What’s Making FX Traders Nervous?

The sell-off in currencies and equities Thursday reflects a sense of nervousness in the financial markets but what could be making investors jittery at the start of the year? 2014 is supposed to be a good year for the U.S. economy and despite the drop in the ISM manufacturing index, recent economic data has been consistent with a continued recovery in the U.S. economy. However an improving economy also means the Federal Reserve will continue its course of tapering asset purchases which will lead to higher borrowing costs for consumers and businesses. 2013 was a great year for the stock market but higher rates increases the cost of doing business, which should be negative for stocks but we have yet to see a meaningful correction. Therefore it is not unusual to see selling in equities especially with thin liquidity. This sell-off spilled over into the forex market, driving the dollar higher and risk currencies lower. The drop in U.S. 10-year yields also confirms that risk aversion is driving price action across the financial markets.

Aside from the prospect of Fed tapering, overnight we also received confirmation that the Chinese economy is slowing, posing a risk to the countries that are dependent on China for growth. The slowdown in China will make U.S. assets more attractive this year. Over the past decade, money has flowed out of Western into developing nations in seek of greater growth opportunities. While China will still grow at a faster pace than the U.S. in 2014, the slowdown in momentum will make investors nervous about leaving their money parked in the East and wary about missing out on opportunities in the West. As such, the slowdown in Chinese manufacturing activity is contributing to the sell-off that we are seeing Thursday in equities and currencies. Among developed nations, Australia is one of the countries hit the hardest by slower Chinese growth and we are beginning to see evidence of that in last night's PMI report which showed manufacturing activity slowing for the second month in a row.

In contrast the U.S. is outperforming the market's expectations. While the ISM manufacturing index dropped from 57.3 to 57.0 in the month of December, economists had been looking for a steeper decline to 56.8. Strong gains were seen in employment and new orders. Construction spending also beat expectations, rising 1.0% in November from an upwardly revised 0.9%. The jobless claims forecast was for a rise to 344k but instead, claims dropped to 339k from 341k. These reports indicate that the U.S. remains on track for a stronger recovery in 2014.

There are no major U.S. economic reports scheduled for release Friday but a number of Federal Reserve officials will be speaking. Bernanke, Plosser, Lacker and Stein are expected to share their views on the economy. Lacker is a non-voter but Plosser and Stein are voting members of the FOMC this year and they generally lean towards hawkishness.

EUR: Potential Triple Top?
The euro sold off sharply against the U.S. dollar Thursday, leaving investors wondering about whether the currency pair has officially carved out a triple top. From a fundamental perspective, uneven Eurozone data and the dovish bias of the European Central Bank are two big reasons why we expect the euro to underperform the dollar this year. According to the final Eurozone PMI numbers released this morning, manufacturing activity in the region expanded for the 6th month in a row. While it may be encouraging to see manufacturing activity expand in the Eurozone and its largest economy Germany, weakness in France raises concerns about how optimistic the central bank can be when the second largest economy continues to slow. Italy and Greece also saw improvements but with a more than 26% unemployment rate in Spain, there is still widespread weakness in the region. The Eurozone is expected to grow this year but the 1.1% projected growth rate pales in comparison to the 3% growth expected for the U.S. this year. From a technical perspective, the EUR/USD failed at a very important resistance level last year. Over the past 2 months, EUR/USD tried to close above 1.3830, the 61.8% Fibonacci retracement of the sell-off that lasted between 2011 and 2012 but failed to do so. However in order for the rejection of 1.38 to become an official triple top, EUR/USD would need to close below the December 20 low of 1.3625 and ideally below 1.3600. With no Eurozone data on the calendar Friday, we are not looking for any big moves in EUR/USD but next week the European Central Bank has a monetary policy announcement that could be the catalyst for a downside break.

GBP: Backs Off Fresh 2-Years Highs on Surprise Decline in PMI Manufacturing
After hitting a fresh 2-year high before the European open, the British pound traded lower against the U.S. dollar throughout the North American session and was actually one of the days worst performing currencies. Given the overall strength of the U.K. economy, the decline in manufacturing growth in the U.K. caught many traders by surprise. Analysts were looking for another improvement especially since a similar survey conducted by the Confederation of British Industry showed a significant uptick in manufacturing activity. Nonetheless the more closely followed factory activity report from Markit Economics dropped to 57.3 from 58.1 in December. On New Years Day Prime Minister Cameron called the U.K. recovery fragile and while Thursday's drop in PMI reinforces this view and drove sterling sharply lower, the details of the report were not nearly as worrisome because employment, new orders and new export orders continued to grow. The selling of British pounds did not gain momentum until the losses started to add up in U.S. stocks. How GBP/USD trades around the 1.6430 level is key because this level is the 38.2% Fibonacci retracement of the 2007 to 2009 sell-off. If the currency pair fails to hold this level, then the near term losses could extend below 1.63 but as long as the pair remains above 1.62, the uptrend is intact. The U.K. is one of the few countries with economic data scheduled for release on Friday. The focus will be on the housing market will Nationwide house prices, the PMI construction index, consumer credit and mortgage approvals on the calendar.

AUD: Beware of a Short Squeeze
While European currencies sold off against the greenback, the commodity currencies traded higher which is surprising given the weakness in regional data and risk aversion. For the past few months, we have seen the AUD and NZD ignore its high beta status and trade purely on the outlook for China and Australia. What makes Thursday's price action interesting was the fact that AUD and NZD rallied despite weaker Australian and Chinese data. According to the latest reports, manufacturing activity slowed in both countries during the month of December. In Australia, the manufacturing sector contracted for the 28th out of the last 30 months with the PMI index dropping from 47.7 to 47.6. In China, the HSBC flash PMI index dropped to 50.5 from 50.8 the previous month. Both AUD and NZD traded lower on the back of these reports but recovered all of their losses during the North American session on the back of higher gold prices. Oil prices on the other hand dropped more than 2% but the impact on the Canadian dollar was nominal. China's non-manufacturing PMI index was scheduled for release Thursday night and was expected to confirm that the Chinese economy is slowing. Among the developed nations, Australia is expected to be one of the countries hit the hardest by slower Chinese growth. Yet it is also important to keep positioning in mind because with traders holding a significant amount of short positions, a short squeeze can drive AUD/USD higher even though the outlook calls for a weaker currency. 90 cents is the key level to watch in AUD/USD.

USD/JPY Slips Below 105 on Lower US Yields and Risk Aversion
With Japanese markets closed on Thursday and Friday, the Yen traded purely on risk appetite. USD/JPY hit a fresh 5-year high of 105.44 before the North American open but ended the day below the key 105 level. Taking a look at the charts, as long as USD/JPY holds above 104, the uptrend remains intact. GBP/JPY and CHF/JPY saw the steepest losses Thursday as the surprise slowdown in manufacturing activity drives sterling lower. The decline in 10-year U.S. bond yields also weighed on USD/JPY but with U.S. rates headed higher this year, we view the pullback as temporary. One of the biggest risks for Japan this year is a higher consumption tax in April. The last time a politician in Japan dared to raise taxes was in April 1997 and the increase plunged the economy into recession and later deflation. In the months leading up to the tax increase, the economy grew rapidly with Q4 GDP growth in 1996 hitting a high of 6.1%. Growth remained strong in the first quarter of Q1, with GDP rising 3%. During this time, USD/JPY rose 10% after rising 4.5% in the last quarter of the year before the rate hike. USD/JPY collapsed once taxes were increased because the economy contracted 3.8% the quarter that taxes were raised but taxes won't be increased for another 3 months. In the near term the focus will be on how much consumers will spend leading up to the tax hike.

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