New Confidence in Divergence Powers Dollar

The dollar fell from late April when it became clear that the populist-nationalist wave was not going to sweep across Europe until early September.  Renewed political tailwinds from Europe and efforts by the Fed's leadership to convince investors that a December rate hike was still seen as appropriate helped the dollar begin recovering. 

The prospect of personnel changes at the Fed, and recognition that practically no one would be as dovish as Yellen has been, coupled with optimism about tax reform, helped spur a backing up of US rates in absolute terms and also relative to other high income countries.  Higher US rates and widening premiums have driven the dollar higher.  Momentum and trend followers have been caught leaning the wrong way and the substantial short dollar position, built in recent months in the futures market. However, the dollar's advance has stretched many technical readings, warning that the risks of a near-term pullback have risen.  

We have been tracking a bottoming pattern in the Dollar Index.  It has convincingly violated the neckline and the head and shoulders pattern projects above 97.00.  The 50% retracement of this year's decline is found near 97.40.  However, before getting there, the euro needs overcome the 95.90 area which corresponds to a 38.2% retracement.    The Dollar Index closed above its 100-day moving average for the first time since Q1 (~94.00).  The 200-day moving average is found a little below 97.00.    A word of caution comes from the fact that the Dollar Index was flirting with being three standard deviations from its 20-day moving average, and finished the week above the upper Bollinger Band that is set at two standard deviations.    This is a question of the pace of the move.  The Dollar Index's two week and almost 2% advance is the strongest of the year.   The Dollar index gapped higher before the weekend, and although it is small (94.717-94.731) it may still attract prices early next week. 

As the largest part of the Dollar Index, the euro was also carving out a reversal pattern.  The neckline of the head and shoulders top was violated with the help of Draghi's open-ended extension of the ECB's asset purchases.  The break of $1.1660 and then $1.1600 projects toward $1.1250, which is where the 200-day moving average is now found.  The 50% retracement of this year's advance is found closer to $1.1220.  The 38.2% retracement found near $1.1425.  The euro is not as stretched as the Dollar Index, but is it closed below the lower Bollinger Band ($1.1635).   Still, the speculative market has been caught wrong-footed.  Many may feel trapped.  On the upside, previous support should now offer resistance.  We peg initial resistance in the $1.1625 and then $1.1660. 

The dollar straddled the JPY114.00 area but was unable to take out the JPY114.50 area that capped the greenback in July.   US Treasuries sustained a break of 2.40%, but the dollar could not extend gains against the yen.  In fact, the yen was the strongest of the majors last week, losing less than 0.15%. The explanation may lie with the yen's role as a financing currency. The yen was used to buy more volatile or higher yielding instruments.  As those assets, such as emerging markets, or the higher yielding dollar-bloc currencies were liquidated, the funding currency (the yen more than Swiss francs) was bought back. The greenback did not trade well ahead of the weekend, and the risk is a near-term setback toward JPY113.00-JPY113.30. 

After the yen, sterling held up best. It lost about 0.4% against the dollar as it appreciated nearly 1% against the euro. The prospects for a BOE rate hike next week lent sterling some support.  Still, in the face of the broadly firmer US dollar, sterling did return to two-week lows.  The low from earlier this month was near $1.3030, which also corresponds to a trend line support.  A convincing break could spur a 2% move in the coming weeks.  The near-term technical indicators are mixed, but weeklies still favor more losses.  If the BOE hikes on November 2, which the market seems confident of, we suspect that the bounce will be sold.   Initial resistance may be near $1.3150, but $1.3200 may be more formidable.    

The Bank of Canada was more dovish than market participants who favor "convergence" anticipated.  After taking back the two rate cuts from 2015 in Q3, the Bank of Canada has made it clear; it is cautious going forward.  This means that the hikes were not part of a sustained normalization cycle as the Fed is engaged in, but a modest adjustment.  The dollar closed above its upper Bollinger Band for the third consecutive session after it approached CAD1.2830, which corresponds to a 50% retracement of this year's decline.   However, the greenback closed on its session lows, suggest a further pullback is likely next week.  New demand for the US dollar may emerge on a pullback toward CAD1.2740. 

The Australian dollar recorded three-month lows before the weekend, but closed well and could correct higher next week toward $0.7700-$0.7735.  A hammer candlestick may be in place with the reversal.  The sentiment is negative, but as with some of the other currencies, it appears to be over-extended in the short-term. It was down five consecutive sessions before eking out a small gain ahead of the weekend.  The $0.7630 that was seen then matches the 38.2% of the rise since the Jan 2016 low near $0.6830.  The next retracement is found closer to $0.7475. 

Light sweet crude oil for December delivery rose to new six-month highs ahead of the weekend.  It was the fifth advance in six sessions and is even more impressive given the strength of the US dollar.  The technical indicators are getting stretched.  The MACDs and Slow Stochastics have not confirmed the new highs.  December crude closed above its upper Bollinger Band (~$53.35) for the first time in three months. Initially, we peg chart support near $52.60.  On the upside, the next important test is in the $54.80-$55.00 area. 

The US 10-year yield did not fall back below 2.40% in the second half of last week.  However, the upward momentum faded after nearly 2.48% before the weekend, and the yield finished the week near a little above 2.41%.   Investors could see a pullback toward, say 2.37%, without giving up on higher yields, but a break of around 2.35% would likely be seen as a sign that the upside break was fake.  The December note futures did not make a new low ahead of the weekend and closed near session highs. This looks like a potential key reversal.  A move much above 125-00 and 125-06 might turn the technical tone more bullish, and signals that the contract will likely move back into the familiar range.  

The S&P 500 extended its record streak to a seventh consecutive week.  It had posted a key reversal at the start of the week and retreated a minor 1% by mid-week before bouncing back strongly on the back of solid earnings reports.  In fact, the strength of several tech giants led to the NASDAQ gap higher opening before the weekend and tacked on another 2% for a new record high. Both the S&P 500 and NASDAQ closed above their upper Bollinger Bands.  The Russell 1000 Growth Index rose almost 1% last week, while the Russell 1000 Value Index fell 0.5%.  The Value Index it gained 2.8% in September is up about 1% this month with two sessions to go.  Half of the 7.4% gain for the year has been recorded in these two months.  The Growth Index streak stands at five weeks and will extend its monthly streak to four.  It has only been down one month this year, and that was June when it slipped almost 0.4%.  

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