What are the Odds of a Correction in the Dollar?

The U.S. dollar has had a great run over the past 3 weeks but now that Non-Farm Payrolls, the ECB, BoJ and FOMC rate decisions are behind us we see a 70% chance of a correction next week. When the Fed upgraded its assessment of the labor market, they set expectations for a very strong non-farm payrolls report and unfortunately Friday's jobs number failed to impress, sending the dollar lower against all of the major currencies. The unemployment rate dropped to 5.8% from 5.9% but the U.S. economy added only 214k jobs compared to a forecast for 235k. While the miss was small and unlikely to delay the Fed's plans for tightening, the greenback is extremely overbought and the lack of U.S. data next week should allow the dollar to catch up to the decline in U.S. rates.

While policy divergence has created voracious demand for U.S. dollars, it failed to trigger a significant recovery in U.S. rates. In fact 10 year Treasury yields fell sharply on Friday and is still trading well below its 1-year average. Of course the problem is that the demand for Treasuries is as strong as ever. The bid to cover ratio of government debt auctions this year has been very strong as foreign central banks, insurers, pensions and investors offset slowing demand from the Fed. Slower growth in Europe and China also increased the attractiveness of U.S. assets. With Friday's retail sales report being the only major U.S. economic release on next week's calendar, the dollar could fall further as investors use the low level of U.S. rates as a reason to take profits near key levels in USD/JPY and EUR/USD.

The strength of the greenback is also becoming a growing a headache for policymakers around the world. Not only does it keep commodity prices low and inflation from rising - creating a big problem for oil producing nations but it also raises the cost of dollar denominated debt for emerging market nations at a time when many of these countries face economic slowdown. Yet not all central bank intervention has been to offset dollar strength. There's talk that Taiwan sold its currency to boost the competitiveness of exports this past week and next week the Bank of Korea is expected to lower interest rates to stay competitive with the weakening Yen.

Positioning also supports our view for a dollar will decline in the coming week. According to the CFTC's IMM report, EUR/USD short positions are at their highest level since July 2012. No additional developments that could potentially change the market's expectations for the Fed and ECB's course are expected for the next 3 weeks so there's a strong motivation to take profits at current levels especially on the back of a light data week.

In summary, there are at least 4 reasons why we believe the dollar is due for a pullback:

1. U.S. Rates

2. Light Data

3. Central Bank Intervention

4. Speculative Positioning

However even though the dollar could see another 1.5 to 3% decline, we are still in the middle of a longer term dollar bull run. This means there are 2 ways to take advantage of this potential move. Short-term speculators can buy the EUR/USD for a run to 1.26 or sell USD/JPY for a move back down to 112.50. Longer term investors can use this same opportunity to add to long dollar positions at lower levels.