Currency Outlook: Is It All about The Fed?

The Fed's foot has not come off the accelerator, of course, it is simply reducing its effort. Yet, it is well appreciated that by doing so, it begins a process that will culminate in the ending of what some had dubbed QE-infinity and, ultimately a normalization of monetary policy, which also means a higher Fed funds target.

The dollar has paradoxically traded heavily since the start of the month. It had generally weakened during most of the Northern Hemisphere's summer. It stabilized, but appears to have settled in ranges, with the notable exception of sterling, which has been lifted by expectations that the BOE raises rates before the Fed.

In games like even-and-odds or rock-paper-scissors, one wins not so much by guessing what the adversary will do, rather the best strategy is aimed at not losing in the sense of being as random as humanly possible. Next week may resemble more one of those games than the hot potato variety that the foreign exchange market may often seem.

It may not suffice just to get the Fed call correct. The latest Wall Street Journal survey shows two-thirds expected the FOMC to announce tapering next week. If they do so, it is hardly a secret and it appears to have been largely discounted. We suspect that even with the scaled back expectations, a taper-lite in response to a taper-tantrum, if you will, there is scope for disappointment.

It can take the form of 'buy-the-rumor, sell-the-fact' type of activity. The FOMC could offer other guidance to keep the signal clear that this is not tightening of policy. It is possible, and a third think likely, that the Fed holds off altogether.

In the first part of next week, ahead of the FOMC meeting, we expect a generally firmer dollar. It seems to be much more forgivable to be long dollars ahead of the decision that has been awaited for a third of the year, than to be short dollars. That said, we suspect the dollar may weaken after the FOMC decision. The Fed is more likely to do less rather than more relative to market expectations.

That sell-off can extend into the end of the week. However, we look for the dollar to begin recovering ahead of the German elections next weekend. While a grand coalition seems to be the most likely scenario, there may be some pressure to reduce long euros ahead of the vote.

Ahead then of the FOMC meeting, we see initial support for the euro near $1.3240. If our general scenario holds, the euro can take out the $1.3325 recent ceiling after the FOMC meeting. Sterling is outperforming and is at the best levels against both the dollar and the euro since January-February. Ironically, sterling's strength in part reflects the lack of confidence in the BOE's forward guidance. The market is pricing in a rate hike a year before the BOE guidance would have it. Provided the $1.5750 area holds, sterling will likely push toward $1.60.

The dollar does look set to concede ground to the yen. The greenback's technical tone has deteriorated since reversing lower at midweek after recording a two-month high near JPY100.60. Initial support will likely be found in the JPY98.80-JPY99.00 area. A break of JPY98.20 is needed to be significant.

The Australian dollar posted a key reversal in response to the disappointing jobs data on Thursday. It had initially made a new high for the move, briefly trading through $0.9350 and then was pushed a half a cent below Wednesday's low and closed below it. Follow-through selling on Friday was limited. When all is said and done, it was still up about 0.65% against the US dollar on the week. Technical indicators are mixed and we suspect that it may require a break of $0.9180 to indicate a downside correction rather than broad consolidation after about 5.3% from the end of August to the employment data.

Over the same period the Canadian dollar appreciated about 2.5% against the US dollar. The greenback appears to have bottomed near CAD1.03. During the first part of the coming week, the US dollar can recover toward CAD1.04 and possibly CAD1.0430.

The Mexican peso, which, according to the latest BIS survey data moved into the top ten most actively trade currencies, has been resilient in the face of the unexpected 25 bp rate cut on September 6. It enjoyed additional gains in the first part of last week before entering into a consolidative range. The US dollar held above MXN13.00. Technical factors suggest the near-term risk-reward may be eroding for new longs. The US dollar could slip below MXN13.00 but the charts suggest the it would likely be limited. We would be more inclined to consider selling dollars on a bounce toward MXN13.20-MXN13.25.

Observations from the speculative positioning in the CME Currency Futures:

1. Net foreign currency positions mostly fell in the latest Commitment of Traders report. Only the yen and peso futures saw a net increase in speculative positioning. Generally, this was a reflection of a reduction in exposures. Specifically, of the 14 gross positions we track, only four experienced increases. Even the peso, where the net position increased, both long and short gross positions were reduced (the former less than the latter).

2. Activity picked up and there were three gross currency futures positions that were adjusted by more than 10k contracts. The gross long euro positions were cut by almost 16k contracts. Over the past two reporting periods, the gross longs have fallen by about 25%. Gross short Canadian dollar and Australian dollar positions were reduced by 11.0k and 16.7k contracts respectively.

3. We are struck by the resilience of the sterling bears. The gross short position is the largest behind the Japanese yen, despite sterling trading at multi-month highs. When the shorts finally do capitulate, it may very well be a sign the a top is nearby.

4. The net short yen position rose by nearly 16k contracts to 95.1k. This is the largest net short position since late May. It was a function just as much of gross longs giving up as the dollar resurfaced above JPY100 as it was new shorts being established The gross short yen position is the largest among the currency, while the gross short euro, sterling and Australian dollar positions are roughly the same size. The gross long euro position is the most among the currency futures, more than twice second largest (peso).