Dollar swoons; more weakness is likely

  • The USD swoons; more weakness is likely
  • Commodities toy with key psychological levels
  • Tough decisions for the ECB
  • UK recovery looks half-hearted
  • Loonie and kiwi grounded for now but may soon take flight
  • Key data and events to watch next week

The USD swoons; more weakness is likely

The Fed consigned the greenback to another bout of weakness, signaling that easy policy would remain in place for the foreseeable future, and markets were only too happy to oblige, sending the USD index to lows last seen in 2008. We see little on the fundamental horizon that could alter the dollar’s downtrend at the moment, with US rates on hold and other major central banks biased toward tightening. That leaves the market dynamic (meaning excessive USD-short positioning could lead to a short squeeze) as the only obvious catalyst to a bounce in the buck, which we would view as only temporary.

Although we anticipate further USD declines in the weeks ahead, we are in no rush to sell at current levels in light of the proximity of key technical and psychological levels, like 1.5000 in EUR/USD, 80.00 in USD/JPY and the series of 2008 lows in the USD index around 71.00-73.00 (last 72.92). Instead, we would urge patience and look for opportunities to re-enter USD shorts, looking to buy dips in EUR/USD around 1.4450/4500, AUD/USD near 1.0450/1.0500, and to sell USD/CHF near 0.9850/9900 and USD/CAD around 0.9800/9850. Finally, we would note that the current USD decline increasingly risks becoming disorderly, possibly leading to more concerted G7, possibly even G20, action to rescue the greenback. A disorderly decline in the USD risks sending commodity prices even higher, sparking even greater inflationary pressures, which we can all do without.

As an alternative to USD shorts, we observed that carry trades (JPY-crosses) failed to extend recent gains, despite the strong performance of other risk assets (stocks and commodities) during the past week overall. If risk sentiment remains buoyant, which we think will be the case going in to the start of a new month, then we would expect to see JPY-crosses resume gains and we prefer to be buyers of JPY-crosses on remaining pullbacks to recent lows seen early last week.

Commodities toy with key psychological levels

The sharp rise in commodities of late has been nothing short of spectacular. While silver has been the clear outperformer for the month of April, gaining over 31%, gold’s performance during the past week far surpassed the ‘poor-mans-gold’, as it rose from lows around $1495 to over $1560 at the time of this writing. This may partially be explained by those short the gold/silver ratio deciding to take profits into the end of the month. Meanwhile, crude oil came in last of the three as it rose a still highly respectable 7.8% in April. At the moment, commodities are toying with key psychological levels – Gold: $1550-1600, Silver: $50, and US Oil: $115-120. So, the overwhelming question we continue to hear is what’s causing this rise? And when will they peak?

As for what’s causing this rise, we believe a ‘perfect storm’ has been brewing for quite some time, but is now just coming to fruition. First and perhaps most importantly, has been the low global interest rate environment, especially in the US , leading to a renewed USD slump. This has led investors who believe ‘printing money’ will ultimately cause inflation to seek fiat money alternatives – hard assets (commodities). If that wasn’t enough, growing tensions in the MENA region saw traders flock to a ‘flight-to-safety’ trade. At the end of February we highlighted this potential in our Commodities Corner report, “with tensions in the Middle East unlikely to subside anytime soon, this flight-to-safety trade could be stronger and last longer than the market currently anticipates, subsequently traders are beginning to take action”. Lastly, commodities have benefitted from a strong technical outlook, especially silver which has made a true a parabolic move higher.

While some may believe buying at such elevated levels could be financial suicide, we actually consider it the prudent thing to do in the current environment – accordingly we do not foresee a peak yet. This week Bernanke, at his inaugural press conference after an FOMC announcement, made it abundantly clear that the uncertainty of the US economic recovery is likely to keep the Fed on the sidelines in 2H 2011 – thus remaining accommodative, until their hands are forced. Consequently, we believe the USD is likely to remain under pressure in the weeks and months ahead. While we are cautious of getting long at immediate levels next week, we would look to be rather opportunistic upon pullbacks as the fundamental backdrop is not going to change drastically overnight. Perhaps ADP on Wednesday or NFP on Friday will give us the opportunity we seek.

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