Currencies Could Explode Next Week

5 Reasons Why Currencies Could Explode Next Week

There are certain weeks in the foreign exchange market that are more exciting than others and the first week of each month is always a busy one. In fact the mini breakout in USD/JPY on Friday gives forex traders a taste of the larger moves they can expect in the major currency pairs in the coming week. There are no shortages of Tier 1 economic reports on the calendar but we also have central bank rate decisions and a major change in fiscal policy in Japan. There will be a lot of news for the market to absorb so directionality may be difficult to handicap but we know with confidence that all of these event risks will increase the volatility in currencies. At the beginning of this week, EUR/USD 1-month option volatilities were at their lowest level since 2007. USD/JPY also started the week with option volatilities at one year lows but all of that should change in the coming week for 5 reasons:

1. Japan Set to Raise the Sales Tax for First Time in 17 Years

2. ECB and RBA Central Bank Decisions

3. US, German and Canadian Employment Reports

4. Chinese PMIs

5. ISM and PMI Reports from US, EZ, Australia and Canada

First and foremost, Japan will be raising its sales tax for the first time since 1997 on April 1. The last time a politician dared to raise the consumption tax in Japan, he plunged the economy into recession. Hopefully it won’t happen again but such a monumental change in fiscal policy is sure to affect USD/JPY. Japan will also be releasing its quarterly Tankan report, which is one of those few pieces of Japanese data that can actually move the Yen. On the side of the dollar, we have non-farm payrolls, manufacturing and service sector ISM reports scheduled for release. An improvement in job growth is just what USD/JPY needs to break above 103 and at this stage of the recovery slower job growth would be jarring and poses a major downside risk for USD/JPY. Neither the European Central Bank or the Reserve Bank of Australia are expected to change monetary policy but the post meeting comments from Draghi and Stevens have the potential of triggering a big reaction in EUR and AUD. Chinese PMIs will also affect how the commodity currencies trade and the Canadian dollar in particular has a busy week with GDP, employment and the IVEY PMI report scheduled for release. So while the market’s appetite for U.S. dollars will play a big role currency movements next week, the abundance of market moving non-U.S. data means there could be more divergence than consistency in the forex market. In other words, relative growth will be most important.

Will EURO Sell-off Ahead of ECB?

After weakening initially on the back of softer consumer prices, Euro ended the day unchanged against the U.S. dollar. As we head into next week’s European Central Bank meeting, we can’t help but think that softer activity and inflation reports from Germany will make ECB President Draghi less optimistic about the outlook for the economy. When we last heard from the head of the central bank, he said there were signs of improvements but over the past month, we have seen more evidence of deterioration. We feel there is certainly more downside than upside risk for the euro in the coming week particularly after reading an interesting study from JPMorgan. According to their quick and dirty analysis, in the last five meetings, the euro weakened an average of 0.8% in the days leading up to the ECB meeting but subsequently reversed in the days that followed. We took this idea a bit further and found that 4 out of the last 5 months, the euro appreciated on the day of the European Central Bank’s rate decision. This mean Mario Draghi has been consistently less pessimistic than investors anticipated and while this could remain true this month, the odds are against it. It all depends on whether the ECB views the recent slowdown as a temporary pullback or a deeper problem. Given the abundance of policymakers talking about the possibility of negative rates, we believe they are growing more concerned about growth and inflation.

GBP: Ends Week With 5 Straight Days of Gains

The British pound rallied every single day this week against the U.S. dollar. Despite today’s surprise deterioration in the current account balance, sterling extended its gains against the U.S. dollar and euro. Economists had been looking for the current account deficit to narrow from -20.7B to -14B but instead the Q3 numbers were revised down to -22.8B and in Q4, the deficit narrowed only slightly to -22.4B. The revision made the Q3 current balance as a percent of GDP the worst on record. Falling investment income and major outflows in foreign direct investment caused the decline. Meanwhile fourth quarter GDP growth was confirmed at 0.7%. There were no revisions to the headlines release but we now know that exports were a big contributor. The outlook for sterling is bright but further gains hinge on next week’s PMI reports. If service, manufacturing and construction sector activity continue to improve, GBP/USD could test its 4-year high of 1.6822.

Big Week Ahead of the Australian Dollar

End of week profit taking drove the Australian, New Zealand and Canadian dollars lower against the greenback on Friday. It has been a great week to be long commodity currencies but the party has to come to an end – even if the end is only temporary. The New Zealand dollar climbed to its strongest level in 2.5 years and after such a strong move, a pullback is not unusual especially on day when U.S. stocks settled well off their highs. No economic data was released from any of the 3 commodity producing countries over the last 24 hours but the market continues to speculate on the possibility of stimulus from the Chinese government. If next week’s PMI reports from China show a further slowdown in manufacturing and service sector activity, the speculation could turn into reality which would be extremely positive for commodity currencies. Aside from these economic reports, Australia will also release its own PMI indices along with retail sales, the trade balance the Reserve Bank’s monetary policy decision. The RBA is not expected to change interest rates but given this week’s comments from Glenn Stevens, the accompanying statement could contain an air of optimism. In the past 2 weeks USD/CAD peaked above 1.12 and whether this is a retracement or a top hinges in large part on next week’s GDP, trade, employment and manufacturing reports. There are no major releases scheduled from New Zealand, which means that NZD will mostly be driven by the market’s appetite for risk.

Will Japan’s Tax Hike Crush USD/JPY?

Next week will be one for the history books in Japan with the government gearing up to raise the sales tax for the first time in 17 years. The last time a politician in Japan dared to raise taxes was in April 1997 and the consequences were severe. It kicked off a long period of recession that later turned into stagnation and deflation. In the month that taxes were raised, the Nikkei and USD/JPY increased in value but the following month, there was a nasty 13% correction in USD/JPY. The rally in the Nikkei extended a bit further but peaked in June and fell 28% over the next 6 months. The increase has been years in the making and Abe’s administration is confident that the times are different and households are better equipped to withstand the rise because of the reduction in income taxes over the past few years and the opportunity to adjust their spending plans accordingly. Abe also feels that consumers understand that these difficult decisions are being made to build a sound foundation for Japan’s future, which he hopes will boost confidence.

We believe his views are overly optimistic especially with wages growing slowly but the pain could be brief if the Bank of Japan sweeps in with another round of stimulus. Also the difference between now and then is that the Asian Financial Crisis hit shortly after the tax increase. However what is similar is that like now, the strength of the economy gave the Japanese government the confidence to raise taxes in 1997 – unfortunately that was not enough to prevent a recession. The sales-tax increase is the biggest risk for Japan’s economy this year. To understand how USD/JPY and the Nikkei could react to this year’s rise, we took a look at how Japanese assets performed in 1997. In the months leading up to the 1997 tax increase, the economy grew rapidly with Q4 GDP growth in 1996 hitting a high of 6.1%. Growth remained strong in the first quarter of Q1, with GDP rising 3%. In the quarter of the increase, the economy contracted by 3.8%. Leading up to the tax hike, the Nikkei fell but rallied strongly in the 3 months after taxes were raised. It was not until August of that year did stocks begin their long-term decline. The sell-off in USD/JPY on the other hand was sharp but short-lived. The currency pair plunged 13% between April and June but recovered strongly for the rest of the year.

We expect the BoJ to respond to slower growth with an increase in Quantitative Easing and if we are right, any sell-off in USD/JPY on the back of weaker demand in April and May will be short-lived. If they stubbornly forgo another round of stimulus next year, USD/JPY could be subject to a nasty correction that could match the move in 1997 because many investors are positioned for more easing. Given how long Japan has waited for its current recovery, we can’t imagine a scenario where they do nothing and risk sending the economy back into stagnation.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.