Fundamental and Technical Factors Point to Further Dollar Gains

The US dollar is poised to extend last year's rally. The US economy is at least several quarters ahead of most of the other major economies. Barring a major surprise, the Federal Reserve will likely hike rates around the middle of the year, while the economies in Europe and Japan need more stimulus.

In the week ahead, investors will likely learn that the euro zone and Japanese economies continue to struggle, while US job growth continues. There are preliminary signs that labor costs are beginning to rise, helped by rising wages. This is expected to continue to underpin US consumption.

Still, it is unreasonable to expect the US economy to maintain the 4%+ pace seen in the April-September period. It also seems unreasonable to think that the drop in oil prices, lower interest rates, and weaker currencies will not have a positive impact on Europe and Japan. It will take some time. In the meantime, the divergence theme is the focus and this bodes well for the greenback.

The US Dollar Index has established a foothold not only 90.00, which was a post-Lehman cap., but closed the week above 91.00. The next important target is near 96.00. Further out a move toward 101-102 should not be ruled out.

The euro is poised to bust the $1.20 support area. A break targets $1.1875 and then $1.1650 over the medium-term. More immediately, counter-trend bounces toward $1.2130-50 will likely be sold. The greenback closed the week above CHF1.00 for the first time in four years. Although there is some nearby resistance in the CHF1.0070 area, the next important target is near CHF1.1360.

The dollar's down draft against the yen that saw it dip below JPY119 on December 30 was a bit of a fluke. Blame it on thin markets. The move seemed sufficient to wash out the weak dollar longs. As they re-build, the dollar will re-test the multi-year high seen earlier in December near JPY121.85. Above there, technicals point to JPY124.15, the high from 2007, and above there JPY125.00-60. Support is seen in the JPY119.40-60 area now.

Sterling shed 2.5 cents before the weekend to about $1.5325, a 16-month low. From the middle of November through the end of December it traded largely between $1.55-$1.58, with a few minor exceptions. The proximate cause of the breakout was the softer than expected manufacturing PMI, but sentiment toward sterling has been souring. The government's fiscal goals do not seem realistic. The current account is deteriorating. Polls for the May election indicate that Cameron/Osborne's hope of heading a majority government is highly unlikely (and that was a precondition for a referendum on the EU). While there may be some support near $1.52, technically better support is seen near $1.50 and then $1.48.

Weak global growth, soft commodity prices and a stronger US dollar leave the dollar-bloc currencies vulnerable. The US dollar met our longstanding target near CAD1.1725, but has not shown signs of topping. There is immediate potential toward CAD1.1780-CAD1.1800. Over the medium-term, there is potential toward CAD1.22.

Look for the Australian dollar to slip into the technically important zone between $0.7950 and $0.8000 in the next couple of weeks. The central bank governor has been quoted arguing for $0.7500. This is do-able, but it will likely take several months to achieve.

US 10-year yields are getting little traction. Throughout the last three months of 2014, the high yield print was lower than the previous month. January is likely to keep the trend intact, and to do so, the yield needs to stay below 2.35%. Capital flight from Europe and emerging markets seem to offer some insight into this new version of the Greenspan Conundrum. This was the problem Greenspan had identified when the Fed was raising short-term interest rates and long-term interest rates continued to fall. Technically, there appears potential for the 10-year yield to slip back toward 2.0%.

The two-year note yield peaked near 74 bp at the end of last year but slipped back to 66 bp at the end of last week, encouraged by the drop in oil prices and the somewhat weaker manufacturing ISM. Further slippage seems likely in the very short-term, but prospects of a Fed hike near mid-year should prevent a significant break of 58-60 bp.

The price of oil (February WTI) fell $3 a barrel since Xmas eve. Momentum has waned near $52 a barrel. We note that both the RSI and MACDs have not confirmed the new lows. However, we are reluctant to read too much into these bullish divergences. While the rig count in the US is falling, output has risen. Russia and Iraq also appear to have stepped up their production.

The near-term technical outlook for the S&P 500 is not clear. The light participation over the last couple of sessions argues against reading too much into the price action. At the same time, both the RSI and MACDs have failed to confirm the new highs reached at the end of last year. The 120 point advance off the low on December 16 may have run its course. The 2048 area seen on January 2 meets the minimum retracement objective of the two-week advance. A break of this area would signal a move to 2033, and possibly to fill the old gap created on the higher opening on December 18. That gap is found between 2016.75 and 2018.98. On the other hand, a move back above the 2171-76 band would point to a resumption of the advance.