Dollar Correction may not Be Complete, but Fed Expectations to Limit the Pullback

The overextended technical condition of the dollar we highlighted previously was expressed in a mixed performance last week. Against the top ten currencies, that dollar fell against five. The drop in oil prices and other commodity prices encouraged rate cut expectations in Australia and Canada, sending those currencies to new multi-year lows.

The New Zealand dollar reacted positively to the RBNZ rate cut in part because the accompanying statement dropped its past calls for currency depreciation. However, with another rate cut likely in September, traders sold into the Kiwi's rise. It still managed to close with 0.8% gain on the week. Disappointing UK retail sales provided a palliative for the rate hike fever, and sterling lost a little more than 0.5%. The euro rose 1.25%, and the yen gained about 0.3%.

It is not clear that the euro's downside correction is over. The euro has not closed above its 20-day moving average since June 22. It and the last week's high are just below $1.1020. More important technical resistance comes in near $1.1060. This also corresponds with the down trendline drawn off the mid-June high over $1.1400 and the July 10 high near $1.1210. It is a four-point trend line.

With significant event risk posed by the FOMC meeting, the euro's upside is capped. However, if the Fed is non-committal, the euro could advance. This may be enough to turn the five-day moving average above the 20-day. This moving average cross-over may be a loose proxy of the signal for trend followers and some model-driven participants.

The recent price action underscores the technical significance of the $1.08 area. Initial support is seen near $1.0920. Despite weekly initial jobless claims setting new cyclical lows, market expectations have not changed. The September Fed funds futures contract was unchanged on the week and the December contract changed by half a basis point. The September contract is pricing in about a 50% chance.

The dollar looks vulnerable against the yen. As the dollar moved toward the upper end of its range against the yen, a Japanese official cautioned against the need for further yen depreciation. That capped the dollar near JPY124.50. The pullback back in US stocks and the decline in bond yields may encourage short-term traders to push the dollar lower. Still, ahead of the FOMC meeting support in the JPY122.90-JPY123.10 may limit the selling.

After rallying from $1.5330 on July 8 to $1.5675 on July 15, sterling has drifted lower. The disappointing and unexpected decline in retail sales warned bottom pickers that they may have been too early. Sterling posted an outside down day on Thursday, and there was follow through selling early Friday. However, sterling stabilized at the 61.8% retracement of the earlier advance and recovered to close near its highs. In doing so, it looks as if a potential hammer candlestick pattern is in place.

The bullish technical implication may be reinforced by the economic data, which may include news of accelerated growth (Q2 GDP) and an increase in the service index and mortgage approvals. However, sterling exposure may be at risk from the general dollar move, which is why its performance against the euro may be more indicative.

The Australian dollar is nearly in free fall it appears. It was the worst performing of the major currencies, losing 1.3%. The sell-off in gold and copper, disappointing economic data from China, and the continued verbal pressure from the RBA Governor sent the Australian dollar to the $0.7265 area. It began the month near $0.7700. There seems to be little in the way of technical obstacles until closer to $0.7000. Initial bounces may be limited to the $0.7330 area.

The OECD's measure of PPP puts the Australian dollar still almost 11.5% over-valued. The New Zealand and Canadian dollars are undervalued by 3.0% and 3.4% respectively. The US dollar spent Friday's session entirely above CAD1.30 for the first time in 11 years. Like the Australian dollar, the Canadian dollar appears to have launched a new leg down. The first target for the greenback is CAD1.3330, which corresponds to 75 US cents. Beyond that is CAD1.3460. During this US dollar bull market, we anticipate it rising over time toward CAD1.40.

Oil prices were drilled. Since May 8, the light crude oil for delivery in September has fallen by 17%. Since July 15, the price has fallen by 11.7%. It closed the week at life-of-contract lows. A continuation futures contract has fared better. It was only at the end of last week that it completed a 61.8% retracement of the rally from the March lows. This is found just below $50 and may act as resistance now. Support is seen near $46.80. A break of it would signal a return to the March low just above $42.

US 10-year Treasury yields fell 10 bp last week to close near 2.26%. The drop in commodity prices and equity market weakness seemed to be the major spurs. For nearly two months now the yield have moved in a clear range--2.17%-2.20% on the downside and 2.45%-2.50% on the upside. The low yield and risk-reward consideration would seem to limit additional yield declines especially ahead of the FOMC meeting and the August 7 employment report.

The S&P 500 peaked on Monday and trended lower the remainder of the week. It lost about 2.8% and completed a 61.8% retracement of the rally from 2044 on July 7 to 2123 on July 20. A convincing break of this area warns of a return to the early July low. The 200-day moving average comes in near 2063, and a test on it had been a good buy signal though last September it spent two-weeks below it before the rally resumed.

Observations from the speculative positioning in the futures market:

1. There were two significant (10k contracts or more) gross position adjustments in the currency futures. Yen shorts jumped 16.7k contracts to 113.2k. Mexican peso shorts rose by 10.1k contracts to 102.8k.

2. The clear pattern, and one that cannot be deduced by the conventional focus on net positions. The gross positions--both long and short--rose among all the currencies this week but for the gross long Australian dollar position. It was trimmed by 2.6k contacts (leaving 52.3k). This tug-of-war suggests the market was at a potential inflection point. The contrarians were making a small stand looking for a correction while the trend followers were playing for a breakout. The dollar-bloc and peso broke out. The others did not.

3. The speculative position in US 10-year Treasury futures switched from net short to long, for the first time since last August/September. The gross longs rose 32k to 459.6k contracts. The gross shorts shaved a thousand contracts leaving 432.2k. The net short position has been trending lower, and the gross position adjustment was sufficient to swing it long by 27.4k contracts after being short 5.6k.

4. The net long speculative crude oil futures position continues to unwind. It fell 10.7k contracts to 253.7k. This is the smallest in three months. It more because of new shorts (7k contracts) than longs cutting (-3.7k contracts). The gross long position of 464.3k contracts is approaching the low for the year set in January. At 210.6k contracts, the gross short position has risen by 40% this month.

21-Jul		Commitment of Traders
	(speculative position in 000's of contracts)
	Net	Prior	Gross Long	Change	Gross Short	Change
Euro	-113.0	-108.0	65.7	3.1	178.7	8.2
Yen	-62.3	-47.4	50.9	1.7	113.2	16.7
Sterling	-21.5	-24.2	35.1	2.9	56.6	0.2
Swiss Franc	3.4	3.1	9.9	3.4	6.5	3.0
C$	-43.6	-40.7	41.4	3.2	85.0	6.1
A$	-40.9	-33.5	52.3	-2.6	93.2	4.7
Mexican Peso	-81.4	-72.7	21.4	1.4	102.8	10.1