Long Awaited Dollar Correction

The US dollar is enjoying a broad correction against most of the major and emerging market currencies. The Japanese yen is one of the few exceptions and it is largely sidelined with the greenback confined in a narrow range on either side of JPY82. Japanese officials continue to brandish the threat of intervention.

The market had struggled to maintain the downside momentum on the greenback, despite the disappointing jobs data before the weekend, heightened expectations of new long-term asset purchases by the Fed, and the continued rise in short-term euro zone rates (3-month Euribor at new 14-month high today). As we had noted at the end of last week, bearish sentiment toward the dollar had become extreme and the market had gone a long way toward discounting the dollar’s negatives.

The US dollar’s downside momentum stalled at the end of last week. The euro first tested the $1.40 level and sterling flirted with $1.60 last Thursday and since then, the market has struggled as bearish sentiment ran into profit-taking. The euro has been sold to a five day low, and this could be the first time since Sept 9-10 that the euro is declining for two consecutive sessions. The euro has come so far so quickly (11% advance from Sept 10 to Oct 7) that it is difficult to place much confidence in nearby technical supports. The $1.3750 area may be interesting, but the near-term risk may extent toward $1.3650-80. Perhaps market participants may be better served by focusing on levels the euro needs to see on the upside to stabilize the tone and that now looks to be around $1.3860.

While the price action looks largely corrective in nature, there may also be a fundamental development at work. In my dollar narrative, I have placed emphasis on the dramatic swing of short-term interest rate differentials against the US. While the pressure emanating from the prospects of QEII have been discussed at length, at the same time I recognized that the ECB was moving along its exit strategy and the reduction of liquidity had helped lift short-term money market rates in the euro zone. The ECB took a step today that might help ease this pressure. In a technical move, it dramatically increased its estimate of its “benchmark allocation”, which is the amount of funds it projects that banks needed to normal operations, from 81.5 bln euros last week to 195 bln euros today.

This would then reduce the amount of funds that officials regard as “excessive” which would be drained. This in turn could help take pressure off euro zone money market rates. However, it is also the end of the one month reserve management period for the ECB and this could be distorting conditions. To avoid some of the “noise” in the very short end of the curve, we have focused on the 2-year spread between the US and Germany. It has widened considerably in recent weeks in Germany’s favor, but it has stabilized in recent days. These interest rate developments suggest that there may be something more at work here than just a technical short squeeze lifting the dollar.