EUR/USD: How Far Will It Fall?

EUR/USD Outlook: How Much Further Will it Fall?

The Euro extended its losses against the U.S. dollar this week but outside of the steep sell-off on Tuesday, the currency pair saw very little change during the rest of the week.  Since Mario Draghi indicated that he is comfortable with the idea of easing in June, weaker economic data validated the need for more stimulus and supportive comments from European policymakers indicate that his peers share his views.  In this context, many market participants would expect EUR/USD to be trading much lower and while the currency pair experienced has steep losses since ECB President Draghi set the stage for easing next month, the euro ended the North American trading session unchanged for the third consecutive day.  The main reason why the sell-off in EUR/USD failed to extend is because of the decline in U.S. yields, but a 300-pip drop is a respectable move for a currency pair after a central bank signals a shift in monetary policy. It is important to realize that the central bank is not planning to introduce Quantitative Easing, which would represent significant step by the ECB.  Instead, according to the hints dropped by policymakers, they are planning to introduce a series of measures that could include a reduction in the refi rate, a cut in the deposit rate, an end to SMP sterilization and new LTROs. Normally any one of these measures could send euro sharply lower but in an ultra low interest rate environment, there's only so much impact these steps will have on rates and the euro.  We still believe EUR/USD is vulnerable to further losses but its decline could be limited to another 100 pips before the June meeting with a possible move down to 1.35 after the central bank eases.  On a technical basis 1.3500 is a key level not only from a psychological perspective but also because it is the 50% Fibonacci retracement of the 2011 to 2012 decline.  However 1.36 is also a former support level for the pair. Whether the currency pair continues to fall or stabilizes at 1.3700 in the coming week will depend on the May Flash PMI and German IFO reports. If economic data continues to surprise to the downside, it would reinforce the need for more stimulus and add pressure on the euro. 

Dollar: Watch Fed Speeches Next Week

There was very little consistency in the performance of the dollar Friday, which weakened slightly against the Japanese Yen, British pound, Australian, New Zealand and Canadian dollars but strengthened versus the euro, New Zealand dollar and Swiss Franc.   The stability in Treasuries and equities helped to stem the slide in the greenback and while we said the dollar will recover once yields stabilize, it is far too early to declare a top in Treasury prices and a bottom in yields.  This morning's economic reports helped to provide support to the greenback.  Housing starts jumped 13.2% while building permits rose 8%.  Low interest rates, a stronger economy and improvements in the weather have helped to boost the momentum in the housing market.  However consumer confidence declined unexpectedly in the month of May, reflecting concerns about rising food and energy costs.  As long as U.S. data is mixed and not consistently positive, the Fed will provide very little guidance on when rates will rise, making a material recovery in the greenback difficult.  There's not much in the way of market moving data from the U.S. next week so all eyes will be on the FOMC minutes and speeches by Federal Reserve officials. Seven different Fed Presidents will be talking about the economy or monetary policy including Janet Yellen but her speech could reveal the least, as it is only a commencement speech at NYU where she will be reading from a prepared text and not taking any questions from the audience.

Sterling: Busy Week Ahead

With no U.K. economic reports released over the past 48 hours, sterling continued to enjoy a relief rally against the U.S. dollar.  U.S. yields edged slightly higher on Friday but the steep decline seen in 10-year yields throughout week kept the greenback under pressure. In other words, the recovery in GBP/USD had less to do with the outlook for sterling than the lack of desire to own dollars.  The Bank of England made it clear that they are happy with the current level of monetary policy and are in no rush to raise interest rates. Next week's economic reports are expected to reinforce their dovish outlook and validate their decision to leave their 2014 GDP and CPI forecasts unchanged. It will be a busy week for the British pound with inflation, retail sales and revisions to Q1 GDP scheduled for release along with the minutes from the last BoE meeting.  Based on the Quarterly Inflation Report, we know that the central bank does not share the market's optimism about the economy and dovish BoE minutes could resurrect the sell-off in sterling. Given the decline in shop prices, consumer prices could also surprise to the downside. However according to the British Retail Consortium, spending was strong in April and upside surprise in retail sales would stem the losses in the currency.  No revisions to GDP are expected.  Of course, the outlook for GBP/USD also hinges on the performance of the greenback and with little U.S. data on the calendar, the focus will be on yields.

Stronger Rally in AUD/NZD?

Like many of the major currencies, the Australian, New Zealand and Canadian dollars were confined within relatively tight trading ranges this past week. AUD/USD for example traded within a narrow 85-pip range while NZD/USD's range was only 5 pips wider.  There was not much in the way of market moving data for any of 3 commodity producing countries but it is worth noting that these currencies benefitted very little from the decline in U.S. yields and part of the reason is because equities also sold off creating a risk averse environment in the markets.  The much anticipated 2014/2015 Budget proved to be a nonevent for the Australian dollar this week.  While there was not much in the way of surprises, in the long run consumer confidence and spending could be negatively affected by fiscal tightening, which could be mildly negative for the Australian dollar.  Even so we expect AUD to outperform NZD in the near term because investors have not appropriately discounted the potential slowdown in RBNZ tightening.  Since Central Bank Governor Wheeler expressed concerns about weakening export prices and raised the possibility of FX intervention NZD/USD fell approximately 50 pips.  The deterioration in this week's retail sales and business PMI index reinforces our view that the RBNZ will pause next month.  Overnight, the central bank also released a paper discussing the impact that LVR restrictions have had on the housing market. According to the report, house prices have fallen by over 3% due to these restrictions, which is more than their 2.5% forecast - the larger decline also boosts the chance of pause.  New Zealand has producer prices and its PMI services report scheduled for release but the most important event risk for AUD and NZD could be HSBC's flash manufacturing PMI report for China.  USD/CAD will be in play towards the end of the week with retail sales and consumer prices scheduled for release.

USD/JPY: Confined in a Broad Trading Range

The decline in USD/JPY this week received a lot of focus from foreign exchange traders but if we take a step back, the currency pair ended the week only slightly lower than where it started.  On Monday, USD/JPY was trading at 101.75 and by end of day Friday it had dropped to only 101.50. The currency pair did fall to a fresh 1 month low but the new level was only 1 pip below the previous level.  For the most part, USD/JPY has been confined within a 101 to 103 trading range for the past 3 months and while the pair could test its April lows of 100.75, we do not expect the broader range of 100.75 to 103 to be broken, especially in the coming week.  The Bank of Japan has a monetary policy announcement and once again with no major deterioration in the economy, monetary policy is expected to remain unchanged. The most important releases from Japan next week will be the trade balance and manufacturing PMI. Last night's industrial production numbers were encouraging with IP revised up to 0.7% from 0.3% but the impact on the Yen was limited.

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