Dollar Prone to Steady Retracement if Risk Aversion Flags Next Week The fundamental high-water mark for the dollar to extend its rally to 11-month highs proved out of reach through the end of this past week. And, with only two weeks left in the trading year (with severe liquidity dampeners along the way), the greenback may have posted its last attempt at forging a lasting rally until at least the second or third week of the new year. Taking stock of market conditions, it is clear that it would be a struggle to support lasting moves (bullish or bearish). From a fundamental perspective, we have seen the limitations of negative market developments (like the Fed’s refusal to expand stimulus and rating agencies’ downgrade of multiple systemically-important banks) garner much smaller swings in speculative positioning than what we would have expected just a month ago. From a capital flows standpoint, participation itself is dampened by the steady unwinding of risky positioning and diminished turnover that is typical of this time of year. Even the surge in volume from the S&P 500 Index through Friday (1.39 billion shares, the most active day since September 16th) can be traced back to the ‘quadruple witching hour’ expiration and pre-holiday liquidation. Investors have little reason to build up speculative positions through the next two weeks – especially as thinned liquidity could lead to difficulty unwinding should another (not-so-surprising these days) Black Swan event occur. However, those that are holding onto their exposure and hoping for a quiet transition to the new year will no doubt be on edge and ready to liquidate at the hint of a real crisis. Though the threshold for negative developments is raised; it is still within reach of some recent concerns. The most immediate threat is a significant downgrade to one of the critical components to the Euro-area rescue (generally the AAA-rated EU members or the EFSF itself), which would escalate the risk of an unstable situation turning into a chaotic one. The true risk to the system (and thereby the most appealing scenario for the dollar) would be the unchecked spread of the European troubles to the US and advanced Asian economies. The transmission of financial trouble is made much easier by the reality that the Fed does not support further stimulus or preemptive assistance for Europe. Another interesting consideration to keep track of going forward is the extreme positioning on EURUSD. According to the recently released COT figures through December 13th, the net short Euro futures holdings are the highest we have seen on record. A short covering drive (unwinding speculative short interest) or short squeeze (forced short covering in the thin liquidity conditions) are higher risks scenarios in current conditions. Euro Traders Weigh ECB’s Liquidity Program against Downgrade Threat The euro is sitting on a keg of fundamental dynamite and officials are hoping that nothing happens to set it off before they can build up additional defenses. The problem is that hoping for a quiet market and the promise in the ECB’s planned lending operation for the upcoming week does not offset the potential risks that the economy and market face. On Tuesday, the central bank will open for bids from European banks for three-year and three-month, low rate loans. For a market that has shown financial stress through quickly rising ECB temporary liquidity facilities, sharply higher costs for US dollars (the Euro-USD basis swap spread) and market credit risk (Libor-overnight index spread) at highs last seen since the first quarter of 2009; this would seem a direct solution. However, higher levels of potentially stigmatic liquidity does not encourage banks to lend once again to each other or purchases government bonds when they have to themselves raise capital ratios. In contrast, the risk is that there is a rating downgrade for a critical player in the EU rescue effort. Moody’s cut Belgium two steps on Friday, but we are looking at the AAAs. New Zealand Dollar Showing Standout Strength as Market Rates Climb Over the past five months, Australian market rates (three-month Libor) have dropped significantly (guided by rate cuts and encouraged further by the risk of further moves); but the New Zealand dollar equivalent has climbed to nine-month highs in that same period. With risk leveling off somewhat, the improving yield is offering some buoyancy to the investment currency. Next week, we will look for possible catalysts (or dampeners) to this drift in 3Q GDP, 4Q consumer confidence or December business sentiment figures. Japanese Yen: Will the Bank of Japan Rock the Boat before Year End? We have a Bank of Japan rate decision scheduled for release sometime in the early hours of Thursday’s Tokyo trading session. Should we expect a move from the policy authority at this particular meeting? The lower liquidity would certainly amplify any intervention efforts they would make. Yet, given the political and policy efforts we have seen lately; the probability of such an ambitious move is low. Swiss Franc Wedged between SNB Efforts and European Crisis The market may not be too concerned about the risk the BoJ poses; but they are certainly weary of what the Swiss central bank will do. The relief rally that the franc experienced after the SNB kept its floor unchanged this past week was a reflection of the market’s fears. With EURCHF once again moving closer to the 1.2000 limit, the market is testing the resolve in one of the most aggressive interventions of modern time. British Pound Likely Pricing Little Risk in BoE Minutes, Sentiment Reports There is a considerable round of event risk on the pound’s docket for the upcoming week; but we have to question whether it would generate substantial volatility. Though we have two consumer confidence surveys, a housing sector figure, final details on 3Q GDP and public finance numbers, they don’t tap into the underlying concerns. The BoE minutes may come closer; but we are unlikely to see a clear stimulus timeframe.

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