The Dollar: Now What?

The US dollar has been on a roller coaster ride. Many have lost confidence in the underlying trend.  An important prop for the dollar, namely the prospects for the Fed's lift-off has been pushed out again, this time ostensibly due to the heightened volatility of the financial markets, apparently sparked by events in China.

The September Fed funds futures have nearly fully priced out the risk of a hike next month. The effective Fed funds have traded 14-15 bp this month, and the September Fed funds contract implies an average effective rate of 17.5 bp next month.

We continue to believe that the main driver of this third significant dollar rally since the end of Bretton Woods is the divergence of the trajectory of monetary policy between the US (and UK) and nearly all the other high income countries, and many emerging markets, including China.  There are a number of cross-currents, and other considerations, including market positioning, use of euro and yen for funding purposes, and hedging flows that at times may obscure or even reverse (technical correction) the underlying trend.

Nevertheless,  we expect the divergence theme to gain more traction over time.  The Federal Reserve will raise rates at some juncture and not only will the ECB and BOJ continue to ease for at least the next 12 months, but there is risk that the central bank balance sheet exercise lasts even longer.  The ECB's staff, which will update its forecasts in the week ahead, is likely to shave both its growth and inflation forecasts at the September 3 central bank meeting.

The Dollar Index was slammed to its lowest level since January in the market panic at the start of last week.  It overshot the minimum objective of the double top pattern we noted (~94.30).   It rebounded and on Thursday had retraced nearly 61.8% of the decline since the August 7 (~98.33).  The trend line drawn off that high and the August 19 high (~97.08) comes in near 95.80 on Monday and falls to about 95.15 by the end of the week.  A move above 96.40 signal a return of the 98.00-98.30 area.

The panic saw the euro reach almost $1.1715 at the start of last week.  The subsequent sell-off saw it shed more than nickel.  The euro settled on its lows for the week, leaving a potential shooting star candlestick formation on the weekly charts.  The break of $1.12 creates scope for another half cent of declines but pushing the euro below the $1.1130 area may require fresh fundamental incentives, possibly in the form of more confidence that the Fed is still on track to hike rates next month, or that the ECB is particularly dovish.   On the upside, the $1.1280-$1.1310 band should limit euro gains if the euro bears who had been squeezed out of their shorts are going to re-establish.

Switzerland unexpectedly reported that its economy expanded in Q2.  The consensus was expected the second consecutive quarterly contraction.  That helped stall the dollar's upside momentum.  The CHF0.9680 is a potent block now to additional dollar gain, though if it is overcome, the next target is near CHF0.9800.  Support is seen near CHF0.9500.  Support for the euro is pegged at CHF1.0750 and then CHF1.0700.  A break of CHF1.0680 would mark a significant technical deterioration.

The dollar also retraced 68.2% of its losses against the yen of the drop from August 18 high near JPY124.50 through the spike low on August 24 near JPY116.20.  When that retracement objective near JPY121.35 is overcome, there is a band of resistance in the JPY121.80-JPY122.15 that will provide the next test.    On the weekly charts, the dollar posted a potential bullish hammer pattern.  An appreciating dollar against the yen assumes firm, if not rising US rates, and stability to higher equities.

The greenback rose against all the major currencies last week save the Japanese yen. Sterling was among the weakest.  Losing about 2.20%, sterling nearly matched the Australian dollar's decline (2.25%), which was only surpassed by the New Zealand dollar's 3.35% fall.  Since August 18, the implied yield on the June 2016 short sterling futures contract fell more than 13 bp as investors anticipate that greater deflationary forces will delay a BOE rate hike.

Sterling fell to its lowest level since July 8 before the weekend.   A convincing break of the low set then (~$15330) could spur a further drop into the $1.5180-$1.5200 area. Sterling closed below its 100-day moving average (~$1.5480) for the first time since early May.  It has spent most of the last two months above the 200-day moving average (~$1.5370) as well.   On the weekly charts, sterling posted a large outside down week, which is a bearish development.  On the top side, the $1.5450 area should offer resistance.

The Australian dollar tested a monthly trend line dating back to 2001.  It is found near $0.7025.   Assisted by a head and shoulders bottom on the hourly bar charts, the Australian dollar bounced a little through $0.7200 before the sellers re-emerged.  It stopped shy of the measuring objective of the head and shoulders pattern, which seems to reflect the aggressiveness of the bears.  Even though the RBA is not expected to cut rates when it meets on September 1, it is not expected to rule out a future cut.  A rate cut becomes more likely if the currency stops falling.  Look for another test on the $0.7000-$0.7025 support.  

Canada's fundamentals are poor and this seemed to outweigh the recovery in oil prices.  Also, the US two-year premium over Canada recouped most of the ground it had lost earlier in the week. Canada is expected to report a contraction in Q2 GDP in the coming day,s and a softening of the labor market in August.   The US dollar's pullback from the CAD1.3355 spike on August 25 fizzled near CAD1.3140.   Another run at the highs looks likely.  Over the longer term, we look for the Australian dollar to fall toward $0.6000 and the US dollar to rise toward CAD1.40. 

Oil prices staged a strong rebounded in the second half of last week after falling to $37.75 on August 24.  The bounce carried the October light crude futures contract to $45.25, which completes a 61.8% retracement of the slide in prices since July 29.  The next objective is seen near $46.80 and then $48.00.  There is good momentum, and the October contract finished the week above its 20-day moving average (~$42.95) for the first time since June 23.  The October contract posted a potential key reversal on the weekly bar charts.  It made a new multi-year low early in the week and then proceeded to rally, taking out the previous week's highs.  It closed at its highest level since the end of July.  

The 10-year US Treasury yield plunged to 1.90% in the panic at the start of last week.  As markets calmed and economic data, including durable goods orders and a sharp upward revision to Q2 GDP helped yields recover by 30 bp before consolidating.  Some link the rise in US yields to selling by Chinese officials.  While we do not rule out some Treasury sales, we suspect that it is being exaggerated as is the market's wont. 

Note that the TIC data, which is not complete, but authoritative, shows China's holdings of US Treasuries rose by about $27 bln in H1 14, which is the most recent data.   The Federal Reserve custody holdings of Treasuries for foreign officials rose by about $26 bln this month, which includes a $9 bln liquidation over the past two weeks.  We anticipate yields can move back into the 2.20%-2.25% range.  A stronger barrier in yields may be encountered closer to 2.33%.  

The S&P 500 recoup half of what it lost after registering the record high on August 18 near 2103 to the panic low near 1867 on August 24-25.  That retracement is found near 1985.  Small penetration of this did take place, but buying grew shy ahead of the 2000 mark.  The 61.8% retracement is found near 2013, and additional resistance is likely near 2050.   Support is seen in the 1940-1945 area.  While the technical considerations appear constructive, with a potential bullish hammer candlestick pattern on the weekly charts, developments in overseas markets are a wild card.  

Observations based on speculative positioning in the futures market:  

1.  The CFTC reporting week ending August 25 saw large swings in currency prices and several significant (10k contracts or more) adjustments of speculative gross futures positions.  The gross long euro and yen positions jumped 19.3k contracts (to 87.8k) and 14k (to 59.9k) respectively.  The powerful short squeeze in the was reflected by a 37.1k contract decline in the speculative gross short position.  

2.  The gross short Australian dollar position jumped by 13.6k contracts to 111.0k, making it the second largest gross short position after the euro.  The euro's gross short position was trimmed by 7.3k contracts, leaving 153.9k still short.  The gross short Mexican peso position soared by 18.4k contracts to 103.5k.  

3.  Although there were minor adjustments in the speculative gross sterling position, they were sufficient to switch the net position from short to long for the first time since September 2014.  The bulls added 6k contracts to the gross long position, which now stands at 58.1k contracts.  The bears trimmed the gross short position by 1.2k contracts, leaving 54.8k.  The net long position stands at 3.3k contracts.  

4.  The general pattern was adding to longs and cutting shorts for the euro, yen, and sterling.  Speculators added to gross short Canadian and Australian dollar positions and the Mexican peso.  Speculators trimmed gross longs of these currencies, except for the Canadian dollar. 

5.  Given the subsequent price action over the August 26-28, we suspect that some of these new positions were unwound in the euro and yen.  Sterling fall in the second half of last week warns that some of the late longs may have also been cut.  Sentiment still appears overwhelmingly negative toward the dollar-bloc.  

6.  The net long US 10-year Treasury futures slipped to 1.3k contracts from 7.3k.  Gross longs and shorts were cut.  The bulls sold 58.4k contracts, leaving the gross long position at 395.2k contracts. The bears covered 52.4k gross short contracts, leaving 393.9k.  

7.  The net long speculative light sweet crude oil futures positions were pared by 5k contracts, leaving 215.6k.  Given the large movement in prices, it is surprising to see how small of a position adjustment took place.  The longs added 1k contracts, lifting the gross position to 474.2k contracts.  The bears trimmed their gross position by 4k contracts, leaving 215.6k.  

25-Aug		Commitment of Traders
	(speculative position in 000's of contracts)
	Net	Prior	Gross Long	Change	Gross Short	Change
Euro	-66.1	-92.7	87.8	19.3	153.9	-7.3
Yen	-39.1	-90.1	59.9	14.0	99.0	-37.1
Sterling	3.3	-4.0	58.1	6.0	54.8	-1.2
Swiss Franc	-12.6	-9.9	4.9	-3.3	17.5	-0.6
C$	-59.7	-66.8	29.6	8.1	89.3	1.1
A$	-63.7	-49.9	47.3	-0.3	111.0	13.6
Mexican Peso	-83.1	-60.4	20.4	-4.2	103.5	18.4
(CFTC, Bloomberg) disclaimer