Will UK Data Drive GBP To 1-Year High?

Will UK Data Drive Sterling to Fresh 1-Year Highs?

Investors are buying British pounds ahead of tomorrow’s key U.K. economic reports. Sterling rose to its strongest level in a year versus the euro and appreciated for the third straight day against the U.S. dollar. Based on recent U.K. data, the economy lost momentum towards the end of the year but investors are optimistic that the central bank will view this pullback as temporary. The U.K. employment report and Bank of England minutes are scheduled for release on Wednesday. While service, manufacturing and construction sector activity slowed, U.K. companies added workers at a quicker pace last month. In fact, employment in the service sector rose for the twelfth successive month at a historically sharp pace and in the manufacturing sector, it grew at its second strongest rate in the past 2.5 years. Therefore, we have strong reasons to believe that the employment report will surprise to the upside, but whether or not sterling hits a fresh 1-year high versus the euro will also be contingent on the Bank of England minutes, which will be released simultaneously. When the central bank last met, they left monetary policy unchanged and provided very little detail on their views. Going into the meeting, policymakers knew that manufacturing and service sector activity slowed and the big question is whether they will focus on the one-month decline or the consistent drop in the unemployment rate. The unemployment rate is now only 0.4% away from the central bank’s 7% target and while they believe that it will hit this level in the third quarter of 2015, we believe that its realistic for the target to be reached this year. The central bank has said that 7% unemployment is a threshold and not a trigger for a rate hike (a point they will strengthen in the minutes) but sooner rather than later, the central bank will have to decide if it is necessary to advance their unemployment rate forecasts and/or lower their unemployment rate threshold to 6.5%. The key lies in the wage growth. Right now wage growth is lagging behind inflation but if it starts to accelerate, the Bank of England will feel more pressure to raise interest rates. Average weekly earnings will be released with tomorrow’s employment report. The British pound will benefit significantly from the combination of stronger employment numbers and a central bank that is growing more aware of the proximity of 7% unemployment. However if the jobs numbers surprises to the downside or the BoE hones in on the drop in PMIs, sterling could give back its gains quickly.

Will the Bank of Canada Crush the CAD?

The Canadian dollar is trading lower against the U.S. dollar ahead of the Bank of Canada’s monetary policy announcement. While the central bank is widely expected to leave interest rates unchanged tomorrow, the recent deterioration in the labor market and manufacturing activity along with low inflation could prompt the central bank to harden its easing bias. It is almost hard to believe that back in September, the central bank was talking about raising interest rates and now the market is beginning to price in the possibility, albeit a small one for a rate cut. Having traded briefly above 1.10 this morning, USD/CAD dropped to the 1.09 handle after the stronger than expected manufacturing sales report. For forex traders, the big question is whether the Bank of Canada will crush the Canadian dollar. In order for USD/CAD to rise to fresh 4-year highs above 1.1020, the central bank needs to do more than maintain its easing bias. They need to downgrade their assessment of the economy, increase its concerns about inflation and make it clear that a rate cut is on the table. There have been calls from the OECD and IMF for the BoC to raise rates and earlier this month even Finance Minister Flaherty said “there will be pressure to tighten because of the U.S. Federal Reserve scaling back its bond purchasing program.” Central Bank Governor Stephen Poloz shot back by saying that to avoid making a big mistake “we should hold rates where they are until the data flow changes our mind.” With the international community and the country’s Finance Minister calling for tighter monetary policy, the central bank won’t be overly eager about lowering rates. In other words, the chance of rate cut this year is still less than 25%. The recent sell-off in the Canadian dollar should also provide support to the economy but so far, we have not seen any evidence in inflation or activity, which is why the BoC could still harden its easing bias. If the BoC were to surprise with a rate cut, USD/CAD could soar to 1.12 but we believe that a stronger easing bias would be enough to drive the currency pair back above 1.10. Since the last BoC meeting in December, job losses hit its highest level in 9 months, driving the unemployment rate to a 5 year high and manufacturing activity contracted at its fastest pace since May 2009, giving the BoC every reason to be dovish. However the big problem for USD/CAD is speculative positioning. According to the latest CFTC IMM report, speculative short positions are at their highest level since May 2013. This means that in order for USD/CAD to extend higher, the BoC needs to be very dovish because anything short of that could lead to a reversal driven by profit taking.

BoJ Meeting Should be Nonevent for Yen

It was a topsy-turvy day for the Japanese Yen which initially traded higher against all of the major currencies during the Asian and early European trading session only to give up most of its gains in North America. The initial rally in the Yen crosses was driven by China’s decision to inject more than 225 billion yuan into the financial system. This announcement drove the Nikkei as well as other Asian stocks sharply higher (more on this in the dollar portion of our commentary). However when U.S. stocks opened for trading and started to decline, USD/JPY followed, giving up nearly all of its gains by the end of the day. The Bank of Japan is expected to make its monetary policy announcement tonight and we don’t expect any changes. The BoJ is happy with the uptrend in inflation and improvements in growth. The consumption tax poses a major risk for the economy but until we start to see demand contract, the BoJ will not act. In fact we still expect growth and consumption to accelerate ahead of the increase in April. While traders should keep an eye out for the comments from BoJ Governor Kuroda, in all likelihood we expect the BoJ decision to be a nonevent for the Yen.

EUR: Optimism from the ECB

The euro ended the day unchanged against the U.S. dollar on the back of mixed economic data. The ZEW survey is a measure of investor confidence and according to the latest report, investors are more confident about current conditions in Germany but less confident about the country’s outlook. This would be worrisome if not for the Eurozone ZEW survey which rose to its highest level since the first quarter of 2004. This improvement indicates that analysts and economists are optimistic on the region’s future despite concerns about growth in countries such as France. ECB member Nowotny shares this rosy outlook. He said today that while the euro upswing is weak, the ECB could revise up its growth forecasts because there is more upside than downside risks for the region. While this conflicts with ECB President Draghi’s view that “growth risks remain on the downside,” it is consistent with our view that the Eurozone economy will recover this year, albeit at a more sluggish pace compared to its peers. There are no Eurozone economic reports scheduled for release tomorrow but the flash PMI reports are due for release on Thursday and they should be big movers for the euro.

Dollar: Chinese Liquidity Injection, IMF Forecasts

The U.S. dollar ended the day higher against all of the major currencies with the exception of the British pound. The lack of U.S. economic data meant that currencies took their cue from equities. The S&P 500 spiked at the open, traded sharply lower by lunchtime and recovered by the end of the North American trading session. It is earnings season and disappointing results from Johnson & Johnson and Verizon sent stocks plunging early in the day. Across the Pacific, China is providing its own economy with a nice jolt of stimulus. The People’s Bank of China injected over 225 billion yuan into their financial system following a short term lending facility that increased cash flow for banks the day prior. While part of the liquidity injection can be attributed to the upcoming Chinese New Year holiday, the government is also trying to boost confidence amidst weakening growth and potential banking sector defaults. Equity traders received the liquidity injection positively across the globe. Meanwhile the IMF also raised its global growth forecast by 0.1% to 3.7% this year. They see the U.S. growing at 2.8%, up from an earlier forecast of 2.6% and the U.K. growing at 2.4% vs. a previous estimate of 1.9%. Their forecast for the Eurozone remained unchanged at 1%. No U.S. economic reports are scheduled for release on Wednesday.

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