Last week, we recognized that the US dollar was overstretched and anticipated some consolidation/correction. Yet the pace and magnitude of the move was surprising, especially in light of the series of disappointing developments in Europe, which include the initial failure to resolve Greece's funding problems and the EU's next 7-year budget. Nor was the economic data inspiring, as the main report of the week, the Nov flash PMI reading, suggests the euro area economy continues to contract here in Q4.
In contrast, the US reported stronger than expect existing home sales and housing starts, as the painfully slow recovery in the housing market continues. Weekly initial jobless claims slipped back as the impact of the east coast storm fades. The newly introduced Markit PMI reading was above consensus forecasts. The University of Michigan's final consumer confidence measure for November was a bit softer than the preliminary report, but still is at 4 1/2 year highs.
Admittedly, the key issue in the US is not how the economy is performing now, but the looming fiscal cliff. The noises and signals emerging from Washington seemed to be a source of some confidence that the worst of it will be averted, though we continue to suspect that brinkmanship tactics will make for only a last minute deal (if not a slightly later one) Yet the optimism was frequently cited for the S&P gains last week.
Recall that the S&P 500 rallied about 16.5% from early June through mid-September. We turned cautious here (Sept 22), anticipating a decline to at least 1400. The S&P overshot this, but staged a reversal on Nov 16 and saw impressive follow through last week. In fact, the S&P's 4.1% advance last week, was the best since June and all the main industry groups, save utilities, participated.
With the pre-weekend advance, the S&P 500 has retraced 50% of its two month slide. The next retracement level is near 1424 and the month's high comes in near 1434. These are the main two technical barriers ahead of a return to the year's high near 1475. We note that the 5-day moving average of the S&P 500 is poised to cross above the 20-day average early next week. In addition, what could be a head and shoulders bottom projects toward 1435. The correlations between the foreign currencies and the S&P 500 has declined over the past few months, but has begun to increase again recently.
Some observers emphasized that even though the European finance ministers initially failed to reach an agreement on Greek funding, a resolution remains imminent and that this lifted the euro. Since the market did not punish the euro on disappointment, we suspect it is not really rewarding the euro because of a soon-to-be-announced agreement. Moreover, baring a dramatic reduction in Greece's debt, which given the ownership structure, will require at some point at least partial forgiveness by officials, the Greek situation will have to be revisited.
We do not see the price action in the foreign exchange market as being fundamentally driven, though post hoc narratives can always be written. Instead, we suggest that the dramatic sell-off in the yen, spurred by anticipation that the next Japanese government will take aggressive measures that will debase the currency. The yen's move forced cross rate adjustments and this took on a life of its own.
Many short-term market participants had been leaning in the wrong direction. The market had been technically poised to set the dollar back, as we suggested last week the dollar bulls had over-reached, as speculators in the futures market (a proxy, we think, for trend followers and momentum traders) were adding on to short foreign currency positions or cutting longs.
If this is correct, the performance of the yen may hold the key to the general dollar performance in the days ahead. As we note below, we see no technical sign that the yen has bottomed and this implies additional near-term dollar weakness is likely. Good selling of the yen, against the dollar and crosses, is still seen on the modest upticks. The weak yen theme may also renew interest in using the yen as a funding currency, ironically shortly after some observers sounded the death knell of the carry trade.
Euro: After spending most of the month below the technically important $1.28 area, the euro jumped back above last week. A rounded bottom has been carved out and the $1.2840 area should now offer support. On the upside, the next test of the bulls' resolve will be in the $1.3000-30 area. The potential downtrend drawn off the mid-Sept and mid-Oct highs comes in near $1.31 by the end of the month. Technical indicators, like RSI and MACDs, are constructive and the 5-day moving average crossed above the 20-day average at the end of last week, suggesting short-term models and momentum traders are getting positive signals. Constructive technical outlook.
Yen: Japan's macro-economic conditions, like the contracting economy, large, even if not heavy, debt burden, and deteriorating external accounts, offer textbook fundamental reasons not to like the yen. However, it took the threat of significant currency debasement by the man expected to become the next prime minister to spur the yen's slide. The adjustment does not appear over, even if the recent pace, a 3.6% slide since November 13 is not sustained. Dollar support is seen near JPY81.60-80. On the upside, there has been reports of good demand for JPY83 and JPY84 strikes. This year's high, thus far, was set in March near JPY84.18. Last year's high was recorded in April near JPY85.50. Demand for euros against the yen may have helped begun the euro rally. The euro is poised to move toward the JPY111 area. Negative technical outlook for the yen.
Sterling: While it has lagged behind the euro, sterling has also gained against the greenback. However, unlike the euro, sterling closed only once below the 200-day moving average, where the euro spent most of the month below it. Sterling's 5-day moving average has not crossed above the 20-day average, it likely will in the week ahead. Momentum and MACD indicators are constructive. The next technical hurdle is seen near $1.6050 and when it is overcome, it could spur another cent or so advance. Initial support is seen near $1.5960 and then $1.5920. Constructive technical outlook for sterling.
Swiss franc: Dragged higher by the euro, the franc is poised to appreciate further against the dollar in the period ahead. The dollar has carved out a round top, confirmed by the push through CHF0.9400. It is testing the CHF0.9280 area now on its way to CHF0.9200. However, significant support for the dollar is not seen until closer to CHF0.9200. The dollar's 5-day moving average crossed below the 20-day on Thursday last week, a day before the euro's averages crossed. Technical indicators suggest plenty of scope for additional near-term dollar losses. Constructive technical outlook for the franc.
Australian dollar: With news that the Chinese economy showing signs of bottoming and many investors looking past the likely early December RBA rat cut, that the Australian dollar advance is not surprising. What is surprising is that it was among the weaker performers. Technical tools are neutral to positive. The next are of resistance is seen in the $1.0480-$1.0500 band. However, the critical cap is not seen until closer to $1.0600-$1.0625, the highs from August and September. Support is seen near $1.0380-$1.0400. Constructive technical outlook for the Australian dollar, but look for it to continue to lag.
Mexican peso: The dollar's recovery against the peso since early October is over, with a convincing violation of the uptrend line. New offers are likely to help cap dollar bounces in MXN13.05-08 area. On the downside the immediate target is MXN12.90 and then MXN12.77-MXN12.80. Long peso, short yen positions posses both carry and momentum features. Constructive technical outlook for the peso and an attractive yield pick-up.