FX Positioning and Outlook: Correction Over?

The upside correction of the major foreign currencies we have been tracking since the disappointing May employment report on June 1, when the euro and Swiss franc posted key reversals, appears to be complete or nearly so.  

The latest CFTC Commitment of Traders report for the week ending June 19 showed a large reduction of net short euro, Swiss franc and Australian dollar futures.  Positioning in the other currency futures was little changed.  

The deterioration of the technical picture that we see dovetails with our understanding of the trajectory of fundamentals.  To be sure the economic pattern of the past few years remains intact.  It slows in H1 and strengthens in H2.  That is consistent with another soft employment report on July 6.   However, the Federal Reserve opted for a relatively mild step of altering the composition of its balance sheets, rather than the size of it.  

Other countries are being more aggressive.  China has cut interest rates and additional easing measures are anticipated as the economy has yet to bottom and inflation has fallen.  Brazil has cut interest rates and that cycle is not complete.  It is also providing fiscal support.  Although India's central bank did not cut rates at its recent meeting, the economy is slowing and inflation is likely to moderate to allow a rate cut in the coming months.  

After losing a vote at the MPC meeting in early June, wanting to extend the gilt purchase program by GBP 50 bln, BOE, Governor King joined forces with the Treasury to take unconventional measures to ease financing costs.  The Treasury will underwrite some of the risk.  King, who has been vindicated when he has lost votes as Governor (an amazing and unthinkable event in any other country), has signaled the likely resumption of gilt buying as soon as the July 5 MPC meeting.  A reduction in the base rate is also a distinct possibility.  

The ECB meets on July 5 as well.  ECB President Draghi indicated that a few members wanted to cut rates earlier this month.  The "few" likely grew to a majority as the area's economy has weakened and the German economy has stagnated, if not worse here in Q2.

In addition, on June 22 the ECB announced an easing in collateral rules.  It is a way to effectively ease credit conditions, even given the risk-adjusted haircuts assigned to the collateral.  It also, as the BBK argues, increase the risk exposure of the ECB's balance sheet.  The decision was made over the BBK's objections, as was the sovereign bond purchases in the past.  This is clear evidence that Germany is not dictating ECB policy, contrary to what passes as conventional wisdom.  

Yet in a larger sense, we continue to underscore an important point:  Germany is not as isolated as the popular press would have it.  The most important division in Europe is not Germany against every one else.   It is between creditors and debtors.  Germany's position on anything that looks like mutualization of debt or financial obligations is shared by Austria, Netherlands and Finland. 

Before the central banks meet, there is a EU heads of state summit  The risk seems asymmetrical.  The agreements, like a 120-130 bln euro growth pact, has been or will be well publicized.  There may be personnel announcements named, including a successor to Juncker as the Eurogroup head (Germany's Schaeuble is the lead candidate) and the replacement for Gonzalez-Paramo at the ECB (Spain's de Vicuna, who heads up the ECB's legal department may be the favorite). 

In any event, investors will conclude that these are not game changers.  There is a clear lack of consensus for more aggressive and innovative action and this will likely weigh on the euro.  

Even the issue of a financial transaction tax (FTT) illustrates the lack of consensus.  Around 11 countries appear to support it, including Germany.  Merkel had to be a more enthusiastic supporter of the FTT in order to secure the SPD support for ESM and the fiscal pact.   This will be a coalition of the willing.  

The road map for a banking, fiscal and political union which is to be presented will likely be a sketch in broad strokes, with the intention of delivering a more detailed plan by the next summit in October.  It will be seen evidence that the European leaders do not appreciate the urgency that many investors feel. 

Euro:  The net short position was cut by nearly a quarter to 141.1k contracts.  It is the smallest short position in about six weeks.  New longs increased by 15.2k contracts to bring the gross long position to 54.4k.  The shorts were cut by almost 39k to a still large 195.5k contracts.

The observation we shared last week remains true this week as well.  Looking beyond the net position to the underlying positions, it is interesting that the euro's gross long and gross short positions are the largest in the currency futures.  Focusing simply on the net short position obscures this important insight into market positioning.

The euro approached the 50% retracement objective of the May's swoon in the immediate aftermath of the Greek election and retested it after the FOMC meeting in the middle of last week.  During this retracement the euro held above the trendline drawn off the June 1, 12 and 18 lows.  It broke the trendline and closed below it on June 21 and June 22.  In these two sessions it managed to give back half the gains scored this month.  

The next objective is near $1.2465.  If the correction is indeed over, a resumption of the euro's downtrend should carry it to new lows for the year.  Alternatively, a move above the $1.2750-80 band would suggest the correction is not over, in which case a move toward $1.29 is more likely.

Yen:  The net long position increased to 15.1k contracts from 12.3k.  Although this is a modest position, it is the largest net long position since the end of February.   Longs rose 6.6k to 44.7k contracts.  The shorts increased by 3.2k contracts to 29.6k The market was leaning the wrong way.  Since the CFTC reporting period ended, the dollar rose 2.4% against the yen, reaching its highest level since early May.

The dollar's 5-day moving average crossed above the 20-day moving average in the second half of last week.  We had previously discussed the possibility that the dollar gains toward JPY81, but had backed way from the that when the JPY80 cap held.  While that objective appears back in play, we are cautious because pressure on the yen from crosses may ease and dollar the appears stretched with its close, for the first time in three months, above the Bollinger Band.  The JPY79.80-JPY80.00 may be the swing area, with a break of it warning that a dollar's high may be in place.      

Sterling:  The net short position was trimmed 4.9k contracts to 17.2k.  The longs rose by 4.2k  to 32.2k contracts while the shorts were trimmed by 1.7k to 49.4k contracts.

Sterling's recovery since June 1, like the euros, has held an up trend line.  That trend line was violated on an intra-day basis on June 22, but the close was back above it.  The close according to Bloomberg was $1.5588,  which is just 38.2% retracement objective of its corrective gains recorded this month.  The next objectives are seen near $1.5530 and then $1.5470.

If further erosion is seen in the coming sessions, the 5- and 20-day moving averages, which crossed to the upside on June 15, may cross to the downside by the end of the week. That said, a move back above the $1.5650-75 area would warn that the upside correction may not be complete and that sterling could head back to retest the $1.5780-$1.5800 cap.  

Swiss franc:  The net short positions was reduced sharply to 7k contracts from 33.3k.  This is the smallest net short position of the year.  It was the result of longs jumping 18.9k to 24.1k contracts and shorts cut by 7.4k contract to 31.1k

The dollar has been in a clear downtrend against the Swiss franc since the June 1 key reversal.  The downtrend was broken, as was the case with the euro, and the dollar closed above it on June 21 and June 22.  In those two days, the dollar recouped half of what it lost during the month.   A move now above CHF0.9600 and especially CHF0.9650 would lift the tone and renew the call for a test on parity in the coming weeks.  Support for the greenback is seen near CHF0.9500.  

Canadian dollar:  The net long position was trimmed by 1.4k contracts to 8.2k.  Long and short positions were reduced.  Longs were shaved by 3.5k contracts and the shorts slipped by 2.1k and stand at 27.8k and 19.6k contracts respectively.

The potential head and shoulders than had carved out with the neckline at CAD1.03 failed following weaker than expected Canadian retail sales and softer then expected CPI figures in the second half of last week.   As we have seen with the other currency futures, the gains in the US dollar, following the mid-week decision by the FOMC to stick with Operation Twist rather than more aggressively expanding its balance sheet, recouped half of what it had lost in the month up to then.

The CAD1.03 area capped the greenback's bounce.   It must be overcome to lift the technical tone.  On the other hand, support is seen in the CAD1.0200-30 area.  

Australian dollar:  Among the currency futures, the Australian dollar experienced the largest shift in positioning.  The net short position was culled to 3.5k contracts from 45.5k the previous week.  This was a function of almost equal proportions of new longs (19.9k) and the covering of stale shorts (22.1k).

The trend line the Aussie has been climbing since June 1 also broke down in the second half of last week, with two consecutive closes below it,warning that some of the late longs were in week hands.  The gains since June 1 saw the Australian dollar recoup half of what it lost since putting in a double top in February near $1.0855.

In the upside correction is over, the Aussie should push below $0.9980 in the days ahead, which would open the door for a move to $0.9900 and then possibly $0.9830, which may offer more formidable support.   Of note, the Australian dollar appears attractive to reserve managers, including the Bundesbank, seeking diversification, and asset managers, looking for a liquid and easily accessible (unrestricted) was to gain Asian exposure.   

Mexican Peso:  The net short peso position fell by about a third to 14.7k contracts.  Longs positions increased by 3.4k to 22.8k contracts and the shorts were cut by 4k to 37.5k.

The technical condition of the peso is arguably the least clear of the currency futures.   Through the middle of last week, the dollar had declined about 6.8% against the peso here in June.  That puts the peso among the best performing currencies in this period.

Mexico holds presidential and congressional elections on July 1.  The institutional money and hedge funds are likely more or less positioned as they wish to be going into the election, which is expected to see the PRI re-capture the presidency.  Shorter terms players may be more opportunistic.  That may mean fading whatever move takes place.  The dollar faces resistance near MXN14.00, while support is seen in the MXN13.63-MXN13.67 area.    

FX Positioning and Outlook: Correction Over? FX Positioning and Outlook:  Correction Over? Reviewed by Marc Chandler on June 23, 2012 Rating: 5
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