Currency Outlook: Mostly Cloudy, Chance Of Rain

There are times that we find the technical picture for the currencies to be clearer than the macro economic fundamentals. This is not one of those times. A key challenge for traders is to determine whether it is a trending market or a sideways market. The problem is that presently it is simply not clear.

We begin with the Dollar Index. Baskets of currencies (and equities) tend to trend better than the individual components. The Dollar Index is a basket, mostly weighted toward Europe. It sold off hard last Tuesday, hitting multi-week lows before recovering fully the next day. It spent the last two sessions ahead of the weekend consolidating in what could be a potential bullish flag pattern. A move above 82.80 is needed to lend credence to a bullish call In addition, downticks need to be limited to the 82.20 area for the constructive tone to gain traction.

The euro appears stuck in $1.30-$1.32 trading range. Implied volatility rose over the past week (from ~8% to ~8.5%), but seems poised to ease and this is consistent with the unclear technical outlook of the spot market and a range trading environment for the euro.

Sterling also looks range-bound between $1.52 and $1.54. However, the tone is poorer and the 5-day moving average is set to cross below the 20-day in the days ahead for the first time since March 19, warning the 6-cent upside correction may be ending. A trend line off the March 12 and April 4 lows comes in near $1.5170 at the start of the new week and is near $1.5220 by the end of the week. At the same time, the $1.5190 area corresponds with a retracement objective of the entire correction.

The yen was better offered in the Asian session over the past week and as we anticipated, Japan did not come under much criticism from the G20/IMF meeting. The yen bears took advantage of this to push the dollar back above JPY99 ahead of the weekend. It appears that many of the yen shorts that were forced to cover in the 4% slide, have scrambled to reestablish their positions. In the options market, dollar calls have been bought and this has underpinned implied volatility and the risk-reversals.

Technically, the dollar looks poised to push through the JPY100 level in days ahead. The 2009 high comes in near JPY101.45 and is the next immediate target. That said, a failure to break the JPY100 level convincingly, while Japanese investors continue to sell foreign bonds, would hit the bearish yen psychology.

Provided the US dollar holds above CAD 1.02, a retest on the Q1 high near CAD 1.0340 is likely. We continue to see potential from a technical (and fundamental) point of view for a move toward CAD 1.05. For its part, the Australian dollar has fallen back out of favor.

In January and February, the Aussie was a dog, falling a nickel from $1.06. However, in March and into early April, it was among the best performing of the majors. In mid-April it was turned back from $1.06 for at least the fifth time since last August. It traded below $1.03 every day this past week, but failed to make a sustained break. The near-term risk extends toward $1.02, while the $1.04 area should contain bounces.

As we noted last week, while Mexico's macro fundamental picture remains constructive, the technical picture is deteriorating. There are reasonable prospects for meaningful reform in the telecom and energy sectors, which could help prompt the rating agencies to upgrade Mexico's credit rating. However, it is a crowded trade and an important psychological level was approached (MXN12.0), oil prices are heavy and the US economy is slowing after what appears to be above trend growth in Q1. The risk on the upside for the US dollar extends toward MXN12.40. Such a correction in the dollar, may provide investors a new opportunity to buy what we still believe is a fundamentally under-valued currency.

We share these observations about the Commitment of Traders

1. The general pattern was for gross longs to be cut. This was true for all the currency futures save the yen and the Australian dollar. Gross shorts were mixed, but were smaller adjustments.

2. There were three position adjustments of more than 10k contracts. These were the longs being cut in Australian dollars and yen. The third was the increase in euro longs.

3. The increase in the net short yen position was largely a function of gross longs being cut rather than the establishment of new shorts. This fact cannot be appreciated if one simply looks at the net position, which is commonly done. The net short position is just shy of the extreme seen in mid-December. Then participation was smaller in that both gross longs and gross shorts were each almost 10k contracts smaller.

4. Speculators in the futures market remain bearish the Canadian dollar, while the Aussie bulls are moving to the sidelines. The gross longs have fallen by nearly a third (141k to 99k) since late March.