Dollar Correction: How Far? How Long?

The US dollar's run stopped last week, but not before new highs were recorded against the euro, sterling, and the yen. By the end of the week, the euro had risen 1.4%, sterling 0.9%, and the yen had risen as much as the two of them put together. It was the biggest weekly gain for the yen in 16-months.

There is one pressing question that international investors will be mulling this weekend: How far and how long is the dollar's correction?

Technically, the dollar has had a strong bull run that has been sustained for several months, and the pullback, thus far, has been quite modest in terms of retracement objectives. While that could speak to the dollar's resilience, it may mean that the correction has more room to run. Market positioning is still very extended, and the technical indicators are consistent with additional near-term dollar losses.

This might not do sufficient justice to market sentiment. Investors have a high conviction that diverging growth and monetary policies favor the dollar in a way that has not been experienced in many years. This point will likely be driven home next week as the Federal Reserve continues to prepare the market for a rate hike around the middle of 2015.

The Federal Reserve will acknowledge that lower oil prices can feed through to inflation and inflation expectations, but this is a short-run impact. It will look past it and focus on the more important and lasting stimulative effect on aggregate demand. Ironically, the Fed's dual mandate and focus on core inflation appears to give it greater degrees of freedom than the ECB or BOJ enjoy.

Still, the price action needs to be respected. Tactically, we want to look for potential inflection points. That is to ask, what chart points could signal a deepening or acceleration in the correction. Our working hypothesis is that the dollar is retracing the move that began on October 15.

The euro peaked near $1.2500 last week, which corresponds to a retracement objective. A break of it would signal a move toward $1.2565. A move through $1.2640 would signal something more significant is unfolding. On the other hand, a break below $1.2350 may indicate the top is in place.

The Dollar Index is heavily weighted toward the euro and currencies that move in the euro's general orbit. However, it offers a handy proxy, even if only partially accurate, for the dollar in general. The initial retracement level (corresponding to roughly $1.25 in the euro) is near 0.8760. A break can spur a move toward 0.8700. A loss off 0.8640 would force long liquidation. On the upside, a move above 0.8880 points to a resumption of the bull trend.

The dollar found initial bids around JPY117.50. The dynamic of weaker equities and stronger yen remains very much intact. The 10% drop in oil prices saw bond markets rally and the U.S. 10-Year yield slipped below 2.10% before the weekend. The premium the US pays over Japan fell by nearly 20 bp over the past week. The JPY117.00 area corresponds with a retracement objective. The dollar's rally was so sharp that should the JPY117.00 level go, there is not much support until closer to JPY115.50. The JPY120.00-20 offers important resistance.

Sterling finished the week with three consecutive closes above the 20-day moving average. This has not taken place since July. Immediate resistance is seen in the $1.5800-25 area and then $1.5860, which corresponds to a retracement objective and the 50-day moving average. A break of $1.5680 would suggest the upside correction is over.

The dollar-bloc got no reprieve last week. Rather than get pulled up with the euro and yen, the Canadian dollar and Australian dollar fell in part as some operators were forced to unwind long positions that had been funded with the yen and euro. The Australian dollar found support near $0.8200. Technical indicators suggest it can consolidate in the coming days. Look for a move toward $0.8400 to be sold into. The Canadian dollar has yet to find a bid as the US dollar reached almost CAD1.16 before the weekend. We have been looking for CAD1.1670-CAD1.1725, and this remains realistic even if there is some consolidation. Look for the US dollar to find support now in the CAD1.1470-CAD1.1500 area.

The collapse in oil prices continues, but the focus shifted from supply to demand. Both OPEC and IEA cut demand projections. It is difficult to talk about meaningful support as prices sink to multi-year lows. With WTI convincingly breaking $60 a barrel, the next target is near $52. Given the diverse challenges that Saudi Arabia faces from within OPEC, as well as with US shale, Canadian tar sands, and the increased use of renewables, it may have to allow the price to fall even further, perhaps toward $40 before its strategic objectives can be secured.

Moreover, it is one thing for the US to satisfy more of its own demand, but US energy exports are likely to increase. US shale producers may bring their competitive challenge to third markets.

The S&P 500 lost about 2.3% last week; its first weekly loss since October. Technical indicators point to additional downside risks. The break of 2020 on a weekly close basis suggests immediate losses could extend to 1980. This is a retracement objective and corresponds to the 100-day moving average. This represents another 2% decline, but in the context of the 14% rally since mid-October's lows, it is quite modest, from a technical perspective.

Observations based on speculative positioning in the futures market:

1. There were two significant gross position adjustments in the reporting week ending December 9. The gross short euro position was trimmed by almost 10% of 21.3k contracts to 195.2k. This brings the decline to 44k contracts since the gross short position peaked in early November. About 10.5k yen contracts were covered, leaving 142.2k gross short yen contracts.

2. Reflecting the diverging price action, speculators reduced gross short euro, yen, sterling and Swiss franc positions and added to the gross short dollar-bloc currencies. Aside from the yen and sterling, gross long positions were grown.

3. The net short speculative currency positions were mostly reduced. The two exceptions were the Australian dollar futures where the net short position grew to 45k from 41.1k contracts. The net short Mexican peso position rose to 48.6k contracts from 43k.

4. The net short speculative 10-year Treasury futures position swelled to 201k contracts from 163k. This was clearly more about longs taking profits rather than shorts selling into the rally. The gross long position fell to 305.7k contracts, a decline of 38.7k. The gross short position rose by 100 contracts to 507.1k.