By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The forex market was rocked by geopolitical risks Monday: first it was the elections in Germany and New Zealand and then North Korea accused the U.S. of declaring war and said it has the right to shoot down strategic U.S. bombers, regardless of location. It should only be a matter of time before President Trump responds and given his track record, he's not going to be gentle. As the war of words borders dangerously on military engagement, USD/JPY and USD/CHF have been hit hard. These currencies, along with the yen crosses, are likely to be dealt another blow when Trump responds. U.S. yields also reversed earlier gains on the news, adding pressure on the greenback. At the end of last week we said the focus would be on geopolitical risks and as the potential for uncertainty turns into reality, it will continue to be the leading driver of currencies, especially with no major U.S. economic reports on the calendar. Meanwhile, we have also been watching Fed speak, which was not as hawkish as last week's FOMC minutes. Although Fed President and FOMC voter Dudley said the U.S. economy is in a good place, he left the door open by saying that the balance sheet could be used again if needed. FOMC voter Evans, on the other hand, said there needs to be clear signs of higher inflation before the Fed hikes again because as of right now, inflation expectations are too low and he doesn't see much risk of an outsized breakout. Kashkari, Brainard, Mester and Yellen will be speaking in the next 24 hours so watch the headlines because they'll determine where USD/JPY is headed next. Unfortunately geopolitical risks are likely to dominate so the risk to the downside for USD/JPY.
The euro and New Zealand dollar were the worst-performing currencies Monday with the single currency dragged down by election results, data, yields and risk aversion. In Germany, Angela Merkel's party failed to secure the grand sweeping majority that she hoped for. Instead, the far-right Alternative for Germany party secured enough support to enter parliament for the time first since World War II. Next to losing, this was probably the worst-case scenario for Merkel, who now has the delicate task of building a coalition government. The most likely scenario is the Jamaica coalition of the Christian Democratic Union, the Free Democratic Party, and the Greens, but even that appears to be facing opposition from the FDU. A coalition government will make it more difficult for Merkel to pass policies and we know that the FDP is adamantly against euro debt pooling, refusing to forgive Greek debt and wanting tougher terms on EU bailout. EUR/USD also received no help from ECB President Draghi, who said that while the bulk of QE decisions will be made in October, the ECB can't afford hasty moves on monetary policy as it needs to be sensitive about not halting the recovery. His concern about the outlook for the economy were reinforced by the softer German IFO business confidence report. Having broken below the 20-day SMA, EUR/USD is headed for a test of 1.18.
In New Zealand, Prime Minister Bill English won reelection but his party failed to capture a parliamentary majority. This means that they will need to form a coalition government, which could take weeks, especially since the Labour Party's Jacinda Arden has yet to admit defeat. Both are expected to reach out to minority party NZ First leader Winston Peters. This uncertainty weighed heavily on the currency and could also affect the Reserve Bank's bias later this week. The RBNZ may opt to be a bit more cautious or firmly neutral until the political landscape becomes clear. In the meantime, New Zealand's trade balance was due Monday evening and significant deterioration was expected. We continue to look for further NZD weakness against the USD, AUD, CAD and other major currencies. The Australian dollar traded slightly lower on the back of risk aversion but RBA Assistant Governor Michelle Bullock was scheduled to speak on a panel Monday evening.
Ten days have now past since we've seen a decline in USD/CAD. It is generally difficult for a move to last this long without a correction, but the pair was unchanged many of those days and it is deeply oversold so a further short squeeze is possible. Whether that happens or not depends largely on Wednesday's speech by Bank of Canada Governor Poloz. The BoC has been extremely hawkish and if this view is reinforced by Poloz, the loonie will reverse course quickly. However if there's even a hint of caution in his voice, USD/CAD will extend its gains to 1.25. The currency pair traded sharply higher Monday despite a nearly 3% rise in oil prices. Yields were clearly the more important driver but that could change if oil prices continue to press higher on Tuesday. Last but certainly not least GBP/USD also traded lower but its losses paled in comparison to the euro. No economic reports were released and nothing substantial is expected until Thursday when BoE Governor Carney speaks in London.