FX Traders Shrug Off Fed, ECB

FX Traders Shouldn’t Expect Much From Fed

The Federal Reserve’s two-day monetary policy meeting comes to an end Wednesday with a decision at 2pm ET. Leading up to the rate announcement, the dollar is trading lower against all of the major currencies. Given the recent disappointments in economic data, it will be very difficult for the hawks inside the Fed to justify hardening their call for a rate cut. In contrast, the doves will sing louder about the need to maintain the current level of stimulus. However none of these discussions is likely to appear in the FOMC statement. Instead, we expect the statement to remain mostly unchanged because the conclusions of the Beige Book suggest that the weakness in March did not extend into April. Yet given the sharp decline in the Chicago PMI report, it may be difficult for Fed officials to believe the Beige Book entirely, especially without seeing Friday’s nonfarm payrolls report.

Conflicting signals in U.S. data should only widen the divergence in views within the central bank, making it difficult for the Fed to make any changes in monetary policy. In other words, Wednesday’s FOMC rate decision could be a nonevent for the U.S. dollar. We are eager to see if the central bank changes its assessment of the labor market from “signs of improvement” to mixed and whether they acknowledge the recent softening in economic data. If they do, it could lead to a small downtick in the U.S. dollar. When the FOMC minutes are released three weeks later, we expect to see less support and more skepticism about changing the country’s asset-purchase program.

The ADP Employment Change and ISM Manufacturing report are also scheduled for release Wednesday. Between the drop in the Chicago PMI, Philly Fed and Empire State indexes, we are looking at a potential miss in ISM. Manufacturing conditions in the Chicago region contracted for the first time in 3.5 years. The index dropped to 49.0 from 52.4 in the month of April hitting its lowest level since September 2009. A reading as weak as the one we saw Tuesday reminds us of recessionary conditions and while one monthly release doesn’t make a trend the data confirms that the pace of the U.S. recovery has slowed. The activity reading was so weak that investors completely ignored the jump in consumer confidence reported 15 minutes later. According to the conference board, consumer sentiment hit its highest level in seven months, which should have been good news for the greenback but this is a sentiment indicator whereas the Chicago PMI index is an activity indicator and therefore a more reliable reflection of how the U.S. economy is doing.

EUR: Ignoring Risk Of ECB Rate Cut

The euro continued to trade higher against the U.S. dollar despite weak economic data and the growing risk of a rate cut by the European Central Bank later this week. According to this morning’s economic reports from Germany, unemployment increased 4,000 in the month of April and retail sales fell 0.3% in March. While the decline in spending was in line with expectations, if we take into account the sharp downward revision to last month’s report, consumer appetite is extremely weak. Originally, retail sales in February were estimated to have increased by 0.4%, but we learned that it fell by 0.6%. On an annualized basis, this dropped the year over year decline in spending to -2.8% from -2.6%. If not for the sharp rise in spending in January, retail sales would have contributed negatively to Q1 GDP. Nonetheless, these are clear signs that the region’s largest economy is slowing, which should be bearish for the euro and yet the currency rose for four out last five trading days. Many traders may be wondering about why the euro refuses to fall. Of the 70 economists surveyed by Bloomberg, 64% expect the central bank to lower interest rates, which is hardly an overwhelming majority. The eonia or (Euro OverNight Index Average) rate has already been trading near zero for the past nine months so a rate cut can’t drive rates much lower unless the central bank is willing to accept negative deposit rates. We are not ruling out this possibility but the euro is trading like it wants more aggressive action from the ECB beyond a rate cut to break below 1.2950. In other words, investors already expect the ECB to ease, so if they do not follow up with a bolder commitment, EUR/USD traders could be disappointed, leaving the euro to trade above 1.30.

GBP: Watch Out For UK PMI Manufacturing Report

The British pound extended its gains against the U.S. dollar and it losses against the euro. The latest economic reports were mixed with consumer confidence declining and mortgage approvals rising. This divergence in data shows that while the housing market has held up well, the overall economy is still struggling. The only reason why the GBP/USD is trading above 1.55 is because hotter GDP numbers led investors to believe that the economy has not weakened enough to warrant another round of easing. We’ll get a much better assessment of whether that is true from the PMI manufacturing, construction and service sector reports scheduled for release over the next several days. Economists are looking for a small pickup in activity and if they are right, the GBP/USD could break above 1.56. However if the U.K. PMI manufacturing report surprises to the downside and based on the sharp decline in the CBI industrial trends survey it could, the rally in sterling could lose momentum quickly.

AUD: China And Australia Releases Manufacturing Numbers

The Australian, New Zealand and Canadian dollars traded slightly higher against the greenback Tuesday. However the sustainability of the gains in AUD and NZD hinges upon Tuesday night's manufacturing numbers from Australia and China. There have already been signs of weakness in the manufacturing sector with HSBC reporting a slowdown in activity last week. If the government’s official release confirms that the sector has slowed and that is accompanied by a slowdown in manufacturing conditions in Australia, the AUD/USD could drop back below 1.03 and the NZD/USD could drop towards 85 cents. Despite the resilience of the AUD and NZD, last night’s data from Australia and New Zealand was also softer than expected. Private sector credit growth in Australia slowed while business confidence and building permits in New Zealand declined. Up North, the Canadian economy expanded by 0.3% in the month of February, matching the upwardly revised pace of growth enjoyed in January. On an annualized basis, this brought GDP up to 1.7% from 1.1%, which helped to drive the Canadian dollar sharply higher against all of the major currencies. The outperformance of the Canadian economy and the recent rebound in oil prices should help the loonie sustain its gains with USD/CAD aiming for a test of parity (1.0).

JPY: Gradual Signs Of Recovery In Japan

It has been a mixed day for Japanese Yen crosses with USD/JPY remaining under pressure. EUR/JPY and CHF/JPY edged higher but only because of gains in the European currencies. A good amount of Japanese data was released last night and overall painted a picture of continued recovery in Japan’s economy. Manufacturing activity expanded for the second month in a row, the jobless rate declined, sales at large retailers increased and housing starts jumped 7.3%. There were some disappointments with industrial production growing at a slower pace (0.2% vs. 0.6% the previous month) and overall retail trade falling 1.4%. On balance, the Japanese economy is slowly reaping the benefits of easy monetary policy and a weak currency but there is a long way to go before the country enjoys a stronger let alone full recovery. Labor cash earnings are due for release this evening and unfortunately wage growth is expected to remain modest. As we said on Monday, we don’t see USD/JPY testing 100 this week.

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