US Dollar Rally Finally Starting to Make Sense

FUNDYS

The initial market reaction proved to be the false one, with the USD selling off sharply in the hour following the Fed into the New York close, on the back of the news that the Fed would reinvest maturing mortgage backed bond proceeds into long dated US Treasuries, and the statement that the pace of recovery was likely to be more modest in the near term than had been anticipated. Intuitively the rate decision was on the whole quite dovish and the initial reaction made sense, with the net effect to only make yield differentials even less attractive for the Greenback.

Relative Performance Versus USD on Tuesday (As of 10:45GMT)

1. YEN+0.33%
2. SWISSIE-0.50%
3. CAD-0.59%
4. KIWI-0.93%
5. STERLING-1.08%
6. AUSSIE-1.13%
7. EURO-1.20%

However, since the New York close, the exact opposite has been the case, with the US Dollar rallying sharply across the board (with the exception of the Yen). In our opinion there are three main drivers of this latest market reaction in favor of the buck.

1. The expectation for some form of quantitative easing from the Fed on Tuesday was very much priced in to the markets, and as such, we have been seeing a buy the rumor sell the news market reaction.

2. The fact that the Fed still remains quite downbeat on their outlook for the US economy, after even downgrading their assessment on Tuesday, is quite concerning to the global economy as it potentially warns that yet another ripple effect could be felt from the weakness in the US economy. This has resurrected a wave of risk aversion that has ultimately results in the latest broad based liquidation of riskier investments (reflected through lower currencies, equities, oil prices etc).

3. Technical studies have been warning for some form of a material correction back in favor of the US Dollar after the currency has dropped off significantly over the past several weeks against all major currencies, including even the Swissie and Yen.

All three of these factors suggest that we could see a more sustained USD rally over the coming days and we would therefore look for opportunities to buy the buck on any intraday dips. The one other currency that stands out at present is the Yen, and we would also recommend that traders start to think about looking to establish a meaningful long position in Usd/Jpy. At this point, it is to be expected that the critical support by 84.80 will be taken out at any moment, but with the level finally cleared and stops finally hit, we see a good deal of risk for a major upside reversal. While the Yen traditionally benefits in negative equity/flight tosafety environments on the back of its low yielding status, in our opinion, the single currency could start to come under pressure even in the event of a widespread equity decline and renewed global uncertainty, with the Bank of Japan likely to resurrect itssleeping intervention policy. As such, we would be on the lookout for any big drops below 84.80 in order to consider establishing a fresh long position.

On the data front, the UK was the main focus, with nationwide consumer confidence coming in softer, and unemployment fairlyin line with consensus. However, the Pound has been hit quite hard as local traders fear the worst following the latest escalation in risk aversion and grow increasingly concerned that the labor market improvement could finally be at an end. Also seen weighing on the Pound has been a fairly downbeat Bank of England quarterly inflation report which revealed that the BOE sees a belowtarget inflation rate. Elsewhere, Australian consumer confidence soured a little bit, while in Japan, machine orders came in much weaker than expected with the year-on-year reading contracting for the first time since February.

Looking ahead, the Norges Bank is out with its rate decision at 12:00GMT. It is widely expected that the Norwegian central bank will leave the deposit rate at 2.00% given softer growth data and subdues inflation readings. Canada international merchandisetrade (-0.4B expected) is then out at 12:30GMT, along with the US trade balance (-$42.1B expected). Oil and gas inventory data are then out at 14:30GMT, with the monthly US budget statement (-$169.0B) capping things off at 18:00GMT. US equity futures are pointing to a much lower open (over 1.0% lower), while commodities are also under pressure ahead of North American trade.

GRAPHIC REWIND

TECHS

EUR/USD: Could finally be showing signs of a short-term top at a minimum, with the market stalling out above 1.3300 and rolling back over. However, at this point it is too difficult to call and we want to see a break and close below 1.3100 at a minimum for confirmation of a shift in the structure. A break back below 1.3100 should accelerate declines back towards 1.3000, below which then opens a more meaningful drop into the 1.2700’s. Back above 1.3335 negates and opens a test of the 200-Day SMA just over 1.3500.

USD/JPY: (See Below)

GBP/USD: Waiting for a daily close on Wednesday for clear bias, but the latest break below 1.5820 has triggered a double top on the daily chart that suggests that some form of a high is now in place by 1.6000. Look for the latest break to now open a measured move downside extension back towards previous resistance now turned support by the 200-Day SMA just over 1.5500 over the coming sessions. Back above 1.6000 negates and gives reason for pause.

USD/CHF: Continues to chop around after being very well supported on dips in the 1.0300’s. However, it appears as though the fresh multi-day lows last Friday could now open some additional declines towards 1.0100 over the coming sessions. Ultimately, the overall structure is still net bearish and a break back above 1.0680 would be required to relieve downside pressures.

FLOWS

Offers in Eur/Gbp from various UK names. Swiss selling in Usd/Chf on rallies into the 1.0600’s. Strikes by 1.3000 reported in Eur/Usd. Large stops below 84.75 in Usd/Jpy. Model accounts liquidating long Aussie positions.

TRADE OF THE DAY

USD/JPY: We like the idea of looking to buy the pair on a break below critical support at 84.80 today. Daily studies are already starting to look quite stretched and any additional declines below these multi-year lows are not expected to be sustained. Instead, the greater risk once 84.80 is taken out, is for a major upside corrective move, with the market needing a healthy bounce at a minimum before even considering bearish resumption. STRATEGY: BUY @84.30 FOR AN OPEN OBJECTIVE; STOP 83.30. RECOMMENDATION TO BE REMOVED IF NOT TRIGGERED BY NY CLOSE (5PM ET) ON WEDNESDAY.

PORTFOLIO OVERVIEW

The model portfolio has been reset as of August 2010 with a starting equity of $10,000. Please note that we still have some positions open that will not be tracked in this portfolio. We are currently Long Eur/Aud (1.53), Short Eur/Chf (1.46), Short Eur/Gbp (0.85), and LongUsd/Cad (1.0245). However, we will continue to update these positions as they progress.

Written by Joel Kruger, Technical Currency Strategist for DailyFX.com

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