By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
- Euro Powers Through 1.12, Is 1.15 Next?
- Weak Data Worries Dollar Bulls
- GBP: No Surprises Expected from BoE
- CAD Hit by Weaker Trade Data
- NZD Extends Losses Following Drop in Dairy Prices
- AUD in Play Again with Trade and Retail Sales on Tap
Euro Powers Through 1.12, Is 1.15 Next?
The euro continued to power higher against the U.S. dollar Wednesday, closing firmly above 1.1215, the 61.8% Fibonacci retracement of the 2000 to 2008 rally. EUR/USD bulls have the ECB to thank for Wednesday’s move. Even though Central Bank President Mario Draghi expressed his disappointment with growth, he laughed at the idea that they are nearing their inflation target and said if anything, they will actually add to policy. The euro jumped after he said the central bank would look through the recent volatility. The reason why this is important is because it suggests that they will not be front loading their bond purchases. Last month, the central bank suggested that the bulk of QE would happen in the summer and this notion put pressure on yields. On Wednesday, though, German 10-year rates jumped approximately 16.8bp on the idea that bond purchases would be spread out more evenly, providing ongoing stimulus to the economy. While this is long-term bearish euros, in the near term, it has led to a significant adjustment in expectations, which has translated into a steep decline in bond prices, sharp rise in yields and a move higher for EUR/USD.
The EUR/USD’s break above 1.12 is significant because there is no major resistance until 1.15. On Tuesday, we listed 5 reasons why the euro jumped 2% and those same drivers continue to fuel gains for the currency pair. Although no agreement has been announced, the market still hopes that a deal for Greece will be reached by the end of the week. We are skeptical because we expect Greece to make a counter offer but a deal will need to be made by the end of the month to avoid catastrophic consequences. Gains in EUR/USD were also supported by stronger Eurozone data. The PMI services and composite index were revised higher for May, the unemployment rate dropped to 11.1% and retail sales rose more than expected. In contrast, U.S. data surprised to the downside putting pressure on the dollar. Service sector activity grew at its slowest pace in a year. As a result, the German-US 10-year yield spread moved more in favor of the euro and the ascent in the currency pair triggered additional short covering. Unless there is a very big upside surprise in Friday’s U.S. labor market report, the EUR/USD should make its way toward 1.15. The road may be bumpy and the rally could stall at the May high of 1.1466, but the path of least resistance for the EUR/USD is higher.
Weak Data Worries Dollar Bulls
Dollar bulls are worried about the latest U.S. economic report. According to ISM, service-sector activity expanded at its slowest pace in a year. The index dropped to 55.7 from 57.8 and while economists had anticipated a softer release, the decline was more significant than they anticipated. The guts of the report were even weaker with employment, new orders, business activity, backlog, supplier deliveries and inventory sentiment falling. The employment index specifically dropped to its weakest level in 4 months. As one of the key leading indicators for non-farm payrolls, Wednesday’s ISM report highlights the risk of a downside surprise. Economists are looking for 227k job growth and based on the ADP report, which showed corporate payrolls rising by 201k up from 169k the previous month, this can be achieved but according to ISM, payrolls may fall short of not only this estimate but also last month’s 223k rise. An unambiguously positive report is needed to drive USD/JPY above 125 and EUR/USD back toward 1.10. Despite Wednesday’s numbers, U.S. yields continue to rise and that has helped USD/JPY hold 124. The Beige Book report was a nonevent for the dollar. There were no surprises with Fed districts simply reiterating their optimistic outlooks for the U.S. economy and their expectations for stronger growth in the second half of the year.
GBP: No Surprises Expected from BoE
Wednesday’s ECB meeting triggered widespread volatility for the euro even though the central bank left interest rates unchanged. Don’t expect the same reaction from Thursday’s Bank of England meeting. When the BoE leaves policy steady, there tends to be very little reaction in the British pound because there is no accompanying press conference to explain the decision. However, even if they held one, their views would be very mixed because the increase in the manufacturing- and construction-sector PMI indices released earlier this week was offset by Wednesday’s decline in the PMI services and composite index. The steep decline in service-sector activity, which represents the largest part of the economy, fell by the sharpest amount in 4 years. According to Chris Williamson of Markit, “Recent weakness in manufacturing and construction has spread to services. Overall growth in May across all three sectors was the lowest since December and the second weakest for two years. The surveys point to GDP growing at a quarterly rate of just 0.4% in May, raising doubts about the ability of the economy to rebound convincingly from the weakness seen at the start of the year. ” So the case for a rate hike has weakened and when the minutes are released from Thursday’s meeting 2 weeks hence, they will most likely show a cautious central bank that intends to keep policy unchanged for the rest of the year.
CAD Tanks on Weaker Trade
The Canadian and New Zealand dollars extended their losses versus the greenback while the Australian dollar moved higher. The CAD was hit hard by a weaker-than-expected trade report. Economists had been looking for the trade deficit to narrow to -2.15B from -3.85B but unfortunately trade activity improved only slightly with the balance rising to only -2.97B for April. The rebound in oil prices helped to boost the volume of exports but internal demand was weaker than anticipated with imports falling 2.5%. The biggest losses were experienced by the New Zealand dollar with investors selling NZD on the back of another decline in dairy prices. At Tuesday's auction, prices fell another -4.3%. The Australian dollar also declined despite stronger GDP growth. According to the latest report, the Australian economy expanded by 0.9% in the first quarter, which was better than expected. However demand was weak with growth largely driven by inventory buildup and exports. Also, service-sector activity contracted at a slightly faster pace in May while the Chinese economy grew at a slightly slower pace according to the HSBC PMI Composite report. Australian trade and retail sales data were scheduled for release Wednesday night. While the sharp decline in the sales component of PMI services points to weaker domestic demand, the rise in the PMI manufacturing index signals stronger trade activity. Of these 2 reports, retail sales should have the larger impact on AUD.