Currency Outlook: Market In Knots

The foreign exchange market has become more treacherous than usual. The main culprit is a growing realization that the low interest rate environment that has characterized the investment climate over the last several years is going to end. Whether it is in 3 months, 6 months or 9, investors realize it is better to be early than late in adjusting positions accordingly. Indeed, it is entirely possible that the low point in interest rates is behind us.

That said, we suspect the first wave of the position adjustment is over and this may translate into a somewhat firmer dollar, and better performing emerging market currencies and a recovery in equities in the days ahead. The dramatic moves last week seemed to have flushed out some of those who came to the party late.

The major currencies stopped near key technical levels. For example, the Dollar Index bottomed in front of the 81.00 area, which corresponds to a 61.8% retracement off the early February lows. For their parts, on an intraday basis the sterling and the euro rose through the 50% retracements of the large decline from early January and early February respectively. For those who suspect that the move still has legs, their sights are set on the 61.8% retracements that are found just below $1.58 and $1.3345 for sterling and the euro respectively.

The dollar reached our quarter-end target against the yen of JPY95 after the US data. This also appears to have completed a technical move. The 38.2% retracement of the dollar's gains since the election was called in the middle of last November came in near JPY94.30. The dollar's recovery before the weekend leaves a bullish divergence on the momentum indicators. We look for a return to the JPY100 area.

While the Swiss franc is widely understood to trade in the euro's orbit, there has been a dramatic shift in recent weeks toward the Japanese yen. The 60-day rolling correlation of the return (percentage change) of the Swiss franc and yen stand at almost 0.42. From November through mid-March the two were inversely correlated. Even as recently as mid-April the correlation was near 0. The euro and franc correlation is higher, near 0.87, but has hardly moved since mid-April.

The technical weakness in the yen we expect, implies a weaker Swiss franc. The dollar has scope toward CHF0.9450-CHF0.9500, while the euro can move back toward CHF1.25 ahead of the SNB meeting on June 20.

The Australian dollar remains a dog, still unable to sustain the slightest of upticks. And the New Zealand dollar's performance is no better. They were the two major currencies over the past week and month. The fact that the Reserve Bank of Australia is still engaged in an easing cycle, while, as we will likely be reminded this coming week at the conclusion of the RBNZ meeting, it is more likely to tighten than loosen and the drop in the kiwi makes it more likely, on the margins.

The Canadian dollar was the strongest of the major currencies before the weekend, bolstered by the strongest jobs growth in a decade (95k). With subsequent loss in the US dollar, it has retraced 38.2% of the May rally (~CAD1.0014 to ~CAD1.0420). However, it finished back above CAD1.02 suggesting the risk of some near term consolidation. Provided the greenback is capped near CAD1.03, it appears technically vulnerable to slippage back toward CAD1.01. The Canadian dollar looks set to continue to outperform the other dollar-bloc currencies.

Last week, we warned that although the technical factors looked constructive for the dollar, the fundamentals, in the form of the ECB not delivering on the negative deposit rate (that Draghi said he had an open mind about) and additional aid for small and medium size businesses, were less supportive. We also anticipated that the jobs data would not support notions from some Fed officials (and market participants) that tapering of the purchases of long-term assets could being as early as this month. Now we suspect the dollar's down move has been largely exhausted and we anticipate a recovery in the dollar into a new trading range.

Observations on the speculative positioning in the CME currency futures:

1. There were unusually large moves in the spot foreign exchange market in the three sessions since the CFTC reporting period ended. For example, the dollar had a five yen range, while the euro and Australian dollar traversed a 2.5 cent range. Sterling traded in a 4 cent range. This makes the data less timely than usual.

2. Gross long positions were generally reduced, except for the euro and yen. Gross short positions were more mixed.

3. There were three significant (more than 10k contracts) adjustments. Gross short euro and yen positions were covered and long peso positions were slashed.

4. As of the end of the CFTC reporting period, speculators have the largest gross short position in sterling. Sterling rose to its highest level in almost 4-months after the reporting period ended.