By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Sterling, currencies and the financial markets have been saved by quarter-end flows. In less than 24 hours, Q2 draws to a close, which means equity funds and corporations will need to rebalance their portfolios and window dress their balance sheets after this month’s strong moves. Before Wednesday’s recovery, the Dow had fallen more than 3% for the quarter, the NASDAQ dropped 5.6%, the DAX was down 7% and the Nikkei was down 10%. The U.S. dollar lost more than 10% of its value against the Japanese yen and gained over 7% versus the British pound. On balance, the Dollar Index depreciated approximately 2%.
All of these moves have been tempered by Wednesday’s recovery, which was largely motivated by portfolio adjustments. U.S. markets outperformed European markets in Q2 and to rebalance their portfolios, managers of index funds and other similar equity-market portfolios need to sell dollars and buy euros or pounds to bring their overall exposure back into balance. Which explains why EUR/USD and GBP/USD performed well on Wednesday while USD/JPY barely budged. With yields continuing to fall and U.S./Eurozone data coming in lower than expected, there was nothing to justify recent recoveries. However even as quarter-end flows will eventually fade, we can’t help but see the impact these rallies have had on market sentiment. The odds may be against them, but investors are hoping that the worse is over for currencies and equities and the that gaps on Friday will be filled. But considering there’s been no additional clarity on the terms of Brexit or the outlook for the U.K. and global economies since Britain’s decision to leave the European Union on Friday, we don’t see fundamental support for the recent moves. With that in mind, sentiment can have a powerful impact on the markets.
One of Wednesday's best-performing currencies was sterling, which fell the hardest after Brexit. GBP/USD took out 3 big figures in its move from 1.3288 to 1.3534. Mortgage approvals and net consumer credit rose more than expected but housing data matters little when institutional and business investment is at stake. We know that global policymakers want to move euro clearing operations out of the U.K., EU Juncker says Scotland has won the right to be heard in Brussels, a view that puts them closer to a second independence referendum, German Finance Minister Schaeuble is worried about domino effects after Brexit, economists and rating agencies are updating their forecast and are now calling for a Bank of England rate cut year end and Governor Carney isn’t likely to have anything positive to say on Thursday because of the high level of uncertainty. So we remain bearish sterling and are looking for the downtrend to resume soon. Revisions to first-quarter U.K. GDP numbers are scheduled for release on Thursday.
U.S. stocks may have recovered but the U.S. recovery is losing momentum according to the latest economic reports. Personal income growth slowed to 0.2% from 0.5% in May. Personal spending slowed to 0.4% from 1.1% and pending home sales fell -3.7%. The story making the rounds on Wednesday was the report by Bloomberg that derivative traders are not looking for a rate hike until 2018 according to Fed fund futures. These numbers show that investors believe there is only a 9% chance of a rate hike in 2016 and a 40.2% chance of a hike in 2017. As we have seen over the past month, future rates can change quickly because on June 1, the market was pricing in a 76% chance of a quarter-point hike by December 2016. The U.S. economy is less sensitive to Europe’s troubles and by the end of the year, many of the questions we have about Brexit will be answered, leading to a calmer period in the financial markets. This, along with the dramatic slide that we have seen already in Treasury yields, should give the Fed the leeway to raise interest rates in 2017. We continue to look for the U.S. dollar to outperform European currencies and underperform commodity currencies. Jobless claims and the Chicago PMI index are scheduled for release on Thursday and given improvements in the Empire State and Philadelphia Fed surveys, we are looking for a healthier manufacturing sector data.
Japanese officials met Tuesday night to discuss the recent decline in the Nikkei and surge in the yen. No official policy changes were announced but Prime Minister Abe pledged to use “all available” tools to keep the economy on track. Japanese data has been terrible with retail sales falling 1.9%, more than double the past month's rate. The Japanese are growing desperate and we would not be surprised to see additional easing in the coming month.
Softer Eurozone data failed to hold euro back from participating in the risk-on rally but compared to sterling, the gains were modest. ECB officials still want to see more weakness before even considering the idea of additional action. Meanwhile, German consumer prices rose at a slower pace and Eurozone consumer confidence weakened. If these surveys were taken today, we’d probably see slightly stronger CPI and even weaker sentiment. German retail sales and unemployment numbers are scheduled for release on Thursday. The jobs number could be strong given the healthier labor-market conditions reported by the PMIs.
The improvement in risk appetite and rebound in commodity prices drove the Canadian, Australian and New Zealand dollars higher. New Zealand business confidence numbers are scheduled for release Thursday followed by Canada’s GDP figures. Data from New Zealand has been relatively healthy so firmer numbers are expected and the same is true for Canada, which has stronger retail sales and trade data supporting growth.