EUR: The Next 48 Hours

Euro Could Hit 1.36 on Weak PMIs

Euro sold off against the U.S. dollar Wednesday, dropping to its weakest level in 3 months. The decline was driven by a rebound in U.S. yields and deterioration in the Eurozone’s current account surplus. In the month of March, the current account balance dropped from 21.8 billion to 18.8 billion, the lowest level since September. While one month does not make a trend, the region’s massive CA surplus has been one of the currency’s primary sources of strength for and cracks are now showing. Over the next 48 hours, the market’s focus will be on the EUR/USD with the release of Eurozone flash PMIs and the German IFO report. We think there’s a good chance that these reports could drive EUR/USD below 1.36. The European Central Bank has made their intention to ease clear and how aggressive they need to be will hinge in large part on these releases. If the PMI reports show a significant slowdown in economic activity, euro will sell-off as the expectations for easing will grow. We expect EUR/USD to fall to 1.36 before the June monetary policy announcement and to 1.35 on the back of their decision to ease. Investors have had plenty of time to discount the central bank’s move and by now everyone expects a combination of steps that will include a cut in the refi rate, mildly negative deposit rate, end of SMP sterilization and new LTROs targeted at commercial banks. If they fall short and only announce 2 of these steps for example, the euro could end up rallying. Based on the latest comments from ECB officials, it certainly seems that policymakers are warming to the idea of negative rates. ECB member Gonzalez Paramo downplayed the move by saying a small cut in the benchmark rate makes no difference, there’s no downside to negative ECB rates and banks are prepared for it. Weidmann believes that a negative deposit rate could be positive for the economy as it should revive lending by punishing banks for parking their reserves with the ECB. While negative rates would be uncharted territory for the central bank, it is certainly less complicated than Quantitative Easing and may not be so bad for the euro. The last 2 countries that officially took their interest rates below zero were Denmark and Sweden and in both cases, the sell-off in their currencies extended by only 3.5 to 4%, which another reason why we don’t think easing by the ECB next month will drive the euro as low as 1.30.

Dollar: Fed Discusses Tools for Normalization

The U.S. dollar spent most of the North American trading session higher against many of major currencies but a late day rally in the comm dollars erased part of the gains. No U.S. economic reports released Wednesday and the minutes from the last Fed meeting had a limited impact on the dollar. While the central bank is comfortable with the current pace of tapering and intends to end QE in 2014 they provided no additional hints on when rates will rise. The primary takeaway from Wednesday’s report is that the central bank is not worried about the inflationary impact of accommodative policy because they don’t expect prices to reach their 2% target for a few more years. The dollar rallied initially in response because some members discussed a clearer policy signal and tools for normalization but the gains fizzled quickly. While the central bank stressed that this does not mean normalization is imminent, the fact that they are having this discussion at all is positive for the dollar. Meanwhile nothing groundbreaking was mentioned in Wednesday’s speeches by Yellen, Dudley and George but Kocherlakota who is a voting member of the FOMC said the central bank should considering aiming for a CPI rate greater than 2% after 2018 to make up for the shortfall in previous years. As one of the most dovish members of the central bank, these comments are in line with his overall views but what we found interesting was his suggestion that CPI may not reach 2% until 2018. We finally have some U.S. economic reports on the calendar Thursday. In addition to weekly jobless claims, existing home sales, manufacturing PMI and leading indicators are scheduled to be released. If claims print below 300k for the second week in a row, we could see a more meaningful recovery in U.S. yields and in turn, the U.S. dollar.

EUR/GBP Slides to 16 Month Lows

For the second day in a row, the British pound was the only high beta currency that outperformed the U.S. dollar. Sterling received a boost from stronger retail sales and less dovish Bank of England minutes. As a result ten year Gilt yields have recovered nicely and are now less than 4bp away from pre-Inflation Report levels. Sterling has not only performed well against the dollar but its strength has also driven EUR/GBP to its lowest level in 16 months. Considering that no changes are expected in Thursday’s report on revisions to U.K. Q1 GDP – the Brits usually do a good job of accurately estimating their economic reports, we expect sterling to hold onto its gains. If Eurozone PMIs surprise to the downside, we could even see fresh lows in EUR/GBP. While the sharp rise in retail sales played a big role in driving the pound higher, the BoE minutes was also slightly less dovish than the Quarterly Inflation Report. According to our colleague Boris Schlossberg, “The release of the BoE minutes noted that all members agree that they need to see more evidence of slack reducing before raising rates, however, decision on whether to raise rates was now “more balanced” for some members. The market reacted with particular vigor to the suggestion in the minutes that the more gradual the rise in rates the earlier BoE need to start the process in order to rebalance the rates. This indicates that at least some of the MPC members are considering the possibility of a rate hike sooner than the expected Q1 of 2015 date.”

AUD: Fiscal Tightening Dampens Confidence

Thanks to a late day rally, the Australian, New Zealand and Canadian dollars ended the day unchanged against the greenback. These currency pairs had actually spent most of the North American trading session in negative territory. Weaker domestic factors kept pressure on the comm dollars with AUD hit by a surprisingly large decline in consumer confidence. Westpac’s consumer confidence index dropped -6.8% in the month of May after growing 0.3% the previous month. Even though the Australian government has gone to great lengths to prepare the market for fiscal tightening, consumers were nonetheless dissatisfied by the recent announcements and worried about the impact on the economy going forward. In New Zealand, credit card spending fell -3.2% in the month of April but what really did NZD in was the persistent decline in milk prices. In the latest dairy auction results, prices fell by another 1.8%, bringing the total decline to 23% over the last 3 months. We continue to believe that NZD needs to adjust to the potential for a pause by the RBNZ next month. No data was released from Canada but retail sales are scheduled for release Thursday and given the drop in employment last month and the decline in wholesale sales, the loonie is vulnerable to further losses on the back of Thursday’s report. For AUD and NZD, the big focus will be on HSBC’s Chinese flash manufacturing PMI report for the month of May. If manufacturing activity slows, AUD/USD could fall to fresh 2 month lows.

JPY Rally Fizzles, BoJ Keeps Policy Unchanged

After hitting a 3-month low of 100.82, USD/JPY staged a strong intraday recovery that helped to ease losses in all of the Yen crosses. Last night the Bank of Japan left monetary policy unchanged, a decision that was widely expected. Central Bank Governor Kuroda continued to express comfort with the current level of monetary policy. He described Japan’s economy as continuing to recover moderately and that the positive cycle is working in Japan’s economy. His view that U.S. growth will accelerate reflects his optimism about his country’s ability to withstand the negative impact of the sales tax increase. With this in mind however, the BoJ will need to continue easing until 2% inflation is reached and according Kuroda, they are only halfway to their 2% target. The central bank head provided no clues on the possibility of additional easing, which means that for time being, monetary policy will remain unchanged. They have made it clear that any action will be reactive and not proactive, so keep an eye on incoming data. While the Yen responded positively to Kuroda’s comments because it minimizes the chance of any near term easing, it eventually gave up all of its gains. The rally was also supported by a larger rise in exports and imports in the month of April. Japan’s trade deficit narrowed to –Y1.44 trillion from-Y808.9 billion. The magnitude of the improvement was less than expected but faster export and import growth is positive for Japan. Wednesday night’s PMI Manufacturing report for the month of May will provide more information on the resilience of the manufacturing sector. Based on recent capital expenditure data, the sector should be holding up well.

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