By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
As we approach the end of the year, many investors AND central bankers are hoping for some year-end profit taking in the U.S. dollar and we saw a hint of that on Friday. Being a dollar bull has paid off handsomely over the past 2 months with the greenback rising 15% against the Japanese yen and more than 7.5% against the euro. Both the speed and velocity of the move has been incredible and when such abrupt fluctuations occur, it is natural to expect profit taking, especially with trading activity, volume and liquidity declining over the next 2 weeks. However, it would be remiss for forex traders to automatically assume that investors will bank profits at the end of the year because history does not confirm it. Taking a look at how the dollar behaved during this period in past years, a further squeeze is more likely than consolidation and a reversal. As we saw over the Thanksgiving Day holiday, thin liquidity conditions can spark exaggerated moves. Over the last holiday weekend, EUR/USD dropped to a fresh year-to-date low right above 1.05 and USD/JPY broke above 112 for the first time since March. In 2015, there was some profit taking in the dollar after the run up to the December 2015 rate hike but the correction began in early December. In 2014, 2013 and 2012, there was a final push in the existing trend in the 2 or 3 days before Christmas with a stronger reversal happening in the New Year. This does not mean we won’t see profit taking, but you shouldn’t bank on it.
Fundamentally, the Federal Reserve gave investors a strong reason to continue buying U.S. dollars this past week. Not only did they raise interest rates, but Fed Chair Janet Yellen called the expectations for 3 instead of 2 rate hikes next year as a “modest adjustment,” which means more tightening could be possible if the economy heats up in 2017. But there’s not much in the way of market-moving U.S. data on the calendar this coming week, which means it's a battle between momentum and profit taking. The key will be U.S. yields. If they start to fall like they did on Friday, the dollar will slip. But if they continue to hold steady near 2-years highs or, better yet, extend their gains, the greenback will rise. While we believe that the dollar is a buy on dips unless data, Fed speak or U.S. rates suggest otherwise, the stronger dollar poses a major problem for U.S. companies with multinational operations and the U.S. economy as a whole. If the Trump administration doesn’t come up with a major fiscal stimulus package quickly and the euphoria begins to fade, we could see the economy wobble, which would translate into a correction in U.S. stocks, the U.S. dollar and Treasury rates. Yet before jumping into selling dollars, there needs to be a reason other than year-end profit taking for dollar bulls to give up their trades. Before that happens, 120 USD/JPY is still in sight.
While there isn’t much in the way of U.S. data, the Bank of Japan has a monetary policy announcement on the calendar. At one point this year, economists anticipated a fresh round of easing from the BoJ but recent comments from U.S. policymakers suggest that they will wait. Data such as the Tankan report has been disappointing but the sharp sell-off in the yen should go a long way in providing support to the economy. In other words, the fall in the yen takes some pressure off the BoJ. With that in mind, we expect the central bank to highlight the need for additional easing.
The euro is trading at its weakest level in 14 years, sparking talk that the currency could see parity versus the U.S. dollar in the coming months. From an economic and political perspective, the euro deserves to be trading at this low level. Yields have been falling, inflation remains low and data including this past week’s PMI reports have been mixed. The weakness of the euro should be helping the Eurozone economy but we haven’t seen evidence of that yet. There are also a number of elections in Europe next year including the closely watched presidential vote in France, which could rock the currency. But parity is still 4 cents away -- a sizeable move in currencies. Parity is a very significant support level and while the central bank relishes the benefits of a weak currency, if we get closer to that key rate, policymakers could start to comment on the currency in an attempt to inject some two-way volatility. Germany’s IFO report on business confidence will be the main number to watch in the coming week. Taking a look at the charts, the euro sank to a low of 1.0364 this past week and as long as it remains below 1.06, the path of least resistance will be lower.
Sterling dropped to the bottom of its month-long range versus the U.S. dollar. U.K. data was mostly better than expected with retail sales rising strongly, wage growth accelerating and core CPI ticking up. However the rally was stymied by a more cautious outlook from the Bank of England. While the central bank repeated its limited tolerance for above-target CPI, it felt that inflation may accelerate less than it had forecasted in November because of recent gains in the pound. The BoE also forecast a slowdown in growth next year and combined, these 2 comments gave sterling traders the green light to sell the currency. With no major U.S. or U.K. data on the calendar this coming week, GBP/USD could bounce off the 50-day SMA and continue trading between 1.24 and 1.2750. EUR/GBP moved to the top of its week-long range and with more U.K. data beats than Eurozone beats, we believe that the currency pair will return to the lower part of its recent range.
All three of the commodity currencies traded sharply lower against the U.S. dollar on Friday, extending a week of consistent losses. The New Zealand dollar was hit the hardest but the Australian and Canadian dollars also reported sizeable losses. The only country with any meaningful data on the calendar was Australia – the country’s employment report beat expectations but the positive impact of the data was quickly offset by U.S. dollar strength. New Zealand reported slower manufacturing activity and there were no major releases from Canada. The commodity currencies are in play next week with the RBA minutes, New Zealand trade and GDP numbers scheduled for release along with Canadian retail sales. While we are looking for further weakness in all 3 commodity currencies, they have experienced steep losses in recent weeks and are primed for a relief rally.