USD: Wake up and smell the (bearish) coffee

The latest CFTC positioning data for the week until 26 May suggests that despite AUD, NZD, and CAD currencies already having rallied to USD/0.6630, USD/0.6200, and 1.3775/USD respectively in the reporting week, speculative accounts were still running large short positions. The chart below shows that net short positioning in these currencies was still sitting at the lower one standard deviation band of the five-year range.

There are signs that the dollar bear trend is becoming more broad-based

One could then attribute the recent rally in commodity FX (2%+ over the last two weeks) merely to a short squeeze triggered by a further turn around in the oil story and perhaps, more importantly, a sense that, as a continent, Europe will contribute to the global rebound (as it did in 2017) rather than be a drag.

But as we discussed last week, there are signs that the dollar bear trend is becoming more broad-based and that even EUR/USD, where the speculative market is already substantially long EUR, is considering a top-side break-out.

There are some interesting signals emerging in the FX options market.

The shape of the traded volatility curves can provide some indication of the mood of the market. A gently sloping positive volatility curve shows effectively a term premium – or investors prepared to pay more for risk over the long term. Inverted curves are typically associated with risk-off episodes and shocks, where the market is prepared to pay up for short-term protection, fearing market dislocation.

Certainly, the events in March saw enormous dislocation in FX markets, massively inverted volatility curves, and a stronger dollar as corporates rushed to hoard dollar cash after US commercial paper markets seized up. Equally, the subsequent calming in financial markets and a modest re-rating of global growth prospects after aggressive intervention from policymakers have started to see volatility curves normalise and the dollar weaken.

What interests us the most at the moment are developments over the last week. Here volatility curves have started to invert again – triggered by both buying of front end and selling of back end volatility – even as the dollar has continued to weaken.

We demonstrate this for the AUD/USD and USD/CAD markets below. This may be just a symptom of the short squeeze by leveraged accounts as the dollar weakens through big technical levels (e.g. the 0.6685 mid-March high in AUD/USD) or perhaps warning that a greater conviction is emerging that the dollar is ready to start on a more significant trend decline.

These trends have not exactly been the case in the EUR/USD market.

Yes, one-year traded volatility has fallen over the last week, but are yet to see a pick up in the 1-month volatility – which would probably represent the active buying of EUR calls/USD puts given that that one-month risk reversal skew has recently moved in favour of EUR calls.

Of course, these currencies (especially commodity FX) have come a long way already and substantial risks remain – most pressingly in US-China tensions and whether the White House administration rips up last year's trade deal.

But for the time being, the momentum is against the dollar and if EUR/USD starts to trade above the 1.1230/40 area on a sustained basis – especially backed by the buying of front end volatility – then EUR/USD could be embarking on a trend towards our year-end target of 1.20 earlier than we expected.