US Dollar Correction Continues

The disappointing US employment data reinforces our expectation that after a strong advance in Q1 the US dollar will correct lower in Q2.  The euro's performance is also broadly consistent with the US experience in which the dollar sold off in anticipation of QE and than rallied on the fact. The euro recorded its low within a week of the ECB's launch of its public sector purchase program.

Our long-term constructive outlook for the dollar remains intact and driven by the divergence of monetary policy trajectories.  We do not expect any one high frequency report to alter the calculation of monetary policy.  Fed officials, including the leadership, recognize that the economy had lost momentum in Q1 15 but understand the headwinds to be transitory.

That puts the onus on Q2 to show improvement.  We anticipate that improvement to be led by the consumer, who pulled back in Q1 after going on the biggest shopping spree in a decade during Q4 14.  The rise in hourly earnings, the relatively cheap gasoline, and an increase in savings will provide the fuel.  The strong March auto sales figures give an inkling of what we expect.

Even before the jobs data,  our reading of the technical condition warned that the dollar's downside correction may not be over. The pre-weekend price action,  even with the light participation, reinforces this judgment.  From a high level view, this offers emerging markets an important reprieve.  There is scope for their assets and currencies to do better.    

The MSCI World Index (Developed) has outperformed the MSCI Emerging Markets equities over the past six months but has begun lagging recently. This trend is poised to continue over the next several weeks.  However, it is mostly tactical and opportunistic, as we remain concerned about the end of commodities super-cycle, slower growth in China and the impact of higher US rates eventually. We continue to favor Asia and Eastern Europe over Latin America.  

The euro has carved out a roughly $1.07-$1.1050 range.  Given the positioning and the mounting evidence indicating that the eurozone growth surpassed the US in Q1 15, the risk is that the range breaks to the upside.  The technical indicators we look at are consistent with this view.  We have suggested that an upside break would target $1.1265 and possibly at most $1.15.  A stronger euro in the current environment is likely consistent with lower implied volatility. We would peg initial support now for the euro near $1.09

The dollar has been in a broad trading range against the yen since last November after appreciating by around 15% following the BOJ's surprise and closed decided decision to expand its already aggressive monetary policy at the end of last October.  That large range is seen between JPY115.50 to JPY122.00. Within that broad range, it has most recently been confined to the middle third or roughly JPY118.30-JPY120.00.    Beyond the bottom of this narrower range, support is seen near JPY117.50.  In this environment, implied yen vol may also ease.  

We note that speculators have been reducing short yen positions in the futures market, leaving positioning considerations not nearly as extreme as the euro's.  In addition, after BOJ's targeted inflation measure has fallen to zero and the Tankan report showed poor sentiment and planned to cut capex, there is likely to be speculation of additional easing measures.   On top of this, Japanese pension funds are believed to be continuing to diversify away from JGBs and into local equities and foreign assets.  This implies that the yen will likely underperform the euro in the period ahead.

With the national election dominating attention, sterling is also likely to underperform the euro in the period ahead.  With the risk of deflation and lowflation in any event, the central bank is in no position to begin normalizing monetary policy.  Sterling frayed the lower end of the $1.48-$1.50 range but did not close below $1.48 over the past two weeks.  The technical indicators are constructive, and sterling finished the week above its 20-day moving average for the first time in a month.  A break of $1.50 could spur a move into the $1.51-$1.52 area.  

The fundamentals for the Australian and Canadian dollars are not particularly favorable, but the technical indicators are constructive.  A rate cut by the RBA in the week ahead is largely priced in, and the RSI shows a bullish divergence.  There is scope for a sell the rumor buy the fact type of activity that could lift the Aussie toward $0.7800 though the upper end of the two-month range is closer to $0.7900.     

The Bank of Canada surprised the market with a 25 bp rate cut in January.  The Canadian dollar sold off in response as one would expect.  However, since late-January the US dollar has been in a clear range against the Loonie:  1.2350-1.2800.  The greenback approached the upper end of its range on March 31. The range held before the US employment disappointment, which saw the US dollar fall to CAD1.2430.  While additional dollar slippage is likely, the market is unlikely to get too aggressive ahead of April 10 release of Canada's jobs data and the central bank meeting on April 15. 

The technical indicators for oil are not generating strong signals, and the fundamental backdrop is mixed.  US output fell ever so slightly, and the rig count decline has begun moderating. Excess production continues to pour into the storage facilities.  There as some financial risk to supply emanating from banks reassessing the value of collateral by the shale producers.  Meanwhile, reports suggest OPEC likely boosted output in March.   A final agreement with Iran has not been reached, and sanctions have not been lifted.  The possibility that an agreement is reached, which still has significant work to be done and faces formidable political obstacles, especially in Tehran and Washington, not to mention Jerusalem and Riyadh, may weigh on forward prices and reduce the contango.

US 10-year Treasury yields fell to 1.80% in exceptionally thin trading in response to the jobs data. Technical indicators allow for an additional decline in yields though profit-taking is likely as 1.75% is approached.  The decline in US yields ahead of the weekend may encourage the same globally in the days ahead.   The December Eurodollar futures tested its contact high (implied yield lows of 57.5 bp) and the pricing of the Fed funds futures strip suggests some are shifting their lift-off expectation into next year.  

The pullback in the dollar and bond yields should help support the S&P 500.  It has successfully retested the lows set earlier in March and appears technically poised to retest the record highs.   Given investors preference in Q1 for European equities over the US, perhaps a contrarian play would be to go the other way   For those who have been tactically hedging euro risk on their equity purchases they may want to consider reducing them.  

Observations based on the speculative positioning in the futures market:

1.  There was only one significant (10k+) gross position adjustment among speculative accounts, and that was a 16.7k cut in the gross short yen positions.  As of March 31, 68.3k speculative gross short yen contracts remain open, which is the smallest since last July.  In early December 2014, there were 153k gross short contracts.  This has seen the net short position fall sharply.  In the last week alone it was nearly halved to 23.9k contracts (from 45.9k).  

2.  The net speculative Swiss franc position swung back to a small long (0.7k contracts).  Throughout the month of March, it has been back and forth, long and short on alternating weeks.  Over the past week, it was more a function of shorts covering (3.6k contracts) than new gross longs being established (1.1k contracts).  

3.  The overall pattern among the speculative participants in the futures market is to reduce exposures.  Of the 14 gross positions we track, all but four were reduced.  The exception were  in the small increases in gross yen (5.3k contracts),  Swiss franc (1.1k contracts), Australian dollar (3.7k contracts) and the Mexican peso (8.2k contracts). 

4.  The speculative net short US 10-year Treasury note futures position fell to 114k contracts form 180k.  This was more a function of short covering (52.9k contracts) rather than new speculative longs being established (13.1k contracts).  

5.  The speculative net long light sweet crude oil futures increased by 19.8k contracts to 226.7k.  Speculators reduced gross short positions by 17.4k, leaving 289.3k contracts. The gross long position edged 2.4k contracts higher to 516.0.   

week ending Mar 31		Commitment of Traders
	(speculative position in 000's of contracts)
	Net	Prior	Gross Long	Change	Gross Short	Change
Euro	-227.0	-221.0	41.7	-8.4	268.3	-2.8
Yen	-23.9	-45.9	44.4	5.3	68.3	-16.7
Sterling	-36.6	-38.6	35.1	-0.8	71.8	-2.7
Swiss Franc	0.7	-4.0	13.7	1.1	13.0	-3.6
C$	-29.6	-32.7	18.8	-0.4	48.4	-3.6
A$	-24.4	-28.4	55.8	3.7	80.1	-0.3
Mexican Peso	-30.3	-41.1	43.3	8.2	73.6	-2.6