By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The U.S. dollar soared to fresh highs against all of the major currencies Tuesday before reversing sharply to end the day well off its peak. At one point, the strength of the dollar pushed euro to its lowest level since January 2013, but as yields retreated, so did the greenback. The pop followed by the drop in the dollar surprised some traders because Tuesday morning’s U.S. economic reports were better than expected. The ISM manufacturing index rose to 54.7 from 53.2, which not only beat expectations but was also the strongest reading in 2 years. Construction spending rose as well, confirming the improvements in the economy. So if data is strong, why did yields fall? Technically, ten-year yields did not decline Tuesday but they ended the day well off their highs. The problem is that the run-up to the Fed’s first rate hike in a year is now over and while policymakers have signaled plans to raise rates 3 more times this year, the dollar’s sharp rally last quarter invited profit taking. There are also concerns about how strong Friday’s nonfarm payrolls report will be. Job growth should be decent but the forecasts for wage growth are high and the unemployment rate is expected to rise -- in other words, the data could fall short of expectations. However Wednesday’s FOMC minutes and Thursday’s ISM non-manufacturing report should support the dollar, which means pre-NFP dips in the dollar can still be bought. A more meaningful reversal would have to be triggered by a disappointing jobs report, which is a legitimate end-of-week risk for the greenback.
While Tuesday's worst-performing currency was the euro, 1.0340-50 continues to hold as rock-solid support for the currency. Eurozone data has actually been pretty good with more people falling off of Germany’s unemployment rolls. Economists were looking for unemployment to fall by 5k, but instead it declined by 17k. The jobless rate also held steady at 6%. More importantly, inflation surged in December. Consumer prices in Germany rose 0.7%, driving up the annualized pace of growth to 1.7%. Not only was this more than double the previous month’s rate, but the pace of growth was also the highest since 2013. On top of all this, on Monday, Germany’s manufacturing PMI index was also revised higher. Revisions to the Eurozone’s December service-sector PMI numbers are scheduled for release Wednesday. Despite Tuesday’s bounce, we still believe that the path of least resistance for EUR/USD is lower and that for the time being, rallies between 1.05 and 1.07 should be sold.
Sterling hit a 2-month low versus the U.S. dollar Tuesday before recovering its losses to end the day down marginally against the greenback. Given the sharp rise in the CBI index and the positive benefit of a weaker currency, the better-than-expected release was not entirely surprising. However few expected the U.K. PMI index to climb to its highest level in 30 months. Unfortunately, this report failed to prevent sterling from experiencing losses Tuesday. As our colleague Boris Schlossberg pointed out, “manufacturing is a minor part of the U.K. economy and most economists expect that the boost to growth will be more than offset by the decline in consumer spending as the high costs of imports takes a bite out of UK GDP.” The story for the British pound this month and probably this quarter is NOT how the U.K. economy is performing but how much risk Brexit poses to the country’s outlook. Brexit concerns will be front and center at the start of the year and the real focus will be the issue of a hard versus soft exit from the European Union. The PMI reports and other economic releases such as Wednesday’s mortgage approvals and construction PMI indexes will easily take a back seat to political developments.
All three of the commodity currencies traded higher against the greenback Tuesday but the gains in the Australian dollar completely outstripped the upticks in the Canadian and New Zealand dollars. A large part of its gains had to do with Tuesday’s rise in gold prices and Monday night’s stronger manufacturing PMI report. Manufacturing activity accelerated despite the recent sell-off in the Chinese yuan and softer manufacturing activity (as reported by the government’s official release). Commodity prices also surged according to the December commodity index, which jumped from 106.9 to 116.8. We still believe that the weakness of China’s currency will come back to haunt Australia’s economy but for the time being, it is the day’s best-performing currency. Gains in the Canadian dollar were curtailed by the sharp drop crude crude prices. Oil turned negative after hitting 18-month highs on the first trading day of the year after reports surfaced that Libya would increase production. The New Zealand dollar underperformed following a drop in dairy prices. At Tuesday’s Global Dairy auction, prices fell -3.9%, the second decline in a row and the steepest fall in at least 6 months.