Guest post: Dollar weakness continues

Submitted by Edward Harrison of the site Credit Writedowns.

As I write this, the U.S. dollar has fallen to new 8-month lows against the British Pound and oil. Sterling is up over 2 big figures to 1.6371 while oil (WTI crude front month contract) has marched up near $68 a barrel. Clearly the sell the dollar meme is still in effect in this new month. I should also mention that treasuries are getting crushed again with the yields on the 5-, 10- and 30-year all increasing 10 basis points. Treasuries had rallied at the end of last week.

The currency team of Brown Brothers Harriman had this to say ahead of the market open:

Momentum traders have contributed to the dollar’s sharp losses in recent weeks exacerbating the fall. This is important because it suggests that the dollar’s move is not being driven by fundamentals at the start of a longer term US dollar trend lower but by market participants jumping on board a moving train. This also suggests the move is likely to come to an abrupt end at some point. Evidence that momentum traders have played a key role in the dollars slump appears in IMM data. Since the end of the first quarter IMM speculators have shifted from being short a net -135,902 of foreign currency contracts held against the dollar to a net long position of 84,848 of foreign currency contracts in the week ended last Tuesday, a 220,750 shift in positions. Details show that net long euro positions, at 15,584 contracts in the latest week, are now at their longest since July 2008 and close to the 2-year average. However, position size does not imply that the market will correct lower. Net long euro positions remained above current levels for much of 2006 through early 2008 as the euro trended higher. One notable factor is that momentum indicators are beginning to diverge. The euro hit a new high today but the RSI remains below Friday’s high. Still, the euro has continued to advance and as we noted in our piece “Questioning the Dollar” the euro could rise toward $1.4600-$1.4800. For the Swiss franc, the RSI diverged last Thursday when the currency hit a new high but the RSI did not. That is not the case with most other major currencies however.

There is no evidence so far that momentum indicators are pointing to a correction for the dollar bloc currencies which all set new highs for the year today even though Australian dollar positions which quadrupled to 32,469 contracts from the end of March to the highest since August 2008, are now above the 2-year moving average; Net long New Zealand dollar positions, at 12,532 contracts (up from -2885 at the end of March) are at the highest since March 2008. Divergence indicators are also pointing up for the Canadian dollar and British pound. Both currencies have posted gains in April and May as the market cut short Canadian dollar and short sterling positions with net long Canadian dollar positions only emerging in May, a shift of 32,304 contracts from the end of March. The market remains short sterling though net shorts have been reduced 19% from the end of March. Sterling is trading at its highest level in 7 months and with momentum indicators still pointing higher, the pound could reach the mid-$1.60’s before turning lower.

This week’s events, particularly anticipation of US jobs data at the end of the week, may contribute to a shift in momentum indicators in favor of the US dollar. Central bank meetings may have less impact but do create risk events. For today, the data have been upbeat with much better than expected euro zone PMI manufacturing data providing further incentive to buy the euro – in addition to the euro zone PMI, regional PMIs from Germany, France, Italy, Spain and the UK all came in above expectations although below the 50/50 boom/bust level. Similarly, today’s US ISM manufacturing index is also expected to improve after a sting of mostly firmer regional indices. One number that could be somewhat negative is personal income excluding transfer payments such as unemployment.

There should be little evidence of inflation in today’s core PCE data. The report is likely to remain almost rock sold, diverging only slightly from the long term average of 1.8% y/y. The consensus is for 1.9%. Other recent inflation indicators have also shown little sign for concern. Euro zone May CPI came in at zero last week while the five year inflation expectation reported in the Michigan consumer confidence release rose marginally to 2.9% from 2.85% averaged over the past 10 months.

As I indicated in an earlier post last weekend, TIPS are a much better play than Treasuries if you want to be long U.S. government bonds, and the short-end of the curve is much better than the long-end because the likes of the Chinese are now avoiding long-dated Treasuries. The rally in U.S. government bonds was a relief rally because auctions went better than expected suggesting there is still appetite for U.S. paper, but the renewed pressure today demonstrates that the inflation trade is well under way, and that is bad for the U.S. dollar and dollar-based asset markets. This inflation trade seems to be pre-mature as deflationary forces are still of over-riding concern. However, clearly, the Fed will have its work cut out to stop inflation wants the reflationary mechanisms gather steam.

In today’s links, I linked out to an FT Alphaville article by Tracy Alloway which notes that Nassim Taleb suggests hyper-inflation as a ‘Black Swan’ hedge trade. This is a view that has gained currency via Marc Faber ( see my post here.) Personally, I think Faber is making a statement for effect. Nevertheless, the concept of taking out a small hyper-inflation hedge via out-of-the money puts might be a trade of value.