How High Can EUR Go?

Over the past two months, the euro performed extremely well against the U.S. dollar, rising from a low of 1.31 to a high of 1.3825 Thursday. This 5.5% move was driven largely by waning demand for U.S. dollars but after such a strong rally, many investors are scratching heads wondering how much higher can the euro rise. First and foremost, it is important to understand that trends in the currency market can last far longer than most people would anticipate but in the case of the EUR/USD, certain factors could quickly sweep in to limit the upside in the pair including a turn in economic data. However the primary catalyst for a top in the EUR/USD should be ECB criticism. Back in February, after the EUR/USD hit a high of 1.37, ECB President Draghi called the euro appreciation a sign of confidence but he also warned that exchange rates should reflect fundamentals. More specifically, he said, "the real and nominal exchange rates of the euro are near their long-term average but if the appreciation is sustained, it may alter their view on price stability." When those comments were made, the EUR/USD was trading a touch below 1.36, which suggests to us that they are comfortable with EUR/USD at 1.37. However the currency pair is now trading at 1.38 and we have not heard a peep from the central bank and the reason we believe is because the pain threshold for the ECB is closer 1.40. If EUR/USD rises another 2 cents, the ECB could start to talk down the currency and that would be a very strong motivation for investors to stop buying euros.

We shouldn't forget that the ECB maintains a dovish bias and recently discussed the possibility of another LTRO or negative interest rates. A stronger currency tightens economic conditions, raising the level of discomfort inside the central bank. We don't think that Draghi will hesitate to verbally intervene in the EUR/USD if it gets to 1.40 and it could get there given the desire to diversify out of dollars before February. At the same time, it is also important to remember that while the dollar has weakened because the Federal Reserve delayed tapering, they have abandoned the idea altogether. When U.S. data starts to improve, the market will re-price the odds of tapering, leading to a recovery in the dollar and a more significant turn in the euro.

Finally, euro-zone data could also hamper the rally in the currency. This morning, the euro shrugged off weaker flash PMIs. While manufacturing sector activity strengthened slightly this month, service sector activity slowed more significantly, causing the euro-zone PMI composite index to drop from 52.2 to 51.5. France experienced deterioration in both parts of the economy but Germany only saw slower growth in the service sector. Considering that this is the first decline in the PMI composite index since April, there's no need to ring any alarms because faster manufacturing activity in China, the temporary resolution of the U.S. fiscal debt crisis and stronger investor demand (as measured by the ZEW) could fuel a recovery in the coming months. Yet traders should beware because the German IFO report is scheduled for release Friday and if the business confidence dropped alongside PMI, 1.38 could become a near term top for the EUR/USD. However if the IFO report is strong, the EUR/USD could make its way towards 1.40.

USD Ticks Lower On Mixed Data
The U.S. dollar traded lower against all of the major currencies except for the New Zealand dollar. This weakness drove EUR/USD to fresh highs and USD/CHF to fresh two-year lows. With 10-year Treasury yields holding near three-month lows and U.S. stocks resuming its rise, the prospect of no tapering this year still has its impact on the markets. This morning's U.S. economic reports were mixed with jobless claims edging lower and the trade balance widening slightly. Claims fell to 350k in the week of October 19th, down from 362k. Economists were looking for a stronger number but the release as a whole continues to be distorted by the backlog in California according to the Bureau of Labor Statistics. The agency also said they can't accurately determine how many non-federal workers filed for claims but Federal workers filed 44.1k claims two weeks ago. In other words, given the labor department's skepticism of jobless claims, the data is basically unreliable. In the month of August, the trade deficit rose to -$38.8B from -$38.6B. This small deterioration was better than expected and caused by stagnation in imports and exports. On Friday, durable goods orders are scheduled for release along with the final University of Michigan consumer sentiment index for the month of October. Neither one of these reports are expected to have a significant impact on the greenback. In fact, all of the major currencies are still vulnerable to a near term correction until more significant U.S. data is released next week simply because many of the pairs have extended to extreme levels. But don't expect a deep correction because the pressure on Treasury yields will prevent a meaningful recovery in the dollar.

GBP: Subtle But Important Changes For The BoE
The British pound traded higher against the U.S. dollar despite weaker economic data and a subtle but important announcement from the Bank of England. Starting with the data, manufacturing activity deteriorated in the month of October according to the Confederation of British Industry. The CBI Index dropped to -4 from 9, which was a big surprise for investors because economists were looking for another improvement. While the rest of the market does not follow the CBI index as closely as we do, it is a useful indicator of manufacturing activity that has a positive correlation with the more important PMI manufacturing report. In other words, the deterioration in the CBI points to a further slowdown in the sector that could hamper gains in sterling. Meanwhile Bank of England Governor Carney announced changes to the central bank's money market operations Thursday. The BoE will be widening access of liquidity insurance and lowering the cost. They will also lend for longer periods and expand the range of collateral accepted. According to Carney "with our announcements today [Thursday], we are building a liquidity framework for the markets of tomorrow [Friday]." In our opinion, the expansion of collateral accepted, the extension of lending terms, the cut in the price of the discount window and the consideration to offer access to these facilities for non-banks are stimulative for the U.K. economy. Clearly the central bank wants to sustain the current pace of recovery. Third quarter GDP numbers are scheduled for release friday and the data is expected to show the economy growing at a faster pace but with retail sales and trade activity deteriorating in Q3 compared to Q2, there's scope for a downside surprise.

AUD: Supported By Stronger Chinese PMI And Gold
The New Zealand and Canadian dollars ended the day lower against the greenback but the Australian dollar held steady thanks to stronger Chinese data and higher gold prices. According to HSBC's flash PMI report, manufacturing activity in China hit a seven-month high in October. As Australia's number one trading partner, the stronger report raises hope for a faster recovery down under and suggests that momentum in the world's second largest economy could extend into the year's final quarter. Recent trade numbers showed potential weakness in external demand but the sharp rise in the new orders points to a potential recovery in external demand. As one of the earliest readings for China's economy, the HSBC report should lend continued support to the AUD. The New Zealand dollar should have strengthened as well because the country's trade deficit narrowed significantly in the month of September. Thanks to a sharp rise in exports and drop in imports, New Zealand's trade deficit is now only -199M compared to -1.234 billion the previous month. Yet NZD extended its losses against the USD and EUR, ignoring the improvement in domestic and external data. Considering that fundamentals for New Zealand have improved, we expect the losses in NZD/USD to stall above 0.8250. EUR/NZD on the other hand broke above 1.6500 Thursday, opening the door for a move to 1.68. No economic reports were released from Canada and nothing is expected from any of the three commodity countries over the next 24 hours.

Japanese Demand For Foreign Bonds Hits 2-Month Highs
The Japanese Yen traded lower against all of the major currencies except for the comm dollars. In contrast to the sharp sell-off in the Yen crosses on Wednesday, Thursday's moves were modest in comparison. The largest change was in NZD/JPY, which dropped only 0.5% compared to losses in excess of 2% 24 hours ago. The Ministry of Finance's weekly portfolio flow report was the only piece of Japanese data on the calendar and the data showed very strong demand for foreign bonds from Japanese investors. In fact, net purchases of foreign bonds rose to two-month highs after Japanese bond yields dropped to a five-month low and the U.S. resolved its fiscal crisis for the time being. This was the second month in a row that Japanese investors bought foreign bonds, restoring a three-month trend that had taken place before the U.S. government shutdown. The Cabinet also released its monthly economic report and their assessment of the economy remained unchanged. The government continues to see the economy on its way to recovery at a moderate pace but it also seems like policymakers are growing concerned about the recent volatility in the financial markets. Economy Minister Amari said the rising wealth effect of stocks on consumption is pausing. Consumer prices were scheduled for release Thursday evening along with the corporate service price index. Price pressures are expected to increase slightly as Japan slowly wins its battle with deflation.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.