By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Over the past few months, we have seen strong correlations between the U.S. dollar, U.S. yields and U.S. stocks but on Wednesday, as the Dow Jones Industrial Average climbed above 20,000 for the first time, the greenback barely budged. Treasury yields responded appropriately, extending their gains as the 10-year rate broke 2.5%, but the dollar was left out of the party. The greenback ended the day lower versus the euro, Japanese yen, British pound and Canadian dollar and the question everyone is asking now is whether the greenback is lagging or diverging. We believe it's lagging because President Trump’s policies from inflation to corporate-tax reform, spending, protectionism and future Fed hikes are positive -- not negative for the greenback. His latest executive order to build a Mexican wall is an infrastructure-spending project that should create jobs and demand for building material. So why isn't USD not strengthening? The problem that the greenback is having right now is two fold -- first, Trump has been talking down the currency and second, his policies make foreign investors nervous. We would not be surprised if China fired back against his recent attacks with a threat to sell U.S. Treasuries. Until the market comes to terms with the risk/benefits of Trump policy, the dollar may have a tough time mimicking the one-way moves in stocks and bonds. No major U.S. economic reports were released Wednesday but the trade balance, jobless claims, new home sales and Markit PMI’s service and composite reports are scheduled for release on Thursday.
Wednesday's best-performing currency was the British pound. Since Prime Minister’s May speech on Tuesday, January 17, we’ve seen a more than 600-pip recovery in sterling. This comes despite Prime Minister May’s plan for a hard exit from the European Union with no involvement in the EU’s single market. While this was the worst-case scenario for the U.K., instead of falling, sterling rose. Since then the U.K. Supreme Court has ruled that the government will need Parliament’s approval to invoke Article 50, which begins the process of leaving the E.U. Instead of rising, sterling fell on Tuesday, which was a bit counterintuitive. But the losses were short-lived as pound pushed above 1.25 versus the U.S. dollar to fresh year-to-date highs. There are still many risks ahead including the impact on the economy and Scotland’s potential push for Independence, but for the time being, investors seem to find comfort in a clear path forward and we expect further gains in the near term as May makes her trip to Washington. Given President Trump’s support for Brexit, there’s a very good chance that the two leaders will announce some type of progress on a bilateral trade deal. If the U.S. becomes one of the first countries to announce a bilateral trade deal with Britain, it would be a vote of confidence for Brexit and force other countries to fall in line. Will it shield the U.K. economy from slower growth or recession? No, but it will be years before the U.K. formally exits from the E.U. and that's when it will feel the brunt of the pain. For the time being, the weaker currency and a friendlier relationship with the U.S. should continue to support the economy. Taking a look at the charts, the break above 1.25 and now 1.26 in GBP/USD opens the door to a move up to the December high of 1.2775 with the uptrend only threatened by a drop below 1.24. We also anticipated a further decline in EUR/GBP with a potential move down to 84 cents.
Euro on the other hand was held back by softer German data. Germany’s German Ifo Business Climate Index dropped to 109.8 in January from 111. This decline was driven by a lower expectations and current assessment report that shows German businesses growing less optimistic about current and future conditions in the Eurozone’s largest economy. What’s interesting about this report is that it's at odds with the PMIs released earlier this week that showed stronger manufacturing activity and hotter price pressures. The only explanation is that the slowdown in services overshadowed the uptick in manufacturing. For the past 3 trading days, euro has struggled to extend its gains and part of this could be attributed to EUR/GBP selling. 1.08 is a key resistance level for the currency pair. If it holds below this rate, then we can expect a move back down to 1.06. However if it breaks 1.0825 or so, we could see a stronger run to 1.09.
The Canadian and New Zealand dollars traded higher against the greenback Wednesday while the Australian dollar lost ground. The underperformance of AUD can be explained entirely by the lower-than-expected consumer price report. CPI rose only 0.5% in the fourth quarter, down from 0.7%. While the annualized pace of growth accelerated, the quarterly report disappointed, giving investors very little reason to believe that the Reserve Bank will move away from its firmly neutral monetary-policy bias. New Zealand consumer prices were scheduled for release Wednesday and the drop in dairy coupled with food prices signals a potential downside surprise. USD/CAD on the other hand continued to fall, extending its slide for the third straight day. Oil inventories were higher but oil prices appear to be unaffected as the currency continues to benefit from Trump’s Keystone pipeline plans.