US Dollar: What Can Break the Range?

06/22/2009 10:32 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

A cursory glance at the foreign exchange market will reveal a consolidated tone across the majors. This is partially due to the summer doldrums, but also due to the uncertainty in the financial markets. The US dollar ended the week modestly lower against the Japanese yen, but virtually unchanged against the euro and British pound. This lack of volatility comes after the sharp selloff in the dollar over the past three months, and nearly all of the major currency pairs are setting up for a breakout. Although the summer doldrums should reduce volatility in the currency market, the apex of the triangle formations in EUR/USD, GBP/USD, and USD/JPY point to a large expansion in volatility (i.e. a possible breakout move) as early as next week.

What Can Trigger a Breakout?

Sometimes, nothing more than the lack of liquidity could cause a breakout in the currency market. No major surprises are expected in US economic data this week with only housing market reports, durable goods, the final release of first quarter GDP, and the Federal Reserve interest rate decision on the calendar. If the Fed expands their asset purchases or becomes more optimistic, it could trigger a break in the EUR/USD, but we expect the central bank to keep the tone of the FOMC statement basically unchanged. The only real possibility is a mention of exit strategies, but so far, currency traders have shrugged off similar talk by the ECB and BoE. Instead, what could trigger a breakout are exogenous events such as growing tensions with North Korea, downgrades, or higher taxes. The late afternoon selloff in the dollar on Friday was driven by speculation that rating agency Moody’s could downgrade California’s debt rating. California’s fiscal finances are a mess, prompting governor Schwarzenegger to even consider a flat tax.

Forex Traders Adjusting Positions

A few weeks ago, we talked about the exaggeration of dollar short positions in the futures market, but these positions have recently been trimmed. Based upon the latest CFTC’s Commitment of Traders report as of the week ending June 16, futures traders reduced their long positions in the euro and Swiss franc, but raised their long exposure in the Australian and Canadian dollars. They have also boosted their short yen positions, but cut their short British pound exposure. These changes are not extremely surprising since strong economic data and higher oil prices make the commodity currencies more attractive on a fundamental basis, while the lack of official reserve diversification talk by the BRIC nations has forced dollar bears to adjust their positions.

Forex Seasonality: Summer Volatility

Two months ago, we published an article illustrating the seasonal patterns of volatility in the currency market using ten years worth of three-month, at the money option volatilities. According to our results, volatility tends to compress in June and July but pick up in August. Here are the charts of average EUR/USD and USD/JPY volatility across different months, and so far, price action appears to be obeying the seasonality.

Click to Enlarge

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By Kathy Lien, Director of Currency Research at