Currency Positioning: USD Outlook Still Constructive

As counter-intuitive as it may seem, the US dollar strengthened for most of last week, despite the nomination of Janet Yellen as Fed chair and the continued partial closure of the US Federal government. While acknowledging the disruptions of the markets by the unprecedented expansion of central bank balance sheets and the new regulatory environment, the markets still appear to be functioning as a large discount mechanism.

The abyss (of a US default) was approached and many institutional investors needed to avoid exposure to short-term US bills. However, we first detected a change in tone on Tuesday, and others did on Wednesday. The collective sigh of relief lifted the S&P 500 by nearly 2.2% on Thursday, the second largest advancing session of the year. The Dollar-Index rose to 2-week highs. The dollar rose to 2-3 week highs against the sterling and yen and the highest in a month against the Canadian dollar.

Nearly no one really expected the US to default, but the risk of ruin had to be avoided. Volume for credit default swap protection from a US default has increased, according to some industry estimates, cited in the Financial Times, to 150 mln euro from 1.6 mln previously. Short-dated bills used for collateral or margin were replaced by some institutional investors with cash.

The market was not complacent, as some have charged. Investors were well aware of the low probability, but high risk scenario. The fact that the S&P 500 had fallen nearly 5% from the mid-September (Sept 19) record high through last week's low reflects the cautious stance. Similarly, as soon as investors felt comfortable to further downgrade the risk of default, the S&P rallied strongly and helped lift global equity markets.

The improved technical tone for the US dollar we identified here last week remains intact. A heavier tone at the start of the week, with the Japan, Hong Kong, Canada and the US on holiday Monday, should not be surprising, especially if whatever progress in Washington over the weekend does take place, has already been discounted. On such a pullback, the 80.00 area should hold if the Dollar Index has truly turned.

Similarly, if the euro peaked in early Oct just below $1.3650, it should now ideally hold below $1.3580. It can fray the downtrend line and probe near $1.3600, without really improving the technical tone On the downside, the euro has flirted with its 20-day moving average, but has yet to close below since Sept 10. It is found near $1.3515 on Monday. If our negative view is right, the euro can move toward our initial target near $1.3400.

We note that the 3-month implied euro volatility fell to 6-year lows ahead of the weekend. While volatility has trended lower, the risk-reversals (price of calls and puts equidistant from the money) have moved dramatically to reduce the premium (skew) paid for euro puts. In early September, the premium for euro puts was about 1.7% over calls (25 delta). Before the weekend that premium had fallen to about 0.8%, the smallest since February.

The combination of falling volume and a smaller premium for euro puts, suggests the selling of euro calls. Given that reports suggesting 1) European funds seeing inflows of 15 consecutive weeks (EPFR) and 2) hedge fund and private equity buying distressed assets, we suspect the call selling is a function of hedging exposures.

The technical tone of sterling has deteriorated. We suggested it has traced out a head and shoulders reversal pattern and the correction to the 14-cent summer rally has begun. The initial measuring objective of the head and shoulders pattern is near $1.5650. The retracement objectives are found just above 1.57, then $1.5540 and then $1.5465. The pre-weekend high near $1.60 should cap nearby upticks.

The dollar appears to have bottomed against the Swiss franc in early October and a possible (though somewhat less pristine than in sterling) head and shoulders bottom was traced out. The neckline is seen near CHF0.9080 and the minimum target is near CHF0.9200, which is the 50% retracement of the dollar's decline from early September near CHF0.9455. The euro has been trending steadily higher against the franc since the start of October after finishing September at 4 month lows. In each session but one, it has recorded higher lows. The euro looks poised to continue to move higher. The next immediate target is CHF1.24.

Early last week, the dollar toyed with its 200-day moving average against the yen, a level it has not taken out in a year. Although some momentum players may has sold the downside break, we suggested it was a better buying opportunity. The dollar did in fact bounce back in a big way; recovering more than 2% by the end of the week and taking out a downtrend line drawn off the September highs. It has effectively retraced half of what was lost since the September 11 high, which was the last time the greenback was above JPY100. The next target comes in just above JPY99.00.

The implied 3-month yen volatility has also trended lower since early September and before the weekend fell to its lowest level since January. It would seem to suggest that many participants have come around to our view that the Abenomics-sparked yen sell-off has run its course and rather than a big trending market, the dollar will likely be confined to the ranges seen over the last few months.

The fact that the Australian dollar's 0.35% gain against the dollar was the best among the majors says more about the weakness of the others than it does about Aussie strength. While we continue to see potential to retest last month's high in the $0.9525-30 area, we are more inclined to sell into strength. Our initial target is near $0.9250. That said, a convincing break of last month's cap could see another leg up toward $0.9700.

The Canadian dollar was second to the yen as the worst of the major currencies last week, losing about 0.85% against the US dollar. The greenback, however, stalled a little above CAD1.04, which corresponds to a 61.8% retracement of its losses since the CAD1.50660 high in early September. It is difficult to get excited about the Loonie unless the US dollar rises above say CAD1.0440 or falls below CAD1.0360.

When everything is said and done, more was said than done and the Mexican peso was essentially flat on the week. For the better, a few brief exceptions, the dollar has been largely confined in a MXN13.0-MXN13.23 trading range for two weeks. The dollar tested the lower end of the range at the end of last week and disappointing Mexican industrial production data helped reinforce the floor. The combination of resistance from the PAN opposition party to the government's tax reforms and some speculation that the weak data will prompt the central bank to cut interest rates again (next meeting, October 25) may deter new strong buying of the peso. Below MXN13.00, we would peg initial support for the dollar near MXN12.96.

The continued closure of the US government means that the CFTC Commitment of Traders report on positioning in the currency futures is not available.