USD Recovery May Reverse into Year End

12/28/2009 10:16 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

The USD has seen its correction extend further this past week, but critical resistance levels (EUR/USD support levels) we highlighted in last week's issue appear to be exerting some influence. The 1.4250 level has held as support on a daily closing basis thus far, and the more significant 1.4170/90 area remains untouched. In USD/JPY, the pair finally broke above the Ichimoku cloud, but has since stalled just below the key 92.00/50 area, with rumored large supply (selling interest) at 92.00. Should USD/JPY break above the 92.00/50 resistance zone, we would expect gains to continue toward the 94.50/95.00 area in coming weeks.

The USD continues to respond most directly to incoming US data, which was mixed so far this week: weaker 3Q GDP; better existing home sales; weaker Michigan sentiment; weaker new home sales. Thursday morning's durable goods and weekly jobless claims will likely set the tone for the rest of this week for the USD. The positive correlation between US Treasury yields and the USD, especially USD/JPY, continues to hold sway, and here we would note the 3.75/3.85% area in ten-year US Treasury note yields. For the USD to continue to strengthen, we would need to see a sustained move above that level. However, we would also note the potential for increased differentiation between USD/JPY and the dollar against other major currencies, meaning USD/JPY may continue to follow US yields higher should they continue, but similar gains in the dollar against others may lag, as JPY cross buying comes into play.

In particular, going into the final week of 2009, month-end/year-end fixing flows (when asset managers undertake hedging/portfolio rebalancing, resulting in significant order flow at the daily fixings) appear to be biased toward overall USD selling, with the largest interest to sell USD against EUR and JPY. This sets up the potential for a rebound in EUR/USD and an unexpected decline against USD/JPY, which may see the relationship between US yields and USD/JPY breakdown in the short run. We would look to exploit any such short-term declines in USD/JPY as buying opportunities. But we won't rush in as the top of the Ichimoku cloud falls sharply to 88.68 in the final days of 2009, potentially setting up a nearly three-yen pullback from current levels (91.65). Complicating matters still further, massive US debt auctions (see below) have the potential to expose USD weakness if demand is soft, even as yields move higher as Treasuries are sold off. We expect volatility to increase as liquidity thins still further into the end of the year and for trading conditions to remain extremely choppy.

CAD Strength Still in Infancy Stage

The Canadian dollar continued to rally without missing a beat this week. Not only has the currency been backed by improving economic fundamentals, but now, rumors that China and Russia are looking to diversify some of their reserves into CAD have added another important element of support. The news exacerbated the squeeze down in USD/CAD and EUR/CAD last week.

The loonie cleared the prior lows for the week that had been sitting near 1.0535 and is now flirting with some important December lows along with an hourly trend line in the 1.0480/70 area. EUR/CAD, meanwhile, continues to plumb the depths and tested below the 1.50 barrier to the downside after opening the week about three big figures north of there. On a daily closing basis, we will now focus on the 1.4840/30 zone for some potentially robust buying interest.

This upside in the Canadian dollar is likely to persist as we head into 2010 and the risk is that rising inflation expectations will force the Bank of Canada's hand in raising rates before that line in the sand of June 2010. An increase in rates ahead of most of the G10 would do wonders for capital flows into Canada and likely push USD/CAD towards parity in no time.

NEXT: Why USD/JPY Could Head Higher, Key Data This Week


Treasury Supply Could Send USD/JPY Higher Still

The Treasury is poised to sell another massive $118 billion in notes next week. These will come in the two-, five- and seven-year maturities. The risk is that we will see yet another backup in Treasury yields (move higher), which could see USD/JPY push into some fresh nearby highs as we close out the year. Ten-year Treasury yields have risen an impressive 55 basis points to trade above 3.75% in recent days. The rise has been two-pronged.

The Fed's exit from the Treasury market, following their $300 billion in purchases, elicited a modest grind higher, but this was to some extent "baked in the cake." The larger factor seems to have been the exit of most of the large macro hedge funds, which had been very involved in the Treasury market all year. What this does is remove a huge source of demand, even as supply remains at astronomical levels. This means bond prices can only go lower in the very short term, pushing yields to fresh recent highs.

What this means is that the risk that USD/JPY breaks above the much ballyhooed 92 barrier is relatively high. The correlation between the pair and the US ten-year yield has been a very robust 87% in December, and anyone watching these two closely on an intraday basis will tell you that is has pretty well become the same trade. The prospect of weaker-than-anticipated appetite in next week's note auctions should not be discounted, and this should help put USD/JPY 92/93 in the crosshairs.

Key Data and Events to Watch This Week

Global markets are likely to be in holiday mode again. Thin markets this time of year (low volume) could make for some very interesting price action, nonetheless.

The US calendar is exceptionally light this week, as expected. Case-Shiller home prices and consumer confidence kick off the action on Tuesday. Chicago PMI is due Wednesday, while the usual weekly jobless claims round out the week on Thursday.

The only noteworthy releases in the euro zone are French GDP and German CPI on Tuesday.

It is even lighter in the UK with only the Nationwide home price report due out on Thursday.

Japanese data begins this morning with preliminary November industrial production and retail trade, with labor cash earnings out in the afternoon. The last data point is on Wednesday with the JMMA manufacturing PMI report for December.

In the commodity currencies, there is no Canadian data. The only Australian data is on New Year's Eve with November private sector credit. New Zealand sees only November money supply on Wednesday afternoon in Wellington.

By Brian Dolan, chief currency strategist,

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