of the brinkmanship in early 2014 and the recognition that the Fed's long-term asset purchases are unlikely to be slowed this year, provides the fundamental backdrop.  

The prospect of unabated asset purchases by the Federal Reserve favor risk assets.  It will likely reinforce the flow into Spanish and Italian assets, and European distressed asset more broadly, including Greek bonds and stocks.   The recovery in emerging markets can continue, even if more selectively.  Here, South Korea, Taiwan and India have stood out in recent weeks. 

Another key characteristic of the price action is the continued decline in implied volatility.  The 3-month implied euro volatility has fallen to new six-year lows even as the euro appeared to break out of its month long consolidation range.  Implied yen volatility has fallen below 10% for the first time since January.  It peaked near 16.4% in June.  

The implied volatility of the other major currencies is also trending lower.  The implied volatility of sterling is approaching 5-month lows it falls through 7%.   Near 8%, three-month implied Aussie volatility is at the lowest level since mid-May and the 5.5% implied volatility of the Canadian dollar has not been seen since mid-year.  To the extent that risk is defined as volatility, the lower implied currency volatility is conducive to greater risk taking and a reduced need (and cost) to hedge.    

The euro is approached the year's high, set in early February near $1.3711, though stopped just shy of it.  Assuming this is breached next week, the next target is near $1.40.  The main caveat from our technical analysis is that the euro closed above the top of its Bollinger Band (two standard deviations above the 20-day moving average) two consecutive sessions at the end of last week.  

Even though the returns in the foreign exchange market are not normally distributed,  arguably undermining the value of such concepts as standard deviations in the first, it is still a rare occurrence. It did take place this year in June and September and although neither time marked a significant high, there was at least a cent pullback.  This would seem to argue against chasing the euro at the start of the week and look for a pullback into the $1.3590-$1.3615 area as a lower risk buying opportunity.  

Sterling does not appear as over-extended as the euro, but its gains do not appear to have been confirmed by the Relative Strength Index.  The high set at the start of the month near $1.6260 is the next immediate target, and over the slightly longer term, potential extends toward $1.6400.  We peg initial support near $1.6100 and $1.6060.  

The dollar is making a third lower high against the yen since peaking in late-May near JPY103.75.  The dollar briefly poked through JPY99.00 on October 17, then it reversed lower and closed below the previous day's low.  Follow through selling was seen the next day and the greenback finished the week at six-day lows.  The market appears to be set to re-test the 200-day moving average that had been successfully tested on the October 7-9.  It is found near JPY97.15.  Below there, the JPY96.50-70 band is reasonable near-term objective.   Lending credence to this negative dollar-yen view, the US interest rate premium over Japan has slipped below 200 bp to its lowest level in nearly three weeks.  

The price action at the end of last week also negated the bottoming pattern that the dollar had appeared to be carving out.  The low for the year was set on October 3 near CHF0.8970 and although the dollar held just above there before the weekend, near-term potential extends toward CHF0.8880-CHF0.8930.  That said, the Swiss franc many under-perform in the period ahead as some will prefer it as the short-leg of carry positions, especially against the Australian and New Zealand dollars. 

The US dollar posted an outside up-day against the Canadian dollar on Tuesday, only to reverse lower Wednesday and experience follow through selling into the weekend.  Still, the Canadian dollar was the worst performing of the major currencies last week, gaining only 0.6% against the greenback.  A break of the CAD1.0270 area could signal a move toward CAD1.02.  

However, the Canadian dollar still looks poised to lag behind the other dollar-bloc currencies.   The other dollar-bloc currencies are in strong uptrends against the Canadian dollar and these moves still appear to have room to run.  The Australian dollar is testing the CAD0.9945 area and, a convincing break, could signal a move toward CAD1.0125.  For its part, the New Zealand dollar is set to test the year's high near CAD0.8780, which is also an eight-year high.  A convincing break suggests technical potential toward CAD0.9000.  

The Australian dollar, like the euro, finished the last week with two consecutive closes above the top of the Bollinger band.    This has not taken place since April and marked an important high.  While this time is seems different, rather than chase the Aussie higher, look for momentum players to buy into a half to a full cent decline.  The next immediate objective is near $0.9715 area, which corresponds to a 50% retracement of the decline since the April high, and then $0.9800.     

The Mexican peso has appreciated by about 4.4% against the US dollar since October 3.  However, the inside trading day record on October 18 may suggest a near-term consolidation phase lies ahead.  With a base near MXN12.75, the dollar can rise toward MXN12.93 initially.  The MXN13.00 area may provide a stronger cap.  Expectations of building for a rate cut at the end of next week.  We note that the other two times that the central bank has cut interest rates this year, the peso has rallied in response.  

Due to the government shutdown, the Commitment of Traders report on positioning in CME currency futures is still unavailable.