Aug 15-21: Market Positioned for a USD Trend Resumption, Risk of Liquidation Not Ruled Out
Posted on: 21 Aug, 2018
Overall, the changes in market positioning ever since the bullish breakout in the DXY (bearish euro/US dollar) continue to signal a market that is supportive of the US dollar, with the recent sell-off in the American currency mainly a result of a removal of liquidity in thin market conditions.
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In the following article, based on the Commitment of Traders report, I dig into the latest positioning by options and futures traders from Aug 15th to Aug 21st, an analysis that helps me in gauging ‘forward-looking’ biases in the currency market. Overall, the changes in market positioning ever since the bullish breakout in the DXY (bearish euro/US dollar) continue to signal a market that is supportive of the US dollar, with the recent sell-off in the American currency mainly a result of a removal of liquidity in thin market conditions. I still see little enough evidence to suggest a turnaround in the prevalent US dollar trend, given that the majority of the contracts’ increases in August remain outstanding and were supportive of an eventual resumption in the US dollar trend.
That said, another scenario that is slowly shaping up as a potential outcome worth taking note is the increasing risks of prolonged ‘risk-appetite’ conditions that may continue to affect market sentiment and consequently hit the appeal towards the safe haven status of the US dollar. Any continuation of the risk appetite profile seen in the last 2 weeks and we could be looking at a US dollar market in trouble, which would potentially force a mass liquidation of US dollar longs should key levels be retaken. Not the main scenario.
As an example of factors that may undermine capital flows into the US dollar, it includes a less hawkish Fed as evidenced by the last intervention of its Chairman Jerome Powell at the Jackson Hole Symposium on Friday, renewed strength in the Chinese yuan after the re-introduction of counter-cyclical measures by the PBoC (Central Bank of China), a new NAFTA deal nearing or an easing of tensions in emerging markets. These are all risks building up for the US dollar that should not be taken for granted.
Main Takeaways from the Euro Contract (6E – CME)
The recovery in the euro keeps its course amid lower open interest, which adds to the prevailing view of the overall positioning still favoring the US dollar bull trend, following a nearly 300 pips sell-off from Aug 7th to 14th on the highest open interest seen since late May this year.
Adding to the US dollar bullish case is the absence of buy-side engagement by large specs on the corrective wave since Aug 15, reinforcing the bearish stance. Total large specs stood flat around -5k total contracts despite the vigorous and impulsive recovery in the euro/US dollar rate.
Interestingly, total commercials saw a notable increase, with both net buying ratcheting up but most intriguing, commercials shorts failed to reinstate short positions even as the rate was snapped back up from 1.13 to 1.16. The lack of involvement by short commercials reveals this group felt not compelled to sell the underlying contract to minimize the risk of exchange rate variations, which tends to occur when they expect better (higher) levels to hedge. This information is a conflictive input for the US dollar and raises questions about the health of the trend.
Leverage funds were caught wrong-sided, as an increase of over 10k new short contracts against a reduction in 6k longs was not sufficient to see any payoff. What this also reinforces is the notion that the increase in the exchange rate runs on a worryingly thin (month of August weighs) buy-side commitment.
Appeasing for the interest of US dollar bulls should be the fact that dealers (net hedgers) increased their long exposure significantly on the way down, while seemingly not interested to sell at higher levels, which essentially should communicate the low need to hedge due to the limited demand of financial strategies by institutions to gain long EUR exposure.
Main Takeaways from the Sterling Contract (6B – CME)
The latest changes in open interest show continued substantial increases in overall trading activity, most notably on the sell-side, with large specs shorts adding over 20k new contracts vs 11k longs, which helps maintain an overall bearish outlook given the proportionally aggressive addition of sell-side contracts.
What remains quite intriguing is the fact that in the sterling contract, there were no signs of commercials getting back into the sell-side despite the recovery in the exchange rate. On the contrary, commercial longs were busy adding longs as 1.27 was seen as an opportunity to hedge.
As in the case of the euro/US dollar, leverage funds were quite active on the sell-side, despite failing to find much follow through in a week where risk appetite dominated.
Dealers kept adding longs aggressively to eradicate their short-side exposure, which comes from designing financial products that get allocated to institutional clients. At the moment, the demand to short the GBP remains very strong. In this case, the spike in dealer longs is yet another reassurance that insiders at dealing desks are taking no chances to let the downside extend without being appropriately hedged via the buying of sterlings.
Strengthening the bearish case for the sterling is the increase in total asset manager shorts, which came at -48.5k vs -44k last. The addition of shorts by these ‘trend following’ account types is another piece of the puzzle that keeps the risk skewed to the downside.
Main Takeaways from the Japanese Yen Contract (6J – CME)
After no changes in open interest the previous week, the week of Aug 15th to Aug 21st saw the open interest increase by 5.5k as the rate tested the critical 110.00 macro level.
Large specs were predominantly long yens, rising their bets on the Yen buy-side by 4k new contracts, although most notably, the appreciation of the currency last week can also be partly explained by a removal of liquidity, as large specs short Yen lightened up from 108k to 101k. We saw the exact same pattern play out via leverage funds.
The retest of 110.00, as one would expect, served as an opportunity for the commercial accounts to dial up their yen short exposure, taking the total commercial contracts from 85k to 73k, in what should be perceived as a logical strategic move by Japanese exporters.
The overall positioning in dealers communicates a familiar theme, that is, the overwhelming demand to allocate financial strategies short yens are forcing dealers to favour longs in a more aggressive fashion, which is for now, a clear bearish sign for the 6J contract (bullish USD/JPY).
Another clue anchoring the bearish view in the contract was the renewed commitment by asset managers to engage in short-sided business as 110.00 was re-tested, resulting in a total increase of net shorts from -3.8k to -8.6k.
Main Takeaways from the Australian Dollar Contract (6A – CME)
Right off the bat, the first hint that last week’s rebound in the Australian dollar may lack sufficient momentum is the revelation that open interest was lower, moving from 169k to 165.7k. What this means is that the adjustment in the rate can be partly explained by a removal of liquidity.
There was a tepid increase in large specs longs, to the tune of 2.4k vs 1.5k shorts bailed out. The changes were rather pyrrhic and not altering the overall bearish picture, especially on the back of the strong increase in short-side open interest on the range breakout.
Despite commercials had yet another chance at gaining exposure to long contracts on the test of 0.72, there was no involvement whatsoever, which tells me there is a perception that risks remain to the downside, and as such, they might feel comfortable not hedging the exchange variations in expectations of lower levels later in the year, which makes sense amid the divergence in bond yield spreads between Australia and the United States, at decade lows.
If anything, the total inaction from asset managers last week, coupled with an increase in dealer longs, should weigh further on the case for the Aussie to stay under pressure.
It’s undeniable that the majority of market participants in futures and options remain with allocations set to benefit if the US dollar were to appreciate from its current levels. After 2 weeks of recovery in sentiment, the market has come at a crossroad, and what we know for certain is that theEUR/USD is testing its previous multi-month range breakout point and PoC (Point of Control), one that was resolved amid an increase in both volumes and open interest. Therefore, if history is any indication, the most sensible scenario whenever a breakout carries these characteristics tends to be a continuation of the underlying trend as long as the conditions that led to aggressively bet towards the US dollar remain in place.
The question we should ask, therefore, is, do they? Let’s look into what have been the main drivers invigorating the US dollar rally in August, and to what extent the recovery in the EUR/USD (a proxy for DXY) justifies these levels. As illustrated in the chart below, the risk profile has recovered but remains far from the hefty levels seen earlier in the month, the 2-yr German vs US bond yield spread remains largely neutral, the Italian vs German 10-yr yield premium has continued to escalate, while last but not least, the EUR/USD rate is testing the area that saw the most accumulation of volume from June until present time. All these factors argue for therecovery in the exchange rate to be limited from current levels.On the contrary, the 10-yr German vs US bond yield spread has seen a major breakout higher, and that should warrant caution.
At the end of the day, however, I find there are still enough underlying factors that fail to justify higher levels beyond the ‘make-or-break’ resistance area at 1.1650-1.1710. However, if we were to witness a sea change that causes the buy-side to take control of the PoC, the run to the exits by an overly committed long US dollar market could be one to remember. So, have an open mind, adapt to the constant change of conditions, but be well aware that this is where the market stands as of today, Aug 27th.
Volume & OI: Open interest represents the total number of contracts, including both buy and sell positions, outstanding between all market participants. We should think of open interest as new business (additional liquidity). Open interest is closely linked to liquidity. Generally, to gain conviction over a potentially developing bullish market, we could analyze whether or not open interest increases, new buyers coming in, which fuels the continuation higher on renewed commitment, ideally replicated by volume increasing or at least maintaining a steady measure. If on a bullish market, the open interest is decreasing, it has a different meaning all together, suggesting shorts covering, players stopped out, and hence money is leaving the market. This information to understand move dynamics is key.
Large Specs: The Net Non-Commercial Positions, often referred as Large Specs, comprise contracts held by large speculators, mainly hedge funds and banks trading currency futures for speculation purposes. Speculators, for the most part, have no need to use the futures market as hedging, with the sole intention being speculative in nature, buy or sell at a profit, before the contract becomes due. This category tends to carry large positions and are often guided by fundamental developments. Historically, they are characterized by being trend-followers and tend to get the right directional bias.
Commercials: Entities that are commercially engaged in business activities hedged by the use of the futures or option markets. The main characteristic of this group is that their activity orbits around the need to buy or sell the underlying contract to minimize the risk of exchange rate variations in the future. Like the large specs, this group also tends to carry large positions at times and due to the hedging nature of its activity, act as contrarian traders, best buying when prices are low and vice versa.
Dealers: These participants are typically described as the “sell side” of the market or net hedgers. They don’t take positions to speculate for profits, but instead design various financial strategies to allocate assets to institutional clients. They help us understand supply and demand dynamics and act as liquidity providers and tend to have matched books or offset their risk across markets and clients. Futures contracts are part of the pricing and balancing of risk associated with the products they sell and their activities. These include large banks (U.S. and non-U.S.) and dealers in securities, swaps and other derivatives. These participants track very closely the open interest.
Asset Managers: These are institutional investors who tend to act slowly in established trends, which include pension funds, endowments, academic institutions, insurance companies, mutual funds and those portfolio/investment managers who predominantly represent institutional clients. Their performance is based on the average of the industry, not in the business of taking contrarian positions and/or changing their macro view that often.
Leveraged Funds: These are typically hedge funds and various types of money managers, including registered commodity trading advisors (CTAs); registered commodity pool operators (CPOs) or unregistered funds identified by CFTC. The strategies may involve taking outright positions or arbitrage within and across markets. The traders may be engaged in managing and conducting proprietary futures trading and trading on behalf of speculative clients.