Divergence Rewards Patient Dollar Bulls

The combination of the dovish signals from the European Central Bank and the rate cut by the People’s Bank of China lifted the US dollar just as it was threatening to fall through the lower end of its recent ranges.  Judging from the positioning in the futures market, short-term speculators appeared to be abandoning the dollar bull camp, perhaps driven the disappointment with the Federal Reserve’s seeming inability to move away from the zero-bound six years into an economic recovery that has driven the unemployment rate to 5.1%. 

The price action underscores that the divergence meme that is central to our bullish US dollar scenario is not only driven by the timing of the Fed’s lift-off but by what other central banks are doing and going to do.   The divergence has not peaked.  Nor will it peak for at least the next year.  It also does not do justice to the way financial markets work to suggest that that has been fully discounted.  After all, the widening interest rate differentials create an incentive structure for new portfolio and direct investment flows and hedging.

The US dollar has been moving broadly sideways after rallying earlier this year.  The extreme long dollar positioning has been alleviated, and the over-extended technical condition has been corrected.  With the fundamentals and technicals aligned, the dollar may be arguably in its best position to appreciate in several months. 

However, with significant gains last Thursday and Friday, and ahead of the BOJ and FOMC meetings, some consolidation should not be unexpected.   To say that the BOJ is most likely to stand pat is to obscure the fact that it continues to pursue an aggressive, unorthodox monetary policy, which includes buying nearly the entire new supply of JGBs.  The Federal Reserve is unlikely to say anything that can be construed as closing the door to a December rate hike.   However, both events pose risks and after substantial moves in two sessions may limit the willingness of taking on new exposures. 

The euro’s technical condition deteriorated markedly.  The mild uptrend line, drawn off the March, April and August’s lows, was convincingly violated.  The five- and 20-day moving averages crossed, and there were consecutive closes below the 200-day moving average.  It finished the week below the shelf carved near $1.1080.  The various technical indicators, like the RSI, MACDs, and Stochastics, have broken down. 

A caveat is that the pace of the euro’s drop has pushed it below the lower Bollinger Band (~$1.1065).  Short-term momentum traders may see a move back above there as a sign to move to the sidelines.  The euro dropped three cents last week.  It is hard to see that being repeated in the next week, though a recovery in jobs growth, back above 200k, the following week could bring the risk of a dramatic divergence drama in December.  A fortnight after the ECB expands in some fashion its unorthodox monetary policy, the Federal Reserve could raise rates.  Specifically, the $1.0940 area is the 61.8% retracement of the euro’s bounce off the March lows, and beyond that is $1.0800.