Once Unleashed, Corrective Forces Dominate

The market's disappointment with the ECB unleashed pent-up corrective forces in the foreign exchange market. This leg up in the dollar began in mid-October. Through the day before the ECB, the euro was the weakest of the major currencies, losing 7.5% against the dollar. The yen and sterling shed a little less than half as much. The Australian dollar was the only one of the majors to have gained against the dollar. And even then, its 0.12% appreciation had only been achieved here in December. Similar, tendencies were evident in parts of the debt markets

The November jobs report was sufficiently strong as to remove a potential risk to the widely held expectation of a Fed hike. Given the light economic calendar, there is little, barring a significant surprise that can impact expectations now. However, the money and risk management behavior that had been started may not be complete. At the very least, it, a period of consolidation is likely in the days ahead.

The issue previously was not if there was going to be a correction but when. Was it going to be after the US jobs data or after the FOMC? Perhaps the ball was initially set into motion by the erroneous claim that the ECB had not cut rates. In any event, we do not expect a new trend to emerge straight away. The damage inflicted on the charts, wallets and egos may take some time to heal.

Our critical assumption is that, technically, the euro is correcting the air pocket entered in mid-October that took the euro from almost $1.15 to $1.0525 shortly before the ECB announcement. It does not mark the end of the dollar bull market. The ECB did, in fact, ease policy, and the Federal Reserve will raise rates. Monetary divergence has not peaked.

The current interest rate differentials mean that savers and investors are paid to be long dollars, and they are likely to be paid more in six months than they are today. While fully appreciating that there can be "buy the rumor sell the fact" and respecting the markets' anticipatory mechanism, we also recognize that capital markets trend in part driven by the incentive structure for new flows and the management of existing stocks.

At first, the euro held the 38.2% retracement just below $1.09. Perhaps with the help of the disappointing US services ISM, the market pushed the euro higher. It made its ways up to $1.0980 (50-day moving average) before pulling back to $1.085. The $1.1000-$1.1060 houses optionality, the 50% retracement objective, the 100- and 200-day moving averages. A move above this general area would likely spark another round of position adjustment that lifts the euro another cent or two.

We would feel more confident that the $1.1000-$1.1060 area will hold if the two-year differential would stabilize. It had peaked the day before the ECB met near 138 bp. It fell to 122 bp before the weekend and finished on its lows. It was near 80 bp in mid-October, when the euro's leg lower began.

The dollar is often in a range against the yen. When it looks like it is trending, it is frequently simply moving from one range to another. Consider the recent price action. From late-August through earl-November, the dollar was confined to a JPY118.00-JPY122.00 range. After testing the lows in late October, the dollar began to trend higher. First to the upper end of the range and through that. It has entered into a new trading range over the past month: JPY122.00-JPY124.00. Although the dollar finished on a firm note, we suspect that the slippage in the 10-year bond differential and an upward revision to Q3 GDP estimates (from a small contraction to a small expansion) may help reinforce the ceiling.

Sterling's latest leg down began after hitting a high near $1.5335 on November 19. It recorded a low just below $1.49 on December 2. The dramatic short-squeeze carried it to almost $1.5160. The 61.8% of the slide was a few hundredths of a cent higher. Initial support will likely be found in the $1.5025-$1.5050.

The euro jumped from near GBP0.70 on 1 December to GBP0.7250 on December 3. This met the 50% retracement objective of the euro's drop from almost GBP0.7500 in mid-October. A move back below GBP0.7130-GBP0.7160 would boost confidence that the short-squeeze is over.

The Canadian dollar and the yen were the only major currencies to fall against the dollar over the past week. It lost an inconsequential 0.1%. However, the other dollar-bloc currencies were up 2% and 3.1% (the Australian dollar and the New Zealand dollar respectively). Pressure on the Canadian dollar is coming from the fresh decline in oil prices, widening interest rate differential, and some poor data.

Even though the US dollar has no momentum, it continues to bump against push near the multi-year high set in late-September near CAD1.3460. The US dollar has been finding support near the 20-day moving average, found near CAD1.3220 at the start of the new week. It has not closed below this moving average since October 22.

The Australian dollar is more interesting from a technical perspective. It is testing a key resistance band that begins near $0.7375 and runs a bit above $0.7400. A push above there cold spur another 1% advance. Some favorable data and a central bank that out of the picture for the next couple of months have provided some fundamental incentive to reduce short exposure. At the same time, the Aussie has decoupled from iron ore prices, which have fallen to new multi-year lows.

The price action suggests the market continues to buy Aussie pullbacks. Closes of the North American session over the past week have been mostly near session highs, with one exception. A break of $0.7275, and especially $0.7250 would suggest the correction is over.

Last minute doubts that the Reserve Bank of New Zealand will cut rates next week helped spur a rally that lifted the New Zealand dollar to near $0.6800 before the weekend. Technical indicators suggest potential for additional gain. Above $0.6800, resistance near $0.6840 may slow the pace but a test on the October high's (~$0.6865 and $0.6900) seems likely. Initial support is seen in the $0.6680 area. This analysis is consistent with the Australian dollar losing ground against the Kiwi. A break of NZD1.0865 could spur a 1-2% decline.

OPEC did nothing, and by doing nothing, the current strategy of trying to force out high-cost producers continues. If anything, OPEC seemed to legitimize the current output above the previous quota. This means the new quota is 31.5 mln barrels a day (1.5 mln bpd increase). This increase does not appear to cover Indonesia re-joining OPEC. The Iranian challenge is even more profound, but OPEC appears to be hoping that a decline in some non-OPEC output and an increase in world demand may make an increase in Iranian (a low-cost producer) supply less disruptive. As we have argued before, this is not proof of OPEC's demise, but rather a common, and arguably, rational strategy of cartels and oligopolies trying to reestablish control of a market.

The fundamental backdrop is poor, and the technicals are poorer still. There is immediate scope to $39 and the August low near $37.75 on a continuation contract basis. The $42.00-$42.50 area may cap upticks in the immediate post-OPEC environment.

US 10-year Treasury yields rose from 2.15% on December 1 to 2.35%, driven mostly by the dramatic position adjustment after the ECB disappointed. Yields backed off before the weekend, and were already ten bp off the session high, encouraged in part by the drop in oil prices. There is scope for yields to slip further at the start of the week ahead, in the light calendar.

The nearly five bp decline before the weekend was particularly notable because the US employment data was, if anything, a bit stronger than expected. This was also a rather large decline yields given the 1.8% rally in the S&P 500. The S&P 500 completely recouped the steep loss suffered in the exaggerated response to the ECB's actions. Technically, the S&P's appear poised for another run at the 2100-2116 post-summer cap.