Buy American: Demand For Dollars, Bonds And Stocks

The new record high in U.S. stocks, simultaneous rally in the dollar, and rise in Treasury prices tell us investors loaded up on U.S. assets Monday. This demand is intriguing considering that U.S. data continues to surprise to the downside. Pending home sales dropped for the fifth straight month in October by 0.6%. According to last week's FOMC minutes, the Fed believes that housing market activity is losing momentum and the pending home sales report confirms that. Most likely Tuesday's building permits and house price reports will show the same disappointment. So the question is then why are U.S. assets rallying if economic data is moving in the wrong direction. The nuclear accord with Iran is perceived as a major win for President Obama and that has benefitted U.S. assets specifically Monday. A reduction in geopolitical uncertainty is always good for a country and with Iran in particular, it is a positive development for many countries around the world. In response, on what would have otherwise been a quiet trading day, risk appetite has improved with investors around the world increasing their exposure to risk assets.

However the simultaneous rally in the dollar, bonds and stocks is different from what we have seen in recent weeks. If the rally in stocks and bonds were driven by reduced expectations for Fed tapering the dollar would normally fall and if it is driven by increased expectations for 2013 tapering, if the dollar would rise and Treasury and stock prices would decline. Unless these moves are supported by stronger U.S. data, we don't expect the divergence to last. The dollar should be able to maintain its gains but bond prices should resume their slide, with yields edging higher and stocks likely to give up their gains in the near term. Of all the economic reports scheduled for release Tuesday, we believe that consumer confidence will be the most important. The reopening of the U.S. government next month should help to boost confidence, lending additional support to the greenback.

Euro To 1.32? Fundamentals, Technical And Positioning
Breakouts are happening across the foreign exchange market but to the frustration of many forex traders, EUR/USD has been missing out on the move. The currency pair has been trapped between a 180-pip range for the past 8 trading days while pairs like USD/JPY soar to a 5-month high and AUD/USD drops to a 2-month low. With the moves in the majors and yen crosses getting away from them, many traders are wondering if there will be a breakout opportunity in the EUR/USD soon. From the perspective of fundamentals, U.S. rates are headed higher so the EUR/USD should be trending lower as the dollar appreciates. However better than expected economic data out of Germany and mixed U.S. data is making investors reluctant about selling the pair. Members of the European Central Bank may be talking about negative interest rates but with Germany growing at a faster pace, troubles in France and the periphery nations could fall to the wayside. In fact positive surprises out of Germany is one of the main reasons why ECB President Draghi is dismissing all talk of negative rates. There is no question that the ECB maintains a dovish monetary policy stance and in the past, when we have heard consistent dovishness from members of the Governing Council, it was their way of preparing the market for a move. However the EUR/USD has not budged this time around because without Draghi's endorsement, traders are skeptical about how serious the central bank really is about negative rates. Also, all of the ECB officials who have talked about negative rates simply described it as a policy option -- they did not say that it is needed. At the same time, U.S. tapering in 2014 is still more likely than 2013 and that has limited the sell-off in EUR/USD. Also, the euro is the only realistic alternative reserve currency to the dollar and with the U.S. government expected to revisit the debt ceiling early next year, global reserve managers are starting to get tired of the U.S. fiscal fight. It is almost hard to believe that the battle in January/February will be the fourth in 2 years. The dollar will always represent an important share of reserves and the process for diversification will be gradual but right now the flows are supporting the currency. The following chart shows the recent correlation between the EUR/USD (gold line) and the price of German 10 year bonds (white line). Even with all of these fundamental factors in mind however, the fact that the ECB is more dovish than the Fed means that the EUR/USD should be headed lower and we believe that it should only be a matter of time before the currency pair drops down to 1.32.

From the perspective of positioning, the latest IMM report from the CFTC showed the smallest amount of long EUR/USD positions since August. Speculators have been net long euros for the past 3 months but the following chart shows how the steep sell-off in the EUR/USD (gold line) between October 29th and November 7 was a liquidation of those positions (white line). Based on tight correlation seen in the following chart, the latest reduction in long positions should have driven the EUR/USD even lower. A new downtrend will require not only liquidation of the rest of the EUR/USD short positions but also initiation of fresh shorts. Unfortunately from a technical perspective, there is no clear direction for the EUR/USD. A head and shoulders pattern appears to be forming but the structure of the pattern is far from perfect. There are 2 levels of support near current prices -- the 50% Fibonacci retracement of 2011-2012 sell-off and 1.3465, a level that was important in September and October. A break of 1.3465 would be required to open the downside for a move down to 1.32. On the upside, 1.650 would need to be broken to open the upside.

GBP: Triple Top?
The British pound's rejection of the 1.6250 level suggests that the currency pair is prime for a triple top. The only piece of U.K. data released Monday was the British Banker Association's loans for house purchases. Normally this report would not be exceptionally market moving for sterling but on Monday, the combination of U.S. dollar strength and a decline in loans was enough to drive the GBP/USD lower. In fact Monday's selloff in the currency pair was the largest in 8 trading days. The U.K. government has gone to great lengths to keep the housing market supported. In October, they launched the second part of their Help to Buy scheme and so far, the results have been limited. Back in April, the U.K. Treasury offered to top up loans to buyers of newly built homes. Last month, they announced plans to guarantee as much as 95% of loans for qualifying new and existing home buyers. While ambitious, the uptake has been weak because lenders were applying tough new affordability rules. We still expect the housing market to benefit from this new plan but it may take a few months before the results are seen. In the meantime, the question of whether Monday's pullback in GBP/USD turns into a top will depend on the market's demand for dollars. Most of this week's U.K. economic reports are second tier and not expected to have a significant impact on the GBP/USD especially since no revisions are expected to the third quarter GDP numbers and as such we would not be surprised in the currency pair pulled back to 1.60 in the near term.

Will The Iran Deal Impact The CAD?
The biggest story Monday was the nuclear deal struck with Iran over the weekend. Iran is a major oil player -- they are OPEC's second largest oil producer and the fourth largest oil reserves. However production has taken a bit hit due to sanctions and the hope by some traders is that the nuclear deal would ease restrictions on the country's energy sector. Unfortunately that is not the case. No additional oil will come onto the market as a result of the deal and for this reason the impact on oil prices and the Canadian dollar has been limited. If Iranian oil were to flow freely into the markets, it would drive oil prices and hence the Canadian dollar significantly lower but the sanctions that are being eased are related to the repatriation of overseas funds and not oil. However oil prices have moved lower because the Iranian deal stalls the U.S.' plans for further cuts in Iranian oil exports. As part of this deal, U.S. lawmakers have pledged not to impose new sanctions on oil over the next 6 months as long as Iran follows through on their pledge to curb their nuclear program. In response, the Canadian dollar sold off sharply against the U.S. dollar, recovering nearly all of Friday's intraday losses. 1.06 is in sight for USD/CAD and we expect this level to be tested. Meanwhile the Australian dollar extended lower for the fourth consecutive trading day to its lowest level in 2 months while the New Zealand dollar held steady. No major economic reports were released from either country but the decline in 10-year Australian bond yields has driven the A$ lower.

Nikkei Rally Drives Yen Crosses To Fresh Highs
Thanks to another 1.5% rally in the Nikkei, Japanese Yen crosses climbed to fresh multiyear highs. Strength was also seen in USD/JPY which rose to its highest level since May. With no economic reports released from Japan overnight and nothing noteworthy mentioned by Bank of Japan Governor Kuroda at a luncheon, the Yen crosses benefitted from the overall improvement in risk appetite. This is a busy week for Japan but the calendar does not heat up until Thursday. Given the recent breakouts in USD/JPY, there is no major resistance until the 2013 high of 103.75. If this level is broken, it should be clear sailing to 105 for USD/JPY in a move that should lift all of the Yen crosses. While U.S. yields are taking a break after last week's rally, Japanese stocks should continue to rise alongside U.S. equities. There's very strong correlation between USD/JPY and Nikkei -- so with monetary policy in Japan expected to support stocks for the next year, further gains in the Nikkei should promote a stronger rally in USD/JPY. This week's economic reports should show a continued recovery in Japan although economists are looking for more downside than upside surprises. The greatest risk for Japan in the coming year is the consumption tax hike. If this week's consumer spending numbers show a slowdown in demand, investors could start to wonder if consumers are as resilient as the Japanese government hopes. We know that the BoJ believes households have budgeted the upcoming tax hike into their spending plans but with the tax not set to be increased for another 4 months, this may be wishful thinking.

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.