The Dollar: Now What?

The US dollar turned in a mixed performance last week.  Firmer oil and commodity prices more generally helped lift the Australian and Canadian dollars, and many emerging market currencies.  These currencies initially extended their  gains ahead of the weekend in response to the Bank of Japan's surprise 20 bp cut on some excess reserves ( to -10 bp).

The yen lost 2.25% on the week, its biggest weekly decline since the BOJ's surprise expansion of its Qualitative and Quantitative Easing in October 2014.  The Swiss franc was the second worst performer of the majors, losing 0.75% on the week.  It fell to its lowest level against the euro since the SNB lifted its cap in mid-January 2015.  There was some speculation, which cannot be verified yet, that the SNB had been weakening the franc in preparation of further easing by the ECB at its next meeting in March.  

The divergence meme, which has been a key factor shaping our dollar outlook, is very much intact. We has suggested that the first phase was driven by what other central banks did. The Fed was on hold.   The second phase began in December when the Fed hiked.  Now the major central banks have moved in opposite directions.  While we doubt that the Fed will hike rates four times this year, as dot plot suggested, we suggest the market may be underestimating the implications of full employment and the prospects of (gradually) rising core inflation (boosted by rents and medical services) by discounting only one hike this year.  

The 100-day average has caught the euro's highs since December ECB meeting.  It was approached on January 28, and, after an initial lackluster response to the BOJ's move, returned to lower end of its $1.08-$1.10 trading range that has confined the bulk of the activity over the past two months.  That Depending on exactly how you draw it, there is a trend line off the Dec ECB meeting low (~$1.0525) and off the Jan 5 low that catches the Jan 21, 22, and 25 lows.  Trendline now looks to be just above $1.08.  

The technical indicators we use are not very helpful in this extended trading range.  However, we suspect that ahead of the US employment, the risk is on the downside.  The recent low was set near $1.0775, and $1.0710 area was seen earlier in January.  These are the initial targets.  Before the ECB disappointment in December, the euro was approaching $1.05.  

There is a reasonable chance that the easing that was widely anticipated then will, for all practical purposes be delivered in two installments, one in December and the other in March. This would suggest, barring a poor US employment report, that the euro is likely return to the $1.05 area.  

The dollar's rally after the BOJ's pre-weekend surprise stopped at the 61.8% retracement (~JPY121.75) of the decline since mid-August.  The dollar finished three standard deviations above its 20-day moving average against the yen.  This extreme was not seen in late-October 2014 when the BOJ unexpectedly expanded its QQE operation from JPY60 trillion to JPY80 trillion.  

The implication of the BOJ's move and that lack of positioning (the speculative players in the futures market, a proxy for trend followers and momentum traders, went into the BOJ meeting with a net long yen position), there is scope for further yen losses. Our next target is near JPY123.00, and in the bigger picture, we expect the dollar to take out last year's highs set in June near JPY125.85.  

Sterling set a two-week high, just shy of $1.4415 in Asia before the weekend, before dropping to $1.4150 into the close of the European session.  Some of the pressure may be attributed to month-end adjustments.  There may also be some heightened Brexit fears after UK Prime Minister Cameron said that although there has been some progress, the EU's proposals are not sufficient.   There was some talk of reserve manager sales, but there was not sign of pressure on gilts, which rallied strongly and were among the best performers before the weekend (10-year yields fell 10 bp).  

However, the December 16 short-sterling futures contract rallied to new lifetime highs before the weekend.  The implied yield of 57 bp compares with 102 bp at the end of last year.   This suggests the market has all but given up on a rate hike this year.   20-day moving average capped sterling gains in the second half of last week.  It has not closed above this moving average since mid-December.  The multi-year low on 21 January was near $1.4080.  That is the next obvious target ahead of the $1.40 level.  

A powerful short-squeeze, helped not doubt by the recovery in oil prices and a sharp reduction in the discount on two-year rates (relative to the US) has lifted the Canadian dollar by a little more than 5% since the multiyear low was set on January 20 (with the US dollar near CAD1.47).  The Canadian discount to the US has fallen from near 60 bp to 35 bp, which is a touch less than it was before the Fed hike rates last month.  

The downside momentum of the US dollar eased in the second half of last week when the greenback met the 38.2% retracement of the rally off CAD1.2830 seen in mid-October.  The first important test on the upside comes in near CAD1.4150.  A break signals that the leg lower is over, and CAD1.4230 is the first retracement objective. On the other hand, if oil continues to recovery and soft economic data keeps the market from pre-pricing Fed policy, a push through the CAD1.3980 area could open the door to another one percent extension.  

We noted a potential head and shoulders bottom in the Australian dollar.  The objective is near $0.7250 though it seemed like a stretch.  We suggested two interim goals:  $0.7080 and $0.7140. The latter was seen before the weekend.  The next near-term target is $0.7200.  The technical indicators remain constructive, but there appears to an easing of the upside momentum. We would peg initial support now near the neckline of the bottoming pattern (~$0.7050).  

At the past week, high (almost $35), the March light sweet crude oil futures contract met a 61.8% retracement target of this year's decline.  Technical considerations remain favorable, though, like the Australian and Canadian dollars, there has been some moderation of the upside momentum at the end of last week.  The gains, however, have left the five-day moving average poised to cross above the 20-day average for the first time since the first half of November. The contract is bumping against the a downtrend off the early November lows that has been tested several times.  It comes in near $34.35 on Monday and falls to about $33.25 by the end of the week.   

The US 10-year yield fell to 1.90% in the wake of the BOJ's surprise move.  This is the low yield print in last August and October.  Below there, the next target would be 1.80%.  However, the technical indicators of the March note futures is stretched after making new contract highs before the weekend near 130-00.  While the technical indicators have not turned, it looks like they may shortly. The market may become more cautious ahead of the US jobs data on February 5 (ADP estimate that steals part of its thunder will be released on February 3).  

The S&P 500 traded broadly sideways last week until Friday.  The RSI has turned up, as has the MACDs.  The S&P 500 traded through its 20-day moving average for the first time this year. Monetary policy in the eurozone and Japan (and China) is still easing, and this is seen supporting equities.  For five sessions, the S&P 500 traded between 1875 and 1916.  This created a shelf of sorts. A break of it warns of a retest of the lows.  However, technical considerations favor a move toward 1945 and then 1980.  

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