My frequent readers know by now that I've been very vocal about US dollar strength throughout this year. It is true that there have been many a times during the past 12 months when the dollar depreciated against the euro and, in particular, against the Japanese yen. That was usually the case when the Federal Reserve kept the market guessing about its future policy moves, including the timing of its first interest rate hike, or when the European Central Bank could not persuade the market of its capability to sustainably increase inflation through its monetary policies, such as negative interest rates and extensive quantitative easing programmes. However, no matter how tenacious the dollar's sideways range has been (just look at EURUSD, which had been stagnating since April 2015), I've always stuck with my conviction that the US dollar would ultimately emerge from this inconvenient bout of range trading as the stronger currency in comparison to the rest of the G10 currency basket.
The main reason being that the US economy has been able to put its economic recession behind itself earlier than European economies managed to do. This time gap of perhaps one to two years was a strong indicator of increasingly divergent fiscal and monetary policies in the US and throughout the euro zone that would help strengthen the US dollar and, on the other hand, devalue the euro. Although this did indeed happen to some degree up until March 2015 when the EURUSD exchange rate came close to reaching $1.05 but instead came to a halt at the intersection of two long-term trend lines and entered the aforementioned sideways market. I must admit that I greatly underestimated the amount of time it would take for the US dollar to resume its appreciation, and that it would be the election of Donald Trump as the next President of the United States that would trigger the dollar's renewed vigor is still somewhat beyond me.
Anyway, the time has finally come that we're seeing a strong trend in EURUSD again. The only thing that worries me at this time is the pace at which it unfolded. Within merely 10 trading days we went from the election night high of $1.13 to today's low of $1.0568 -- that's almost an eight big figure move without noteworthy backlash! The daily RSI currently reads 22 and other oscillators confirm that the pair is oversold. While I appreciate the fact that such moves often extend even beyond these levels, I must also acknowledge that the previously favourable risk-return profile of the EURUSD short trade has worsened significantly, which is exactly why I closed my USD long trades yesterday. Traders thinking about selling the euro versus the US dollar should think thoroughly before doing so. Personally, I expect a bit of profit taking to begin soon, but I will stand ready to buy the US dollar again once the extreme momentum has abated. The US dollar still has the majority of arguments on its side, and that is not going to change unless the ECB and, more importantly, the Fed will disappoint in December. Next month will be at least as interesting (or should I say, challenging?) as this month turned out to be.
As I wrote in yesterday's FX newsletter, traders should prepare for a pivotal week in the foreign exchange market with both the BoJ and the Fed holding important policy meetings.
Judging by the major banks' research reports, most analysts expect the BoJ to attempt to steepen the JGB yield curve, but the effect that would have on the JPY remains open to interpretation. It will perhaps be more crucial that the BoJ can convince the market that it is not running out of options to step up its easing measures if required, but that will be a tough task to achieve without support from Japan's Ministry of Finance. While I expect JPY strength to come to an end soon, the Japanese currency remains supported by the unwinding of carry trades and next week's central bank meetings will provide plenty of downside risk for my base scenario. Given this uncertainty, I'm afraid USDJPY might test the 100 level if neither the BoJ nor the Fed can reintroduce JPY weakness and USD strength, respectively. I hold a USDJPY long position with a S/L just below 100 and a short-term target at 105.
Speaking of the Fed, don't expect too much from Yellen & Co.! A rate hike would be a big surprise that would push EURUSD below 1.10 and USDJPY above 105, but the more likely scenario is that the Fed will (once again) not hike and merely introduce a slightly more hawkish tone to its statement instead. Although that should signal perhaps one rate hike by the end of the year, it will not be broadly USD-supportive and thus the risk of temporary EURUSD and USDJPY volatility without a sustainable breakout from recent price channels remains high, i.e. there will be a lot of risk in the market but the likelihood of an adequate compensation for that risk remains relatively low. Risk-averse traders will remain on the sidelines. Those open to more speculative positions will put on EURUSD short, GBPUSD short and USDJPY long trades.
"Billion Dollar Day" is a short 1986 documentary on forex trading that was produced by the BBC. From today's point of view, where it is possible to trade in FX at a 100+ leverage using only your mobile phone, much of what the documentary depicts may seem historic or even silly, but at the heart FX prop trading has remained pretty much the same. The main difference may be that fewer institutions have retained their prop trading desks, having significantly reduced risk after the recent financial crises and the wave of financial market regulations that followed them.
My personal highlight is the Reuters pager though -- watch out for it around the 10-minute mark!
I still believe the US dollar will be stronger going forward and I think that its recent weakness presents an excellent buying opportunity. As I wrote in March 2015, there was no reason for the EURUSD exchange rate to go up at that time, unless the Fed would change course and oppose the dollar's strength. Well, that is exactly what happened, unfortunately:
The Federal Reserve has still not hiked rates and some even doubt that it will do so in 2016, while both the ECB and the BoJ have embarrassed themselves by botching up press conferences or entering negative interest rate territory, only to see their currencies go up in value afterwards.
The USD has lost versus most peer currencies, especially the JPY. It's still difficult for me to understand why people have been so concerned about the US economy lately. Every data release that was even slightly below expectations quickly led to more USD selling and EUR or JPY buying. As a result, USDJPY is now fighting not to fall below ¥105 (or even ¥100) while EURUSD recently tried to break above $1.15 (although it has so far failed to do so). The American economy isn't doing that bad, and market participants' obsession with the unemployment rate has reached an outright ridiculous level. At this point it's all about productivity figures!
Anyhow, speculative USD short positions are the highest since 2013. That's a good sign for traders: The extreme EUR & JPY short positions that were the cause of much volatility in 2015 have been reduced substantially, providing new entry opportunities without the risk of extremely sharp moves as in April and December 2015. Market positioning is way more neutral now, which is also a result of investors' inability to interpret central bank actions. Most likely central bankers don't really know what they're doing themselves anymore, so traders are now looking for new reference points that will help them navigate through the muddy waters that are the financial markets. Fundamentals in the US are still better than in Europe and Japan, despite the recent string of disappointing data releases.
But which currency to sell versus the dollar if you share my view? I don't really think the ECB holds much credibility in the markets anymore. Also, Draghi and his team have repeatedly said that they wouldn't introduce new policy measures in the near future because the implemented policy tools needed time to have an effect on the economy. Europe's central bankers are probably too busy discussing their independence from politicians anyway. I expect the EUR to remain range-bound for the time being -- although I must acknowledge that the sideways range in EURUSD has been going on for what looks like a disproportionately long time when comparing it to similar patterns in the exchange rate's history. Be that as it may, the BoJ seems more likely to surprise markets by introducing new easing measures. It is also in a very tricky position now where it has to make decisions within very little room for action around the zero bound. Just how negative can you go, after all? Japan's still fragile economy is in a tough spot here, and I believe both fundamentals and further BoJ actions will reverse the JPY's bout of strength into extended weakness by the end of this year. Conclusion: I'm a USDJPY buyer.