Keeping the Eyes on the Prize

The US dollar is trading heavier today as Asia and Europe sold into the strong gains scored in North America yesterday following yesterday’s surprise Chinese rate hike. Of the majors, the euro and Australian dollar are leading the move, but given the magnitude of yesterday’s losses, these gains today are modest.

The dollar’s pullback after Asia initially managed to marginally extend yesterday’s gains, but has left short-term technical indicators over-extended. The price action in recent days has been exceptionally choppy and the underlying direction is not as clear as it had been in recent weeks. Today’s North American session could be pivotal. If North American participants take advantage of the foreign currency bounce to cut stale positions, it would point to a deeper correction of the dollar’s precipitous decline.

The choppy price action in the foreign exchange market is frustrating short-term operators, but my assessment of the medium term drivers remains largely intact. I have argued that the combination of the strong prospects of QEII in the US coupled with the normalization of European interest rates would undermine the dollar and carry the euro and sterling to $1.40 and $1.60 respectively. The move was more rapid that we expected. Indeed the speed of the move has prompted different responses from market participants. Some chase the market higher and we have seen several large investment houses revise lower their dollar forecast. While this may be the appropriate strategy for short-term momentum players, I have been reluctant to advise medium and long term investors to project the trends far into the future.

The market has gone a long way toward discounting QEII in the US and now with 3-month Euribor at the ECB’s refi rate (1%) for the first time in more than a year, the key driver we identified is losing its power. Sentiment reached extreme readings and market positioning also seemed stretched. While the choppy price action in recent days seems to be largely a function of market positioning, we anticipated a more durable dollar bounce after the monetary and fiscal uncertainty is lifted after the election and FOMC meeting next month. For the near-term, our bias is for the dollar’s upside correction to continue, provided the euro holds below $1.3875 and the Australian dollar holds below $0.9830, to cite the lead currencies.
Keeping the Eyes on the Prize Keeping the Eyes on the Prize Reviewed by Marc Chandler on October 20, 2010 Rating: 5
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