The USD: Time To Buy Or Sell?

Is it Time to Buy or Sell Dollars?

The volatility that we have seen in currencies, equities, Treasuries and commodities over the past 48 hours give investors a taste of what is to come in the year ahead. We are no longer in an environment of one-way bets. Tuesday's weaker-than-expected U.S. data serve as a reminder to investors that handicapping monetary-policy changes is never easy for traders or the central bank. The U.S. may be quarters ahead of other major economies in terms of growth but it is not immune to risks and uncertainty. The Federal Reserve signaled plans to raise interest rates this year but Tuesday's sell-off reflects the fear that if there is a more material slowdown in growth the central bank may have to reconsider their position. It won't go unnoticed that service sector activity grew at its slowest pace in six months. Furthermore, prices paid contracted for the first time since September 2009. In addition, the employment component of the report dropped its lowest level since July, signaling a potential slowdown in job growth in the month of December. With the risk skewed to the downside for NFPs on Friday, many traders are wondering whether they should buy or sell dollars at this time, especially after the steep slide in USD/JPY.

The answer to that question depends on what type of trader you are and your time frame. Short-term traders could have the opportunity to sell USD/JPY on a break of 117.75 for a move down to 116.00 -- but they should wait for that break before taking a trade. Medium-to-longer-term investors could look to scale into long USD/JPY trades between 115.75 and 118. While the sharp decline in U.S. rates is contributing to the slide in the dollar, investors around the world are also looking to Treasuries for safety. After Friday's payrolls report, traders will come to realize that the Fed is still on course to raise rates in the second half of the year and as long as they do not waver on this message, the dollar will retain its attractiveness. In 2014, we have seen how King dollar can rally even as yields fall. The ADP report, trade balance and minutes from the last Fed meeting are scheduled for release Wednesday -- hawkish minutes could carve out a short term bottom for USD/JPY ahead of Friday's payroll report.

Very Little Reason to Own Euros...But

While the euro ended the day unchanged against the USD, the downtrend is far from over. Between weak growth, the prospect of Quantitative Easing and the real chance of a political upset in this year's Greek, Spanish or Portuguese elections, there is very little reason to own euros unless you believe that Friday's U.S. non-farm payrolls will be weak, leading to a near term correction in the dollar. Even if that is the case though, the ECB is still widely expected to announce Quantitative Easing this month. When all else fails, central banks resort to printing money and buying government bonds. The Federal Reserve, Bank of England and the Bank of Japan have all done it and it won't be long before the European Central Bank follows suit. If not for the legal and logistical challenges, the ECB would have resorted to Quantitative Easing a long time ago. However with oil prices breaking $50 a barrel and inflation falling even further as a result, the ECB is running out of options. Technically under the European Union Treaty, the central bank is prohibited from financing individual governments. Germany who pretty much underwrites the euro has been a particularly vocal opponent of any policy that would expand the supply of money. Some investors still believe that the ECB won't find enough support to launch QE. However ECB President Draghi believes that QE is within their mandate and more importantly, asset purchases aren't new to the ECB. They already bought sovereign debt from countries like Greece, Spain and Italy between 2010 and 2012. The recent fall in oil prices makes deflation a risk that even the Germans cannot ignore. Therefore, as the January 22 ECB meeting approaches, the euro will remain weak, hanging below 1.21. And when the actual announcement is made, it'll head even lower.

GBP is Headed for 1.50

Based on the recent price action of the British pound, many investors are starting to believe that the Bank of England will forgo a rate hike in 2015. Sterling dropped to a fresh one-year low Tuesday against the US dollar on the back of weaker or economic data. Both the PMI services and PMI composite index surprised to the downside, with service sector activity growing out of slowest pace in 19 months. This follows a similar slowdown in the manufacturing and construction sectors and collectively indicates that the UK economy is losing momentum. When combined with the negative impact that the recent slide in oil prices has on inflation, the case for rate hike in 2015 weakens. At the same time, sentiment is deteriorating, the government's fiscal goals are unrealistic and the current account balance is weakening. The BoE may be the next central bank in line to raise interest rates behind the Federal Reserve but between weak Eurozone growth and their inflation mandate, the distance between these moves should widen. The Bank of England meets this week but no changes are expected. As the Fed continues to prepare the market for tightening we expect GBP/USD to extends its losses making a run for 1.50. This week's Non-Farm Payrolls report poses some risk for GBP/USD especially if NFPs rise less than expected but unless there is a major downside surprise (which we do not anticipate), it will not take the Fed off its course of tightening and GBP/USD out of its downtrend.

NZD: Soars On Rising Dairy Prices

The best-performing currency Tuesday was the New Zealand dollar. NZD/USD soared as much as 1.5% at one point following stronger than expected dairy auction results. For the second auction in a row dairy prices, increased and this time by 3.6%, the largest rise in at least 12 months. This increase helps to validate the Reserve Bank of New Zealand's optimistic outlook for the economy and the need for more tightening along with the hope that 2015 will be a better year for the New Zealand dollar. However given that slower growth in China and uncertainty in Russia are the main catalysts for the decline in prices in 2014, stability in dairy prices is the best that producers could hope for. As the AUD received a boost from a smaller than anticipated trade deficit, the CAD resumed its slide with oil prices reaching new 5.5-year lows. Since June oil prices are down 55%. The Canadian trade balance and IVEY PMI report are scheduled for release Wednesday. While the Royal Bank of Canada argues that lower oil prices could be net positive for the economy because cheaper oil will boost U.S. activity and drive the CAD lower -- they are in the minority. Most economists believe that Canada will suffer from the decline in oil with Wednesday's trade and IVEY PMI report to show evidence of that.

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