The Land of the Rising Dollar

Next week, which may be considered one of the most important weeks of the year, brings a host of important events and data releases that many investors have been waiting for. The week technically kicks off tomorrow when the US reports 3Q GDP. The consensus is for a 2% increase. Next, is the midterm elections take place on Tuesday with the markets looking for clues to the outlook on policies. Notably the markets are focused on fiscal policy, the China bill and more color on the debate surrounding rare earths.

And not to be overshadowed by the midterms, the Fed is expected to announce its large scale asset purchases, dubbed QEII, on Wednesday. Many feel the Fed will target purchases around $100 bln a month for an extended period until inflation reaches acceptable levels. The recent price action in the currency markets (along with fixed income and equities) has been choppy, which can be taken as an indication that despite the announcement that the markets knee-jerk reaction may increase volatility. Over the past week, for example, 10-year Treasuries have increased by 12 bp nearly 2 bp a day. This price action can be taken as a sign that the markets were too quick to price in further Fed easing and is now retracing as uncertainty over the size of the asset purchases increases. Given the relentless USD selling pressure for much of September and October, we could see “sell the rumor, buy the fact” reaction to QEII.

Our SpecialFX piece from last Friday (Euro-Dollar Outlook) suggested medium term investors begin cutting short dollar exposure. We identified three factors that should be tracked that we still feel are the key drivers going forward. Again, the markets should keep their attention focused on the 5 – and 20-day moving average, and, of course, the 2- and 10-year interest rate differential. Here is an overview of the drivers and their likely impact on direction.

The 5-day moving average of the euro is still poised to fall below the 20-day in the coming days. Sterling’s moving averages turned late last week and the Swiss franc’s turned at the start of this week. The Australian dollar’s averages, too, are about to cross. The cascading effect where all the moving averages turn in different sequence is not unusual and is consistent with our understanding of bottoms and tops being processes that are carved out over time rather than precise moment. Other technical indicators (e.g. trend line violations, chart patterns, momentum) also warn of heightened risk of a dollar recovery after its recent slide. That said, fundamental developments next week could contribute to potential gains as well.

We have found over the past year or so, the euro tends to track the US-German 2-year spread. That spread made a high for the move last Friday near 65 bp in favor of Germany. The spread has narrowed ever so slightly, but not very convincingly yet. Given that the US 2-year is anchored by overnight US rates, it is not surprising that the widening of interest rates in the US favor is happening first at the intermediate and long-end of the yield curve. US interest rates are rising and the entire US coupon curve has risen relative to Japan’s and this may be contributing to the dollar yen getting slightly better traction, although we are sympathetic to recent choppy trading that continues to whipsaw currency markets.

Weekly trading recommendations:

· Maintain long CAD/CHF at current levels with an initial objective of 0.9766 and readjust stops at 0.9466 to secure profit.

· Enter long AUD/NZD at current levels with an initial object of 1.3461 and a stop of 1.2827.

· Enter short EUR/CAD at current levels with an initial objective of 1.3626 and a stop of 1.445.

· Enter short EUR/USD position at current levels with an initial objective of 1.3454 and a stop of 1.4108.

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