The Dollar's Near-Term Vulnerability is an Opportunity for Medium and Long Term Investors

The market staged a dramatic reversal of the near-term trends in response to the Federal Reserve meeting. In a masterstroke, Yellen dropped the word patience from the Fed's forward guidance and avoided delivering a hawkish signal. 

The equity markets bounced back. Bond yields fell. The relentless dollar advance stopped in its tracks. It suffered one of the largest setbacks in nearly a year. 

We recognize that the pace of the dollar's ascent has been unusual and unsustainable. We anticipate a period of consolidation, potentially choppy, as short-term participants re-enter the market. The dollar spent the last two sessions within the wide range established in the four hours after the FOMC statement. Due to the light economic calendar in the week ahead, the key issue facing market participants is whether the bout of profit-taking on long dollar positions is over.  

More broadly, the key fundamental driver in our understanding has been the divergence between the US and most of the other high income countries.  It is not simply growth differentials though that is part of it.  After all, Japan grew faster than the US in Q1 14 and Germany grew faster in Q4 14.  The divergence of monetary policy is the bedrock.  That divergence has not peaked, and it is not clear precisely when it will.  

It is not just that 15 of 17 Fed officials (Governors and Presidents) expect to raise rates this year.  It is also that the Fed's balance sheet will most likely begin falling next year as instruments it bought several years ago begin maturing.    The ECB appears committed to expanding its balance sheet until at least September 2016 and the BOJ's purchases have no clear terminus.   The point is that divergence has not peaked, and the peak is still at least six quarters out.     The magnitude of the peak is not known and, therefore, can not be priced in as some who are claiming that the dollar's peak is at hand suggest.   This is not even to incorporate the political developments of Greece or the uncertainty created by negative interest rates in the Europe.  

Moreover, even if the market has priced in the fact that US monetary policy is tightening as the ECB and BOJ's is easing, it is not a once and done sort of thing. It creates incentive structures for new investment flows and hedging decisions.  The pricing mechanism of fiat currencies is far too complex and subject to large and prolonged overshoots than allowed by economists' conception of fair value. 

For short-term market participants, last Wednesday's euro and sterling ranges are significant.  The $1.1045 area the euro approached represents a technical retracement objective of the euro's decline since the last peak on February 16 near $1.1450.  Market positioning remains extended, and the downside momentum has been arrested.  

The technical condition of the market does not rule out a break to the upside, in which case the next target is near $1.1265.  A close above the 20-day moving average, which has not been recorded in a month (now ~$1.0925) could be the first tell.  That could be a new opportunity for those, like ourselves, view the price action as a long-over correction and not a trend reversal. On the downside, the new found dollar bears may offer the euro support in the $1.0630-50 area.   

Technically, sterling appears weaker than the euro and may surrender more of its recent gains against the euro.   The recent dovish comments by Carney and the uncertainty shrouding the outcome of the May election are arguably important fundamental considerations.  Sterling jump after the FOMC carried it to about $1.5165. It stopped ahead of a key retracement objective ($1.5200) and the 20-day moving average (came in near $1.5185 in the middle of last week).  It failed to finish the week above the psychologically important $1.50.   It may offer initial resistance, but the more important test comes near $1.5130.  We would peg support near $1.4850.  

Like the euro and sterling, the yen has traded within the range against the dollar seen in the middle of last week.  The dollar closed on session lows ahead of the weekend and appears poised to test the JPY119.30-70 band support that protects the downside.  On the upside,  the JPY121.20-40 area appears to offer formidable resistance.  From a technical point of the view, the yen is poised to under-perform the euro and sterling in the days ahead.  

From a broader perspective, the dollar remains in a broad range against the yen as has been the case for the past four months.  This has been conducive for a general downtrend in dollar-yen volatility.  Benchmark implied three-month volatility (~8.9%) is near the lower end of where is has been since the BOJ's surprise expansion of its asset purchases at the end of last October.  It is below the 50 and 100 day averages.  By contrast, implied three-month euro volatility (~11.7%) is at the upper end of the range of the last few months and is above the 50 and 100 day averages.  

Turning to the dollar-bloc, the Australian dollar is in a stronger technical position than the Canadian dollar.  The Aussie closed near session highs before the weekend.  The market appears to have rejected the $0.7600 area.  It is flirting with 4-5 month down trend line, which comes in near $0.7800 at the start of the new week.  Key resistance is last week's high near $0.7840.  A break could send the Aussie up another cent.  

The US dollar posted an outside down week against the Canadian dollar. This is  a reversal pattern, and the greenback finished on its session lows ahead of the weekend, despite the disappointing retail sales report ( -1.7% vs. -0.8% consensus).  Initial support is seen in the CAD1.2450-CAD1.2500. However, the lower end of the range seen since the end of January is in the CAD1.2360-80 area.  

Despite our misgivings over the Dollar Index's representativeness of the dollar (gives to much weight to the euro and currencies that move in its orbit, and does not include two of the US top four trading partners--China and Mexico), we recognize the practice of using it as a proxy.  A move below the 97.20 area will signal a move toward 96.50.  If this goes, the next leg down in the Dollar Index could carry it toward 94.00.  

The most active light sweet crude futures contract (May) posted a key reversal after the FOMC meeting, but there was no follow through to the upside last week.  Nevertheless, the technicals are constructive, suggesting a further try next week.  The $47.80 area is the first hurdle and then $49.00. Stiffer resistance is seen in the $49.80-$50.20 band.  A wild card in the week ahead is progress on talks with Iran, which if successful is seen as negative for prices as it would be seen as lifting supplies.  

Immediately following the FOMC meeting we identified the 1.87% yield as key for the 10-year US Treasury.  Although this area held, the market may not be done, and below there a move back toward 1.78%-180% is possible.  Technical indicators also suggest the S&P 500 can set a new record high in the days ahead.  Support is seen in the 2085-2087 area.  

Observations based on speculative positioning in the futures market:

1.  There were several significant position adjustments (more than 10k contracts) in the five sessions before the FOMC meeting concluded.  Far and away, the largest adjustment was in gross long Australian dollar positions.  They jumped almost 48k contracts to 63.  The gross short peso positions increased by 13.4k contracts to 79.6k.  The gross long yen position rose by 11.6k contracts to 44.5k.  The 10.9k rise in gross long franc positions (to 18.1k contracts) was sufficient to turn the net position long for the first time since last June.  

2.  The speculative community went into the FOMC meeting with a near record large gross short euro position of 250k contracts.  The extreme market positioning helps explain the violence of the subsequent price action.  

3.  The net short speculative US 10-year Treasury note futures position slipped by 38k contracts to 108k. The gross long position rose 14.1k contracts to 390.7k.  The gross short position stands at 498.2k contracts, a 16.7k decline.  

4.  The net long speculative light sweet crude oil position was trimmed by 17.2k contracts to 243.5. The gross longs added almost 22k contracts to 517k.  The shorts jumped by almost 15% to 273.5k.  

week ending Mar 17

		Commitment of Traders
	(speculative position in 000's of contracts)
	Net	Prior	Gross Long	Change	Gross Short	Change
Euro	-194.0	-181.0	56.3	-4.9	250.0	7.8
Yen	-48.1	-59.4	44.5	11.6	92.6	0.3
Sterling	-37.9	-32.6	47.1	-0.9	65.0	4.4
Swiss Franc	2.2	-8.4	18.1	10.9	15.9	0.3
C$	-32.8	-39.0	21.0	-1.0	53.8	-7.2
A$	-28.8	-76.8	63.0	47.9	91.9	-0.1
Mexican Peso	-55.9	-35.6	23.7	-6.9	79.6	13.4