Dead-Cat Bounce Or Recovery?

FX: Dead Cat Bounce or Recovery?

With no major U.S. economic reports scheduled Tuesday, currencies and equities rebounded following the steep sell-off on Monday. Compared to the magnitude of yesterday’s losses however, the relief rally was modest. So far, the move in currencies and equities represents nothing more than a dead cat bounce but that can change if Wednesday’s ADP and non-manufacturing ISM reports surprise to the upside. The sell-off in U.S. assets on Monday was triggered by the sharp decline in the ISM manufacturing index but the U.S. is a service based economy so if non-manufacturing ISM increases, Tuesday’s corrective rally could turn into a stronger recovery. According to the Congressional Budget Office, “economic activity will expand at a solid pace in 2014 and the next few years” with the jobless rate holding at 6.7% in the fourth quarter of 2014. The CBO’s unemployment rate forecast is a bit conservative in our opinion but to project a an unemployment rate lower than the Fed’s threshold this year risks triggering unwanted volatility in the financial market. While the ISM report is important, our focus will be on the employment component of the index because it has a very strong correlation with non-farm payrolls. Although it failed to forecast the dip in payrolls in December, it accurately forecasted the direction of the wild swings 6 out of the last 8 months. In order for currencies and equities to extend their recovery in a meaningful way, we need to see the ISM index exceed 55. The ADP employment report will also be important in setting payroll expectations but at the end of the day, investors will most likely trade cautiously ahead of Friday’s report. Tuesday’s rebound in USD/JPY stopped short of the December 101.60 low and Wednesday’s ISM number will determine whether this new level of resistance can be broken. EUR/USD on the other hand could remain under pressure ahead of the European Central Bank meeting on Thursday.

Meanwhile the passage of the Farm Bill Tuesday by U.S. Senators received very little response from the market. We are quickly approaching the deadline to raise the debt ceiling but investors are not nearly as nervous as they were last year when the debt debate shutdown Washington. We know from last year’s experience that politicians won’t go as far as allowing the U.S. to default on its debt and with this being an election year, there won’t be much appetite for another game of chicken. On Monday, Treasury Secretary Jack Lew said the government will only have enough money to keep paying its bills using “extraordinary measures” for a “brief span of time” after the Feb 7th deadline, which most likely means the end of the of the month. For the most part we are looking for a drama free increase to the U.S. debt ceiling that will be received positively by the market.

NZD Soars on Stronger Employment

The New Zealand and Australian dollars were the best performing currencies Tuesday, rising approximately 2% versus the U.S. dollar and euro. Less than an hour ago, New Zealand reported healthy labor market numbers. Employment grew 1.1% in the first quarter, which was much stronger than the 0.6% forecast. This improvement drove the unemployment rate down to a 4 year low of 6% but what made New Zealand’s report even more positive for NZD was the fact that the participation rate rose from 68.6% to 68.9%. Given the hawkishness of the RBNZ and Tuesday’s better-than-expected data, we continue to look at the sell-off in NZD as a great buying opportunity. Meanwhile after selling off for the past 3 months with virtually no relief rallies, we believe that the Australian dollar has officially bottomed. For the first time in 2 years, the Reserve Bank of Australia expressed comfort with the current level of interest rates AND their currency. By dropping their easing bias, the RBA set off a wave of short covering in the Australian dollar last night that we expect to continue in the weeks to come. In fact we are looking another 4% to 6% rally in the currency. Going into the monetary policy meeting, A$ was trading near its 3-year lows because investors had been pricing in one more rate cut in 2014. According to the CFTC, there was also a significant amount of short positions in the Australian dollar so when the RBA said “on present indicators, the most prudent course is likely to be a period of stability in interest rates,” it immediately prompted short covering. For the first time in a number of months, the central bank also did not describe the Australian dollar as “uncomfortably high,” which suggests that they are comfortable with an AUD/USD exchange rate in the high 80s. By shifting from a dovish to neutral bias, the central bank is telling the market that they aren’t worried about the recent deterioration in Australian and Chinese data as they expect the recent decline in the Australian dollar to balance growth in the economy. While the RBA still believes that growth will remain below trend for a time and the unemployment could rise further before it peaks, the central bank doesn’t feel that it is necessary to ease monetary policy further especially with inflation at the top of its 2-3% range.

Based on the rally in the Australian dollar Tuesday, the RBA’s decision to shift to a neutral bias caught every one by surprise. Having ended their easing cycle at a time when speculative short positions are near extreme highs, the central bank stands the risk of driving their currency sharply higher. Without the support of a potential rate cut, there is very little reason for traders to hold a significant amount of short Australian dollar positions especially given the negative interest rate differential with the euro and U.S. dollar. The following chart illustrates the magnitude of previous rallies in the Australian dollar (white line) when speculative short positions (yellow line) were unwound. They ranged anywhere from 3% to 26% and since short positions are higher now than they were in 2010 and 2012, we are looking for another 5% rally in AUD/USD that would make the move from the bottom closer to the 8.5 to 9% rallies that we saw in 2012 and 2013. AUD/USD" title="AUD_Positioning" border="0" height="366" width="610">

GBP: Will PMI Services Add to the Pain?

Thanks to stronger than expected economic data, the British pound rebounded against the U.S dollar and euro. This marked the first rally in 4 trading days for the GBP/USD. According to Markit Economics, construction sector activity expanded by its strongest pace since August 2007. The index rose from 62.1 to 64.6, easily beating the 61.5 forecast by economists. The housing market was an essential driver of the U.K. recovery last year and we believe that it will continue to fuel growth in 2014. The upside surprise helped to ease some of the market’s concerns about yesterday’s drop in the PMI Manufacturing index but traders always attribute greater significance to the manufacturing and service sector reports. If service sector activity accelerated in the month of January, we could see a stronger recovery in sterling. However if services slowed alongside manufacturing, GBP/USD could drop to 1.62. The Bank of England releases its Quarterly Inflation Report later this month and the changes in the PMI indices can affect their decision.

EUR: Only Upside Data Surprise

Although Eurozone producer prices increased in the month of December, the euro traded lower against the U.S. dollar. Since the currency pair failed to close above 1.37 last month, it has fallen nearly 200bp, breaking below 1.35 intraday in each of the past 3 days. The EUR/USD’s inability to rally can be attributed to the market’s expectations for dovish comments from ECB President Draghi later this week. Eurozone producer prices increased 0.2% in the month of December, but on an annualized basis, it is still down 0.8%. Eurozone retail sales and revisions to PMI services are scheduled for release Wednesday. Given the sharp decline in consumer spending in Germany last month and the drop in retail sales in France, a contraction in spending is expected at the end of the year. Revisions to service sector activity is difficult to handicap but if the stronger manufacturing data can serve as a guide, then the odds favor an upward revision.

USD/JPY Rebounds but Stalls at Former Support

The rally in the U.S. dollar and recovery in U.S. Treasury yields helped to drive all of the Yen crosses higher. Of course AUD/JPY and NZD/JPY were the best performers. USD/JPY also strengthened but the rally stopped short of a key former support level at 101.60 that now appear to be resistance. As of the early Asian trading session, USD/JPY is struggling to rise above this rate. The recovery in U.S. stocks will most likely drive the Nikkei higher during the Asian trading session. No major Japanese economic reports were released last night but Bank of Japan Governor Kuroda reminded investors that, “it is too early to mention specifically how BoJ will exit its ultra easy monetary policy.” Given the recent rise in the Yen and the risk that the consumption tax poses to the economy, the central bank is still thinking about more stimulus. A report on labor cash earnings was the only release due out from Japan Tuesday evening.

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