Currency Outlook: What Next?

The main development in the foreign change market over the past week has been the short squeeze of the yen, and to a lesser extent, the Swiss franc.

The move coincided with a backing up in JGB yields, with the 10-year approaching the 1.0% threshold, a nearly three-fold increase since the BOJ announced its more aggressive monetary stance in early April. The Nikkei took it on the chin, falling 12.5% between Thursday's high near 16k and Friday's low just below 14k.

Many of the foreign investors who have poured almost $80 bln into Japanese equities this year have hedged the currency risk, by selling the yen. However, given the slide in Japanese share prices, they may be over-hedged. To reduce the hedge yen needs to be bought.

At the same time, Japanese investors are not exporting their savings. Instead they appear to be taking profits on some of the foreign assets they had previously acquired. This is more consistent with the behavior on investors who do not expect the recent yen weakness to be sustained or substantially extended.

A band of support for the dollar extends from JPY100.60 to JPY100.00. The top of the band corresponds to a 61.8% retracement of the rally that began on May 9 near JPY98.65. The lower end of the band is the top of the month-long consolidation triangle pattern (early April through early May). The RSI, MACDs and Stochastics have turned lower. It probably takes a break of JPY99.60 to start talk in earnest that a top of some significance is in place. It would likely coincide with weaker Japanese shares.

The euro was confined to the previous week's trading range and chopped around a roughly $1.2820-$1.3000 trading range. The technical indicators we look at favor an initial upside break of this range. Additional resistance is seen in the $1.3020-40 area, which corresponds to retracement objectives and the 20- and 200-day moving averages. If this is overcome, there is potential toward $1.3200.

The euro has held support near JPY130. The measuring objective of the triangle pattern carved out mid-April through mid-May is near JPY135 and provided the JPY130 area holds, that remains a reasonable target. On the other hand, a break of JPY130 could be part of a large short squeeze on the yen, another 1-2% decline for the euro.

The upticks may have to be fought for as many anticipate a refi rate cut next month and there is speculation that a negative deposit rate may be introduced then. With EONIA trading around 5 bp, another 25 bp rate cut remains more in the symbolic world than substantive. We continue to believe that the ECB will be persuaded that the cost (somewhat unknown) is greater than the benefits (elusive) of a negative deposit rate.

Soft inflation figures and a horrific April retail sales report (-1.4% vs 0.1% consensus) pushed sterling toward $1.50, which has acted as support since mid-March. Off a two-day base there, sterling tested resistance in the $1.5140 area. A move above $1.52 could see a push toward $1.53, which as it approaches may offer a new lower risk short.

Against sterling, the euro has been in a clear range for a little more than two months. It is GBP0.8400 on the downside and GBP0.8600 on the upside. The euro tested the upper end of the range twice in the second half of last week. That the resistance held would favor a test on the lower end of the range.

The euro rose to 2-year highs against the Swiss franc following news that the IMF endorsed the idea of Switzerland adopting a negative deposit rate if the franc's strength was renewed. In addition, some of the broad forces that were weighing on the yen, such as perception of a diminished need for safe havens, may have also weighed on the franc. The recovery of the yen coincided with the recovery of the franc in the second half of last week. The franc was the second strongest of the major currencies (+1.2% against the dollar), behind the Japanese yen.

The Canadian and Australian dollars were the worst performing of the major currencies over the past week, losing 0.4% and 0.8% respectively. Since around the middle of the month, the US dollar has gained almost 4% against the Canadian dollar and nearly 7% against the Australian dollar. The technical indicators we look at still have scope for additional near-term losses for both currencies. We note the Australian dollar is approaching the lower end of a two-year-old range against the Canadian dollar, near CAD0.9900.

The Mexican peso lost about 1.5% against the US dollar last week. As we noted, macro-economic fundamentals remain supportive, but the technical condition had worsened. The dollar cut through resistance in the MN12.40 area and the weekly close was the strongest for the greenback since mid-March. The MXN12.60 area offers initial resistance, given the extent of market positioning, we continue to see potential toward MXN12.80.

Observations from the latest CFTC report on CME currency futures:

1. Gross long positions were trimmed in all the currency futures we examine here, except the Canadian dollar. The adjustment to gross short positions was mixed.

2. Two positions were meaningfully adjusted (10k contracts or more change). The gross long Australian dollar position was cut by 11.6k contracts and the gross short euro position grew by 24k contracts.

3. It is the largest net and gross short euro position since last November. The gross short position is half the size of last June's record. The net and gross short sterling position are records. The net short franc position is the largest since last July,while the net short Australian dollar position is he largest since last June.

4. The gross short euro position is larger than the gross short yen position.

5. Significant moves especially in the yen, franc, Canadian dollar and Mexican peso took place after the CFTC reporting period closed. The former appreciated while the latter declined. We expect next week's report to reflect this.