FX Traders May Be Overly Optimistic

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

After the big move in currencies at the start of the week there was a sense of calm on Thursday in the foreign-exchange market. Many of the major currencies licked their wounds and recovered their recent losses -- but we fear that there could be a false sense of optimism in the market. The best performer was USD/JPY, which traded up as much as 300 pips from its low on Wednesday. We had been pointing to the 2-year U.S. – JGB yield spread and speculative positioning as reasons for a bounce in USD/JPY and while those certainly played a role, stronger-than-expected U.S. data also contributed to the move. We didn’t expect much impact from jobless claims and durable goods but when the market is bullish USD/JPY, positive data can reinforce current sentiment and have a more meaningful impact on the currency. Jobless claims actually rose more than expected so the boost to the dollar came solely from durable goods. Orders for products made to last 5 years or more rose 4.9% in January and excluding transportation, these orders increased 1.8%. This was the largest increase in capital goods since June 2014 and not only does it suggest that the drag from the strong dollar is fading, but that first quarter GDP growth may not be as weak as some anticipate. However we’ll have to contend with revisions to fourth quarter GDP numbers first, which according to the forecasts, economists are looking for a significant downward adjustment on Friday that could strip away some of USD/JPY’s gains.

Meanwhile EUR/USD continues to flirt with 1.10 – it traded above and below that rate multiple times during the North American session. Eurozone data was mixed with German consumer confidence ticking higher and Eurozone consumer prices falling. CPI dropped 1.4% in January, adding pressure on the ECB to ease. German consumer prices and Eurozone confidence numbers are scheduled for release Friday and chances are they will confirm that economic activity and inflation remain weak. While expectations for ECB easing grows, what is interesting about the euro is that it has been moving on risk appetite. EUR/USD traded higher on Wednesday when stocks crashed and gave back its gains when the Dow turned positive. On Thursday, the continued rally in U.S. equities and the improvement in risk appetite kept EUR/USD under pressure for most of the day. Historically, euro is a high-beta risk currency, which means that it rallies when investors are optimistic. But that changed with negative interest rates. The ECB turned the risk currency into a funding currency that rises when stocks fall and vice versa.

The British pound ended the day virtually unchanged against the greenback. The fact that further losses were not seen is good news for sterling because it means that investors are taking a break from Brexit selling. They were also encouraged by the latest GDP report. Investors had been bracing for a downward revision but instead, growth held steady at 0.5%. However the details of the report show underlying weakness with consumer spending growth printing lower than anticipated and exports falling instead of rising. 2016 is a challenging year for the U.K. economy and as such we’ll be looking for further losses in the currency.

As for the commodity currencies, we are a bit surprised by their immunity to Wednesday night’s meltdown in Chinese equities. Overnight the Shanghai Composite Index fell -6.4% and the Shenzhen Composite dropped -7.3% ahead of this weekend’s G20 meeting. It was declines of these magnitudes that sparked the beginning-of-the-year meltdown in global equities -- but the market ignored the sell-off, attributing it to tighter liquidity. While European stock indices ended the day up approximately 2%, we believe that investors are remiss to shrug off the moves in Chinese equities. There are legitimate concerns about the economy and upcoming IPO reforms that could cause more anxiety in the markets. So keep an eye on AUD and NZD because if Chinese stocks fall once again Thursday night, those currencies may not be able to hold onto their recent gains. Part of their resilience can be attributed to data. Wednesday night we learned that private capital expenditure in Australia surged in the fourth quarter and New Zealand migration increased significantly. On Thursday evening, New Zealand trade balance numbers were scheduled for release and the increase in the manufacturing PMI index signals a potential upside surprise.

USD/CAD traded sharply lower Thursdaay on the back of the sharp intraday reversal in oil prices. The price of crude was down 2% at the start of the U.S. session and ended the day in positive territory. This sell-off took the pair well below the 100-day SMA. We are a bit surprised by Wednesday’s reaction to the oil inventory report. Even though refined product inventories fell, the fact of the matter is that crude stockpiles hit a record high. There’s more supply than demand in the market and that is not expected to change any time soon. We continue to look for oil to break $30 a barrel and for USD/CAD to make another move above 1.38.