By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
What a week it has been in the foreign-exchange market! The turnaround in oil, recovery in currencies and rebound in global equities has many investors hoping that 3 weeks into the New Year, we've finally seen a bottom. 2016 started with major losses across the financial markets and even with the latest bounce, oil prices are down more than 28%, U.S. stocks are down +6%, European stocks are down anywhere between 5% to 7% while Japanese stocks have lost 10% year to date. Currencies fared better as the latest recovery left most of the majors with an average of 2% to 5% in losses versus the U.S. dollar. But the question is, has the selling finally come to an end?
The answer, simply, is 'No'.
There are rallies in every bear market and most importantly nothing significant changed over the past week. Of course most markets are not in bear territory, which is typically defined by a more than 20% drop from a recent high. But many markets are oversold and a short-term recovery is not unusual. Iran is still poised to add 500,000 barrels a day to oil exports and supply far exceeds demand. Oil prices fell hard and fast over the past week and finally found some support near $25 a barrel. There was no specific reason to catalyze the rally but it was enough to drive up equities and currencies. While the Bank of Canada's optimistic attitude was a valid reason for the rise in the Canadian dollar, the decline in oil prices will certainly weigh on economic activity in the coming year.
Looking ahead, it will be another busy week for currencies.
Three central banks are scheduled to make monetary policy announcements, giving FX traders 3 reasons to be worried. The Federal Reserve's monetary policy meeting will be the most important event risk of the week. Coming off the heels of a 25bp rate hike, no one expects another round of tightening in January. However after last month's meeting, Yellen expressed confidence in the economy and the possibility of inflation returning to 2% once transitory factors fade. This time around, it will be difficult for Federal Reserve officials to keep a brave face. While Yellen will not be holding a press conference, we would be surprised if the FOMC statement did not contain a tinge of concern. The ECB with its weak currency is worried about inflation and economic uncertainty. The same is true of the BoE, so it's hard to believe that U.S. policymakers haven't been unnerved by the volatility in equities and commodities. The big question is whether these concerns appear in this month's FOMC statement and if they do, USD/JPY will give up its recent gains.
However USD/JPY faces the small-but-significant risk of additional easing from the Bank of Japan. According to one of the country's largest papers, Nikkei, the BoJ "is taking a serious look at expanding its monetary easing measures amid market uncertainty." They note that the central bank is worried about falling oil prices, a rising currency and tumbling stocks. While the decline in oil makes oil imports less expensive, it also makes it more difficult to achieve their inflation target. But throughout last year, despite widespread calls to do so, the central bank refused to increase the size of its Quantitative Easing program. But what's different now is that the yen is rising and stocks are falling. We're not sure if there is enough support for more stimulus, but there's no question that the BoJ will be discussing the option.
We are not looking for the Reserve Bank of New Zealand to cut interest rates again after just doing so in December. However there's a reasonable chance that it will shift its forward guidance. At the end of last year, the RBNZ said it "expect[s] to reach their inflation goal at current rate settings." That line implies that it is not looking to lower rates again in the near term, which is reinforced by its upgraded 2016 GDP forecasts. However since then we've seen dairy prices fall and CPI match the 2008 decline, which was the largest since 1998. The markets also went haywire in December, so it's likely that this month RBNZ Governor Wheeler will emphasize the possibility of further rate cuts.
Softer Eurozone PMI numbers drove the euro lower against the U.S. dollar on Friday. Manufacturing and service-sector activity slowed in January bringing the Eurozone's composite index down to 53.5 from 54.3. After Mario Draghi's strong signal to the market that additional easing could be delivered in March, the path of least resistance for EUR/USD will be lower. However it may be more of a slow drift than a steep decline. He couldn't be any clearer when he said the ECB has the power, determination and willingness to act with plenty of instruments at its disposal. Germany's IFO report is the only significant piece of Eurozone data on next week's calendar and given Friday's drop in the PMIs, we are looking for softer numbers that should take the euro lower.
Sterling traded sharply higher against the U.S. dollar Friday despite weaker retail sales numbers. Consumer spending dropped 1% in December, which was significantly weaker than the market's -0.3% forecast. Excluding auto fuel, spending still fell -0.9%. These numbers subtract from GDP growth and put the risk of next week's report to the downside. While investors ignored the news, choosing instead to focus on borrowing data, which came in much better than expected, we believe that sterling remains a sell on rallies because of the deterioration in spending, slowdown in wage growth and less hawkish BoE comments.
Finally, after rising for 12 trading days in a row, USD/CAD dropped for the third straight day. Friday's Canadian economic reports were mixed. Canadian retail sales jumped 1.7%, which was much better than anticipated, but consumer prices fell 0.5%. Ultimately we think these numbers are good for Canada because the retail sales surprise was much larger than CPI, which bodes well for next week's GDP report. Between the Bank of Canada's optimism, the whopping 8% recovery in oil prices and stronger CAD retail sales, we are looking for USD/CAD to test 1.40.