By Kathy Lien, Managing Director of FX Strategy for BK Asset Management
Typically when there are spikes low in currencies like the ones seen Wednesday in GBP/USD and USD/JPY, investors start to wonder if a bottom is near. Overnight sterling dropped to a fresh 30+ year low of 1.2798 on nothing more than thin liquidity conditions. The move coincided with a drop in all of the major currencies but the majority of losses were recovered by the end of the North American trading session. AUD/USD even turned positive, to end the day up more than 0.50%. The rise in U.S. stocks and drop in Treasuries reflect a slight improvement in risk appetite but the moves are too small to draw any real conclusions. There was also little consistency in the dollar's performance, which appreciated against GBP and NZD but edged lower against EUR, JPY, AUD, and CHF. U.S. data was mixed with a sharp improvement in the non-manufacturing ISM index offsetting a wider trade deficit. Many investors anticipated stronger service-sector activity and more specifically an uptick in the employment component of the report, but the ISM index hit a seven-month high and increased by the largest margin since 2008. The employment component also jumped 3 points, signaling the potential for a sharp rise in nonfarm payrolls. While a good jobs number won't change the Fed's minds about keeping interest rates unchanged this year, a rise of more than 200K could still be enough to extend the recovery in USD/JPY and the decline in GBP/USD. So in other words, while USD/JPY should find itself back above 102, GBP/USD is poised for further losses. Meanwhile, the FOMC minutes did nothing but highlight the division within the central bank. Policymakers felt that it was prudent to wait for more data before raising interest rates and we are certain that the "data" they've gotten in the form of Brexit will be enough to turn some hawks into doves.
Sterling hit fresh lows against all of the major currencies and while there was no news to explain the move, the sharp selloff sent fresh jitters across the financial markets, driving investors into the safety of the U.S. dollar, Japanese yen and gold. Now that GBP/USD has traded below 1.3000, there is no support until the June 1985 low of 1.2565. Resistance is at 1.3000 but a short squeeze could easily take the pair to 1.31. Ultimately, sterling is headed lower as bad news worsens. We just started to see property funds freeze redemptions but in the coming weeks and months, bank stocks and property prices will continue to fall, putting greater pressure on businesses and consumers. Brexit puts significant stress on the financial sector and property funds are the first to feel the pain. Other sectors will start to implode, edging the U.K. economy and British pound lower. Industrial production numbers are scheduled for release Thursday and healthier numbers won't help the currency.
The euro's resilience has been nothing short of impressive. The currency pair traded as low as 1.1030 before bouncing to end the day near 1.1100. This price action is important because it takes the pair back above the 200-day SMA. The "break" isn't convincing but is enough to lead us to believe there could be a stronger recovery to -- and possibly above -- 1.1150. Euro has been a major beneficiary of anti-U.K. flows and we can see that through the more than 1% rise in EUR/GBP. The Eurozone is hardly sheltered from the U.K.'s troubles and there could be a banking-sector crisis brewing in Italy. But for now, the greater concern is clearly Britain. Italian bank stocks have fallen 30% in the last 2 weeks and according to a recent report from the WSJ, 17% of bank loans in Italy are bad debt, which is 3 times more than what the U.S. had during the financial crisis. It's a ticking time bomb ready to go off. We've been down this road before with other countries and know how things can end very badly. In order to avoid this scenario or shore up the economy when it happens, the Italian government will either have to inject money into the financial system or the ECB will need to ease monetary conditions.
The Canadian dollar took its cue from oil prices, which turned positive toward the end of the U.S. trading session. Canada reported a much weaker-than-expected trade deficit (-3.28b vs. -2.7b), which sent USD/CAD to 1-week highs. However when oil prices began to recover, USD/CAD gave up on all of its gains. Canada's IVEY PMI report is scheduled for release Thursday and the high price of oil in June is expected to lift the sector from contraction to expansion. The Australian dollar traded sharply higher Wednesday while the New Zealand dollar underperformed, leading to a 1% rise in AUD/NZD. There was no news to explain the divergence outside of Tuesday's marginal drop in dairy prices. We still believe that if one of these central banks were to ease after Brexit, it would sooner be the RBA than the RBNZ. Both currencies represent great yield plays but Australia is still mired in political uncertainty and suffers more from a weaker Chinese economy/currency. Australia provides hard commodities to China, which will be cut first when the economy slows whereas New Zealand provides soft commodities such as the milk and meat that will see demand grow as the country shifts from an export- to consumption-based economy. For all of these reasons, we don't believe that AUD/NZD deserved Wednesday's strong gains and would not be surprised to see a pullback before the end of the week.