E.U. summit relief rally may be short lived

USD under pressure on a number of fronts

The USD was hit hard this week, as long-USD positions were liquidated en masse. Apart from positioning, the USD is under pressure as risk markets rebounded, reducing safe-haven appeal of the buck and US Treasuries. We would also note that risk aversion remains in the background as seen by continued strong demand for the other FX safety valves, CHF and JPY. But the big driver by far of the current risk rebound/USD weakness are growing expectations that the Fed may deliver QE3 at the conclusion of next Wednesday’s two day meeting (see more below). We would expect further USD weakness if the Fed delivers more QE, but it will depend on the size of the program. If the Fed abstains, the USD is more likely to bounce back. Lastly, we also think the USD is under pressure across the board on month-end portfolio re-balancing flows. Given the outsized gains in US stocks in particular, foreign investors have larger USD exposures and need to sell more USD to maintain hedging ratios. We would expect further USD weakness to start the week based on these flows, but that the selling pressure may culminate following the 11EDT fixing. If the USD shows resilience in early NY trading, it likely means markets have turned more risk averse on a reconsideration of the prospects of success of the EU debt plan and USD-demand is swamping asset manager USD-supply.

The USD index has dropped to finish the past week just above the 75.00 level, holding above the 76.4% retracement (75.01) of the late August rally to just below 80.00. In EUR/USD, that level equates to 1.4220/50 as the key hurdle to further gains. In AUD/USD, August highs at 1.0765 are the equivalent pivot to fresh upside. Gold prices have recovered as the USD has weakened and are currently testing the daily cloud between 1747/1756; price looks like it should open next week above the cloud top, which falls to 1727/26. However, be alert for a failure and daily close back below. Friday’s price action across most major USD-pairs also resulted in numerous small real bodies (doji and spinning tops) on daily candle sticks, an indication of uncertainty following Thursday’s huge rally/USD sell-off. This keeps us alert for a potential USD reversal, but mostly we expect further consolidation ahead of the FOMC.

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