By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It has been an interesting start to another busy week in the foreign-exchange market. There were no U.S economic reports released Monday morning but the surge in commodity prices and positive comments from Federal Reserve officials gave investors a lot to think about. Oil prices rose nearly 6% with WTI crude climbing to its strongest level year to date. In addition to oil, the price of gold, silver, copper and iron ore also extended higher, paving the way for gains in the Canadian and Australian dollars. But the gains in these currencies should have been stronger given the magnitude of the increase in commodity prices. Last week’s better-than-expected U.S. economic reports gave investors hope that the global demand story is not as weak as they feared at the beginning of the year. There’s also hope that OPEC will officially freeze production – while a number of countries agreed to do so last month, Iran needs to come on-board for the plan to take affect. Nonetheless, the recent recovery in commodity prices should make policymakers less worried about low inflation. In fact that was exactly what we heard from Fed Vice Chair Fischer on Monday who said, “we may be seeing first stirrings of higher inflation.” If oil prices stabilize near these levels, there will be less need for easier monetary policy.
Of course, the Fed is on the track to tighten -- not loosen -- so the move in oil along with Fischer’s comment that the U.S. is in the “vicinity of full employment” suggests that they will maintain a hawkish bias after leaving rates unchanged this month. We also heard from Fed President Brainard and while he expressed concerns about slow job and wage growth, he also feels that the labor market is showing continued strength and inflation should move higher if oil prices stabilize. So even though there’s not much U.S. data on the calendar this week, these views should limit the losses in USD/JPY and keep the pair confined within a narrow trading range.
The ECB is widely expected to ease monetary policy this week yet the euro refuses to fall, which leads many investors to wonder if easing has been completely priced in. The market expects the central bank to lower the deposit rate (a decision they passed on in December), but there’s very little consensus on the actions they could take. The ECB experienced the consequences of under delivering last year and they will want to avoid a decision that could squeeze EUR/USD higher, undermining the effects of the stimulus. Besides lowering the deposit rate, the ECB could increase the amount of assets purchased per month, extend the end date of bond buying and possibly even introduce new TLTROs. Since analysts are predicting an increase to the QE program of anywhere from zero to 20 billion euros, there’s plenty of room for surprise. In addition, Mario Draghi could talk about doing more in the coming year, which could also affect how the euro trades. So while we agree that investors have priced in a 10bp deposit rate cut, there’s so much more the ECB could to do that would weaken the euro.
Meanwhile the 5.6% rise in oil prices sent USD/CAD to a fresh 3-month low. In fact in the past 9 trading days, we’ve barely seen a rally in USD/CAD. If oil extends its gains to $40 a barrel, we will see USD/CAD below 1.32. The latest increase in oil prices along with recent improvements in Canadian data should keep USD/CAD under pressure. When the Bank of Canada last met, it left rates unchanged with Governor Poloz sounding surprisingly optimistic. He was not concerned about a global recession and believes that the weak Canadian dollar will aid growth. Poloz was also encouraged by the economy’s resilience and flexibility and instead of lamenting about the currency’s rapid decline, he said a further fast fall could boost inflation. This month he has even less to be worried about with oil near $35 a barrel, GDP growth accelerating and consumer prices rising, but Canada is not out of the woods as consumer spending and labor-market conditions remain weak. USD/CAD has found support above the 20-day SMA at 1.3285 but chances are this level will be broken.
While the Australian dollar drifted upwards on the back of stronger gold, copper and iron ore prices, the New Zealand dollar fell sharply with this divergence driving AUD/NZD above 1.10. Both currencies are vulnerable to Monday night’s Chinese trade numbers but the New Zealand dollar erased its earlier gains after Fonterra (AX:FSF) lowered its milk price forecast. It remains to be seen whether the RBNZ will be swayed by this reduction. The last time Fonterra lowered its forecast was in January right around the time of the RBNZ rate decision and yet the Reserve Bank did not seem to be particularly concerned about the drop in dairy prices even though it is one of the country’s most important industries. We believe that Fonterra’s announcement could have a bit more impact on NZD/USD at the start of the Asian trading session but beyond that, losses should be limited as we are not looking for any fresh concerns from the RBNZ. China’s trade numbers on the other hand are tricky. The surplus is expected to narrow with exports and imports falling. Investors will be watching closely to see if China’s economy slowed further in February.
Lastly, six trading days have past since we’ve seen a pullback in sterling. The currency’s relentless rise has been sparked by the government’s continued attempts to downplay the consequences and possibility of Brexit. At the start of Monday's European trading session, British Chambers of Commerce director-general, John Longworth resigned after being suspended for saying that the U.K. economy could be better off outside of the European Union. During the U.S. session, Bank of England Governor Carney unveiled plans to keep markets stable closer to the EU referendum. Last month, Carney stated that counter measures were being discussed in preparation for the referendum. On Monday those plans were unveiled as they intend to offer 3 long-term repo operations between June 14 and June 28. This will ensure liquidity in the markets and provide flexibility for banks and other large institutions. That said, we remain skeptical of the GBP/USD rally because the sharp drop in PMI manufacturing index points to lower industrial production and trade. In light of this we believe the 50-SMA near 1.4362 should hold.