What's Driving European Currencies?

Behind the Outperformance in European Currencies

Only 2 words are needed to describe the performance of currencies, equities and Treasuries Thursday and that is “risk aversion.” Weakness in Chinese and U.S. manufacturing activity raised fresh concerns about global growth. The commodity currencies fell sharply, which is expected on a day when the Dow Jones Industrial Average was down nearly 200 points. The rally in European currencies on the other hand is not what we would normally expect in periods of risk aversion. The euro, Swiss Franc and British pound performed extremely well with the first two currencies rising more than 1% against the U.S. dollar. Normally when there is trouble in Asia or the U.S., investors sell all high beta currencies including the euro and British pound but these currencies did well thanks to the recent strength in European data. The performance of currencies has everything to do with expectations.

The European Central Bank’s concern about the “downside risks” to growth led many investors to believe that Eurozone data will be subdued but this morning the flash PMIs surprised to the upside with manufacturing activity in Eurozone growing at its fastest pace since May 2011. At the same time, the majority of market participants believe that the Federal Reserve will reduce asset purchases by $10 billion at each successive meeting but the recent weakness in U.S. data has them second guessing their opinions and this sentiment drove the dollar sharply lower against the currencies of countries with upside surprises in data. This divergence in economic data surprises is also the reason why the British pound rose to a fresh 2.5 year high against the U.S. dollar. The unemployment rate in the U.K. is falling much faster than the central bank or the market was prepared for especially given the drop in U.K. PMI and this has prompted widespread position adjustments in sterling. Thursday’s move has driven EUR/USD to a key level of resistance. If the currency pair breaks 1.37, there is no major resistance until 1.38.

The Swiss Franc on the other hand is benefitting from completely different news. The Swiss National Bank published a notice this morning proposing an increase in capital buffers by 1% to cool the housing market. While this move reduces the chance of a rate hike by the SNB, the market viewed it as an attempt to tighten the economy. We expect gains in the franc to be limited because the increase in the capital buffer is lieu of a rate hike.

Dollar: Weaker Data Raise Concerns About Fed Tapering

The dollar traded sharply lower against all of the major currencies with the exception of the comm dollars. The trigger is U.S. yields, which have fallen to their lowest level in 6 weeks and weaker economic data. This morning’s jobless claims report has been far from impressive. Claims held steady near 326k, house prices grew at a slower pace, the expansion in the manufacturing sector slowed according to Markit Economics and leading indicators rose 0.1% compared to 1% the previous month. Existing home sales beat expectations but the 0.4% gap between what economists forecasted and the actual report was more than offset by the 1.6% downward revision in November. This contrasts with the strong PMIs from the Eurozone, healthy labor market numbers from the U.K. and stronger than expected consumer spending in Canada. These second tier economic reports do not indicate that the U.S. economy is in trouble but with the Federal Reserve meeting next week they give investors a stronger reason to believe that the central bank could take a break from reducing asset purchases this month.

CAD Powers Higher Despite Stronger Retail Sales

Unlike European currencies, the commodity currencies were hit hard by risk aversion. The Canadian and Australian dollars took the brunt of the selling Thursday as both currencies were driven to fresh lows against the greenback. The CAD dropped to its lowest level in 4 years while the AUD fell to a 3 year low. Better than expected Canadian retail sales briefly eased the selling but when U.S. stocks accelerated their losses, traders returned to selling the loonie on the basis that the central bank knew about the uptick in retail sales before lowering their inflation forecast and strengthening their dovish bias this week. The Canadian dollar remains in focus Friday with consumer prices scheduled for release. Given that low CPI is the central bank’s number one concern, Friday’s report could be another big mover for the currency especially since economists are looking for CPI to decline. If prices drop on a monthly basis and drives annualized price growth lower, USD/CAD could break 1.12. However if the data is not nearly as bad as the Bank of Canada or economists fear, USD/CAD could succumb to profit taking. The currency pair has enjoyed a very strong rally in recent weeks and with speculative short positions in the Canadian dollar at extreme levels, the currency pair is particularly vulnerable to a reversal. Meanwhile the biggest loser was the Australian dollar, which dropped between 1% and 2% against the U.S. dollar, euro, British pound and Japanese Yen. The currency was hit hard by weaker Chinese PMI. According to HSBC, manufacturing activity in China contracted for the first time since August. Not only did the Flash PMI index fall to 49.6 from 50.5, but the expectations component of the report all declined. As evidence of slower growth, the Chinese PMI report is bad news for the commodity currencies. The New Zealand dollar would have experienced steeper losses if not for the sharp rise in consumer confidence.

GBP Hits 2.5-Year High Versus Dollar

With no U.K. economic data on the calendar, the British pound extended its gains against the U.S. dollar but fell sharply against the euro. While the breakout above 1.66 in the GBP/USD has been modest, the currency pair climbed to its strongest level since May 2011. Sterling is doing well in general with GBP/AUD and GBP/CAD rising to their highest level since 2009. While we are bullish sterling, Thursday’s Confederation of British Industry’s retail sales report leaves us concerned about the level of consumer demand in the month of January. The CBI index dropped from 34 to 14 against expectations for a decline to 25. According to the CBI survey panel’s chair, Barry Williams, “While retailers predict some modest growth ahead, the prospect of continually slow pay growth is likely to mean cautious consumers for some time to come.” Grocers and furniture stores saw stronger spending but clothing sales declined due to the mild weather. No U.K. economic reports are scheduled for release Friday.

Japanese Yen Crosses Hit by Risk Aversion

The sell-off in U.S. stocks sent investors running into the Japanese Yen. The Yen traded higher against all of the major currencies with the steepest losses seen in AUD/JPY and CAD/JPY. While the sell-off in USD/JPY led the move, the Australian and Canadian dollars were not immune to risk aversion. As mentioned in the dollar portion of our commentary, the trigger for the sell-off is the drop in U.S. yields. Ten-year bond yields fell below 2.8%, hitting its lowest level in 6 weeks. This move drove USD/JPY below 104, putting the currency on track to test 103. If yields continue to fall, 103 could also give way in USD/JPY but right now it is the main support for the pair. Unfortunately the yen crosses are vulnerable to additional losses during the Asian session when traders in the region wake up and see how much damage was done in U.S. stocks. Don’t forget that USD/JPY has an uncannily strong correlation with the Nikkei. The Bank of Japan released its monthly economic report and they described the economy as having “continued to recover moderately, and a front-loaded increase in demand period to the consumption tax hike has recently been observed.” While this is a much more detailed assessment than the last few months where they simply said the economy has been or is recovering moderately, it does not provide much in the way of new information because the real question is whether the front loaded consumption will evaporate once the tax is increased. According to the Ministry of Finance’s weekly portfolio flow report, Japanese investors were net buyers of foreign bonds last week.

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