Crunch points could be near for euro / dollar, dollar / yen

One very interesting question in the minds of many market participants is what will happen to the US dollar and whether its rally since May / June of 2014 has now finally come to an end. Technically speaking, the prospects of its major rivals such as the yen and the euro, are looking much better for the moment. The dollar is looking bearish in both euro / dollar and dollar / yen as the 200-day moving average and the Ichimoku cloud show – at least on the daily charts. The moves against the dollar may look a bit excessive according to the Relative Strength Index, but short-term technical traders would nevertheless wait for an opportunity to short rather than go long the greenback.

Overall the bearish case for the dollar is being greatly helped by the Federal Reserve’s backtracking on its plans to raise interest rates 4 times during 2016. There have also been some soft indications in terms of business investment and trade, while consumption as mirrored by retail sales and consumer confidence, is also facing challenges. It looks like the Fed will not raise rates even once during the first half of the year, since a Fed official recently sounded concerned about the possibility of Brexit and the implications of such a scenario for the world economy. This is mentioned because the Fed is going to meet on interest rates a few days before the UK referendum on EU membership and unless the polls start showing that the ‘leave’ vote is no longer competitive (something unlikely given the present polls), the Fed might not want to deliver more bad news to the world economy in terms of higher interest rates days before a potential Brexit shock will rock the UK and wider European economies.

This would leave a narrow window of the July and September meetings in which to deliver an interest rate increase since the November meeting is also likely to be avoided because of the US Presidential elections a few days afterwards. Even during the July and September meetings, the Fed is giving the impression it will only hike if Brexit is averted, if things in China are under control, if financial markets are calm, if the price of oil stays supported, if the US labor market continues to improve, if inflation moves higher etc. In short, there are a lot of conditions that need to be met and a lot of things that need to go ‘right’ for the Fed to raise rates from the present 0.25-0.50% range to 0.50-0.75%. This realization has been painful for dollar bulls who were banking on the theme of monetary policy divergence and higher US interest rates to strengthen the greenback.

It is helpful at this point to keep in mind that currency pairs always involve one currency relative to another. The fact for example that US dollar interest rates are not going to rise as fast as first anticipated, does not necessarily mean that the US dollar will drop, as long as other central banks exceed expectations on the stimulus side. This is now the main question for the dollar / yen exchange rate for example. How Japanese authorities will react to the recent strengthening of the yen and the downgrading of the country’s inflation and growth prospects is very important. The inaction of the Bank of Japan at its meeting on April 28 led to a big selloff in dollar / yen as it seemed that policymakers were not in a hurry and taking their time to assess the situation before additional action. This is not the same however as saying that the bank will also not react during its next meeting on June 15/16, which will deliver a verdict a few hours after the June Fed meeting ends by the way. The market looks like it is testing the Japanese authorities to see at which point they will react. As a weaker yen has been an important part of the Abenomics policies to reinvigorate the Japanese economy, there could be an attempt at some point to drive the currency lower again. The tricky part is that Japan will not be able to target the yen directly in order not to anger its G7 partners but to achieve this through monetary stimulus of some sorts. Therefore given the state of the Japanese economy and the desire of the authorities to see a weaker yen, the yen rally could run out of fuel sooner rather than later despite the yen’s positive technical picture.

Finally, concerning euro / dollar, it looks like the euro is trying to break out of the 1.05-1.15 range it has been in for the past 15 months or so (save 1 or 2 spikes above this area). However, the euro’s rally to these levels could have also been the result of excessive dollar positioning and the hunting of stops around the 1.15 area – as this has been a well-established range and it is understandable that speculators might have tried to take advantage of it. There have also been some positive news for the Eurozone economy in terms of stable business sentiment surveys and steady – if unremarkable – growth. There is also a feeling that the ECB might have reached its limits in terms of stimulus. Given the region’s reliance on exports and a slowing global economy, there are also concerns at how much stronger the euro can get before it becomes an issue for businesses (note that no complaints have been heard thus far). At the same time, the ECB is continuing to aggressively pursue monetary stimulus through quantitative easing and negative interest rates.

To sum up, although the technical picture of the euro and the yen versus the US dollar is looking good at the moment, it is less clear what medium-term fundamental arguments one can make in favor of the two currencies against the dollar. True, the Fed has been more dovish than expected this year, but it’s also possible that neither the Bank of Japan nor the European Central Bank have said their last word in terms of extra stimulus.