The Dollar Breaks But It Isn’t Broken

The dollar’s decline accelerated and broadened last week. It convincingly broke out of its recent ranges. Tactically, we did not expect the sustained break ahead of the December 10 , where the central bank does not pre-commit to easing policy. The recent string of economic data suggests that while US activity has moderated, the recovery continues; Japan and Europe may be experiencing a new contraction.

Strategically, we have been arguing that the third big dollar rally since the end of Bretton Woods is over. We began the year noting that the policy mix was less supportive. At the same time, the exchange rate was overvalued against all the major currencies, and the interest rate differentials were moving against it. The onset of the pandemic was disruptive for the capital markets, and the dollar rallied on safe-haven and unwinding of funding positions. However, as governments and central banks responded forcefully, what we think is the underlying trend, re-emerged. Listening to clients and other market participants, it struck us that the framing being used to understand the dollar decline was a return of the twin deficit problem. 

The twin deficits refer to the fact that the US runs both large budget and current account deficits. The eurozone, Japan, and China have budget deficits but current account surpluses. In order to finance the twin deficit, the US has to have interest rate differentials (often supported by growth differentials). When the differentials are not sufficient, the dollar acts like a shock absorber and shoulders some of the adjustment by depreciating.

Here is how we see the current technical condition.

:  Last week, like the previous two, the Dollar Index managed to rise in one session. It has fallen for four of the past five weeks. Over that span, it has depreciated by about 3.8% and visited levels now seen since April 2018. The MACD is near three-month lows, and the Slow Stochastic is flatlining in its trough in oversold territory. It has finished the past four sessions below its lower Bollinger® Band (~90.75). The next significant technical area is around 90.00. The four-year low set in February 2018 was near 88,25.

 The euro broke through the top of its four-month trading range near $1.20 and raced up to almost $1.2180 before some consolidation ahead of the weekend. It was unable to make new session highs after the disappointing US jobs report, indicative perhaps of the stretched momentum indicators. After breaking above the upper Bollinger Band, the euro has ironically been finding support near it (~$1.2135). The 2018 high was around $1.2555, and ahead of that, various technical levels are cited between $1.22 and $1.24. The downside risk emanates from the ECB. A push back into the $1.2025-$1.2075 area would help make the rally appear and feel orderly while not jeopardizing the upside breakout.

: The dollar made new 2.5-week lows when the JPY104 level gave way on December 3 despite an option struck there for $3.5 bln and fell to almost JPY103.65 before finding good bids. Like a rubber band snapping back, the dollar recovered above JPY104 and settle the week with a small net gain. In fact, the yen was the only major currency that was unable to close higher against the dollar last week. The momentum indicators are not generating strong signals, and understandably so, given that the narrowness of trading range for a little more than two weeks. Still, after testing the lower end, the rule of alternation favors a test on the upper end, which is initially around JPY104.75.

 The combination of the weak dollar and hopes of a UK-EU deal lifted sterling to $1.3540, a two-year high, before the weekend. It is the fifth consecutive weekly advance, sterling’s long rally in since last 2018-early 2019. The next chart area of note is around $1.3640, representing a (61.8%) retracement of sterling’s losses since the referendum in June 2016. The  MACD continues rising slowly, and although the Slow Stochastic is tired and stretched, it has not turned lower. Sterling is fraying the upper Bollinger Band (~$1.3485) but has not closed above it. The finished higher on the week against sterling, and a good part of the early gains was reversed over the last couple of sessions. One-week implied volatility is elevated, with cable a little above14% and euro-sterling near13.7%. The skew in the options suggests participants are seeking downside protection.

:  The Canadian dollar was among the strongest of the major currencies, gaining about 1.5% against the greenback, with a third of the gain scored after its better than expected employment report. The US dollar began the week above CAD1.30 and finished with a push below CAD1.2800, and takes a four-day slide into the start of next week. It is at its lowest level since May 2018. The pace of the move is illustrated by the fact that the US dollar closed below its lower Bollinger Band (~CAD1.2845) for the past two sessions. The momentum indicators are still falling even if stretched. The next chart area to note is in the CAD1.2680-CAD1.2700 area.

:  After the yen, the Aussie and were the under-performers among the major currencies last week. The New Zealand dollar fell by a little more than 0.5% ahead of the weekend after the central bank suggested it could buy foreign bonds, which would be seen as a type of foreign exchange intervention. The Australian dollar rose by about 0.65% to extend its rally into a fifth week. The Aussie rose to $0.7450, a new high since August 2018. The first sign of preliminary divergence may be emerging as the Slow Stochastic did not confirm the high in price. It is toying with its upper Bollinger Band (~$0.7445). A break of $0.7400 could spur a wave of profit-taking that may be worth 1%. On the top side, the $0.7500-$0.7520 is the next hurdle.

 The dollar fell 1.35% against the peso last week. It is the fifth consecutive loss. There have been only five weeks here in H2 ’20 that the dollar has risen against the Mexican peso. It tested MXN19.74 at the end of last week, a new nine-month low. The Slow Stochastic did not make a new low even though the dollar did, underscoring the stretched conditions that prevail. Initial resistance now may be seen near MXN19.90. It is difficult to see meaningful support ahead of the MXN19.00-MXN19.15 area.

:  The three strongest currencies in Asia last week were the , which gained nearly 2% as the dollar fell through KRW1100 for the first time since mid-2018, the (~1.0%), which is at its best level since 1997, and the Chinese yuan (~0.70%). While the dollar spent most of last week within its recent consolidative range, the downside pressure proved too much, and the new lows below CNY6.53 were seen before the weekend. The next area of note is near CNY6.50. The price action reinforces the cap near CNY6.60. 

:  The sell-off that we date to the Pfizer) vaccine announcement on November 9 culminated with a low to start last week, a little below $1765. Prices recovered to reach $1848 ahead of the weekend before some consolidation took place. The bounce stalled after reaching the (38.2%) retracement objective (~$1841.5) and the 20-day moving average (~$1845.4). The momentum indicators have turned up, and a further correction is likely. A move above the $1850 area could spur a move toward $1865, which houses the next (50%) retracement objective.

:  The OPEC+ decision to allow a small boost in output (500k barrel a day) next month, with future moves being decided on a monthly basis. Participants concluded that this is not enough to erase the tightness of the market. Also, many are looking at the post-vaccine increase in demand. The January WTI futures contract rose to almost $46.70 at the end of last week, its best levels since March. It takes the rally since November 1 to a dramatic 37%. The (61.8%) retracement objective of this year’s drop was met at around $46.45. The Slow Stochastic has turned lower and did not confirm the new high. The MACD is still trending higher. The upper Bollinger Band begins the new week near $47.50.

US Rates:  The fact that the US yield rose by more than six basis points despite the disappointing employment report suggests investors are looking elsewhere. The 13 bp increase was the largest in any week here in H2. The prospects of a fiscal stimulus package have increased dramatically over the past several days. The $908 bln bipartisan offering is roughly twice what Senate Republicans had wanted and a little more than a third of what the Democrats in the House passed. The proximity of the Georgia Senate races, the surge in the virus with nearly all US states in a red zone, and the unexpectedly weak may be adding pressure for a deal. The other issue is rising inflation expectations. The 10-year break-even, which is the difference between the conventional 10-year yield and the inflation-protected security, rose by 14 bp, suggesting the rise in nominal yields can be fully accounted for by the increase of inflation expectations rather than real yield. While we do not want to exaggerate the precision, the rise of inflation expectations is notable. The 10-year breakeven reached 1.90% before the weekend, new highs for the year. Two numbers to anchor its meaning. First, the 10-year breakeven was near 1.74% at the end of last year. Second, the high set in 2019 was just below 2.0%. 

: The S&P 500 closed at new record highs before the weekend near 3693.50. It was the second consecutive weekly gain and the fourth in the past five. It is up about 12.8% since the end of October. With a five-week rally in tow, the has rallied by more than 22% over the same period. Both benchmarks rose by a little more than 1.3% last week. Rising yields did not stand in the bulls’ way. It seemed consistent with the broad reflation trade, which is understood to be negative for the dollar. It is not yet a focus,  but as attention turns to Q4 corporate earnings, the weaker dollar will likely bolster many reports, especially in tech and consumer product areas. The S&P 500 gapped higher on Tuesday and has not been entered, let alone filled. The gap is found between roughly 3634.2 and 3645.9. The bottom of it may offer technical support ahead of 3600.

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