USD recovery may reverse into year-end

The USD has seen its correction extend further this past week, but critical resistance levels (EUR/USD support levels) we highlighted in last week's issue appear to be exerting some influence. The 1.4250 level has held as support on a daily closing basis thus far, and the more significant 1.4170/90 area remains untouched. In USD/JPY, the pair finally broke above the Ichimoku cloud, but has since stalled just below the key 92.00/50 area, with rumored large supply (selling interest) at 92.00. Should USD/JPY break above the 92.00/50 resistance zone, we would expect gains to continue toward the 94.50/95.00 area in coming weeks. The USD continues to respond most directly to incoming US data, which was mixed so far this week: weaker 3Q GDP; better existing home sales; weaker Michigan sentiment; weaker new home sales. Thursday morning's durable goods and weekly jobless claims will likely set the tone for the rest of this week for the USD. The positive correlation between US Treasury yields and the USD, especially USD/JPY, continues to hold sway, and here we would note the 3.75/3.85% area in 10 year US Treasury note yields. For the USD to continue to strengthen, we would need to see a sustained move above that level. However, we would also note the potential for increased differentiation between USD/JPY and the dollar against other major currencies, meaning USD/JPY may continue to follow US yields higher should they continue, but similar gains in the dollar against others may lag, as JPY-cross buying comes into play. In particular, going into the final week of 2009, month-end/year-end fixing flows (when asset managers undertake hedging/portfolio rebalancing, resulting in significant order flow at the daily fixings) appear to be biased toward overall USD selling, with the largest interest to sell USD against EUR and JPY. This sets up the potential for a rebound in EUR/USD and an unexpected decline against USD/JPY, which may see the relationship between US yields and USD/JPY breakdown in the short-run. We would look to exploit any such short-term declines in USD/JPY as buying opportunities. But we won't rush in as the top of the Ichimoku cloud falls sharply to 88.68 in the final days of 2009, potentially setting up a nearly 3 yen pullback from current levels (91.65). Complicating matters still further, massive US debt auctions (see below) have the potential to expose USD weakness if demand is soft, even as yields move higher as Treasuries are sold off. We expect volatility to increase as liquidity thins still further into the end of the year and for trading conditions to remain extremely choppy