Dollar Consolidation Ending, Poised For New Leg Up

The US dollar has been consolidating for the past couple of weeks, and that phase appears to be coming to an end. This coming week's economic data and events will likely underscore the divergent theme, which works in the dollar's favor.

We do not expect the ECB to announce a sovereign bond purchase program at this coming week's meeting, the last of the year. Recall that when Lithuania joins the EMU on January 1, the ECB will reduce its policy making meetings from once a month to once every six weeks, like the Federal Reserve. It also introduces a rotating voting scheme, which means that all member central banks, including the Bundesbank, will not vote at every meeting.

Many important ECB decisions have taken place over the objections of the Bundesbank,such as the initial bond buying program SMP and OMT (which the Bundesbank has argued against before the European Court of Justice), and the recent covered bond and asset-backed securities purchase plans. Nevertheless, many observers still see the Bundesbank as having some sort of veto over ECB action, even though such veto power has not been tested. Others argue that the rotating voting is of little consequence in the ECB's deliberative process. It is not as if, they say, the ECB will be able to take action just because the BBK did not have a vote at a particular meeting.

The biggest development has been a breakdown in oil prices. It will add to the divergent theme. Even though US oil output surpassed Saudi Arabia in recent weeks, American policy makers will view it as a net stimulative for the US economy. It is tantamount to a modest tax cut. In terms of the impact on inflation, the Federal Reserve puts more emphasis on the core rate.

In contrast, the drop in energy prices will be seen exacerbating the disinflationary/deflationary headwinds in the euro area. This, more than the small stimulus that BBK's Weidmann acknowledged, will be the focus of the ECB. While the Bank of Japan places greater weight on the core measure of inflation, excluding the sales tax, its core measure includes energy.

The euro has largely been confined to a $1.24-$1.26 trading range through November. The lower end has been frayed a bit, but the breaks were not sustained. Technical indicators are not generating strong signals presently, however, ahead of the ECB meeting on December 4 the risk is on the downside. The message from ECB officials appears to be that they want to see how the existing initiatives pan out over the coming weeks before taking new action.

However, it will emphasize that all its options are open, including sovereign bond purchases. Moreover, ECB officials cannot be very happy that the new EC Commission, like the old, is not insisting forcefully enough on structural reforms. The combination of ECB meeting and the US employment data at the end of next week gives the euro potential toward its cyclical low recorded on November 7 just below $1.2360. A surprise move by the ECB could send it lower still. The next key target is $1.20.

Sterling is pointing the way. It has been in a four cent range this month, mostly between $1.56 and $1.60. Since the middle of the month it has, with one brief exception, stayed in the lower half of that range. The precipitous drop in oil prices is yet another factor pushing the market in the direction it was going in any event, and that is to defer the first rate hike. Ahead of the weekend, the December 2015 short-sterling futures contract set a new high for the year (which implies lower interest rate). A break of $1.56 targets $1.5540 then $1.5500. We see near-term potential extending toward $1.5425.

The range for dollar-yen last week was set over the last two sessions. The dollar had eased to JPY117.25 on Thursday before OPEC's announcement and rallied to hit a high near JPY118.80 on Friday. The dollar is poised to rise through the previous high set just below JPY119. The JPY120 level is likely to be a more formidable obstacle. While officials seem more concerned about the pace than the level, there have been some officials (like Finance Minister Aso) and former officials (like Sakakibara) who are getting more concerned about the level. Despite claims by some journalists that Japanese monetary policy is tantamount to a shot in a currency war, few countries have objected to the BOJ's course.

Within the dollar-bloc, we had liked the Canadian dollar over the Australian dollar. That worked out fine until the OPEC meeting. In fact, the day before OPEC met, the Australian dollar had fallen to its lowest levels against the Canadian dollar since January. However, despite higher than expected October inflation, a stronger than expected Q3 GDP, and a more dynamic US economy (judging from Q3 GDP's unexpected upward revision), the drop in sharp drop in oil prices proved too much for the Canadian dollar. There is room for the Aussie to extend its correction against the Canadian dollar. That said, we are cognizant that both central banks meet next week and that the RBA presses harder than the BOC against their respective currencies.

The US dollar is challenging the multi-year high set on November 5 just below CAD1.1470. A move through there targets CAD1.1670-CAD1.1725. Technical indicators are generally supportive of the US dollar. However, its sharp two-day gain leaves it just below the upper Bollinger® Band (~CAD1.1440). This suggests buying a modest dip is preferred to chasing the market. For its part, the Australian dollar is also flirting with its (lower) Bollinger Band just below $0.8500. The Aussie's price action is a bit more constructive than for the Canadian dollar, especially given that the $0.8480 multi-year low set at midweek held on the retest at the end of the week. To be clear, the downtrend still seems to be intact.

The Mexican peso cracked under the weight of the political woes and the drop in oil prices. The peso fell each day last week for a cumulative loss of 2.3%, the most since September 2013. Of the major currencies, only the Norwegian krone lost more (3.1%). Within Latam, the Bazilian real (-2.4%) and the Colombian peso (-3.2%) lost more than Mexico. Mexico's stock market fared better than the other two markets as well: (Brazil's Bovespa -2.1% and Colombia's COLCAP -5%, with Mexico's Bolsa off about 0.6%).

Turning to other markets, the U.S. 10-Year yield slipped through the 2.20% level. With Q4 growth tracking around 2.5% and the drop in oil prices, inflation expectations will likely soften further. The risk is that the 10-year yield eases to 2.13%, and possibly to 2.06% in the period ahead. Energy accounts for a larger component of the S&P 500 than the Dow Industrials and NASDAQ. This could hold back this key benchmark, which staged a key reversal before the weekend (it set a new record high before falling and closing below the previous session's low).

The S&P 500 gapped higher on November 21. The gap has not been filled yet, but the technical condition is such that the gap could be filled in the week ahead. The gap is found between 2053.84 and 2056.75. In last week's technical note, we had suggested that the Dow Jones STOXX 600 could begin outperforming the US S&P 500. This was the case (1.65% to 0.7%). The technical case for this continues.

In terms of oil prices themselves, the downside beckons. We are using a light sweet futures continuation contract to determine downside targets. The next target is the spike low from 2010 which was near $64.25. Below there, is the $59.50-$60.00 band that could slow the descent. That said, the January contract closed more than three standard deviations below the 20-day moving average (Bollinger Band is set at two standard deviations). Given the speed of the descent that was fundamentally driven, it is difficult to have much confidence in the magnitude of a corrective bounce. We suspect it will be shallow and capped around $70 a barrel.

(Due to the holiday, the latest CTFC Commitment of Traders report is unavailable)