By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
- EUR/USD is Rising for the Wrong Reasons
- What About USD/JPY?
- AUD Soars 1.3% Post RBA
- NZD: Dairy Prices Fall 3.5%
- CAD: Wider Trade Deficit Offsets Rise in Oil
- Sterling Bounces as Election Nears
EUR/USD is Rising for the Wrong Reasons
In talking to many investors Tuesday, we saw a lot of confusion about why the dollar performed so poorly. Everyone understands that the trade deficit ballooned and that it will weigh heavily on first-quarter growth, but the uptick in the non-manufacturing ISM report should have offset negative sentiment. It is no secret that the U.S. economy slowed in the first quarter and that the Fed views this decline as transitory. First quarter GDP numbers will be revised lower but a rebound is expected for the second quarter. In fact, the rise in Treasury yields and relatively modest sell-off in USD/JPY suggests that rate-hike expectations did not changed dramatically after Tuesday's reports. Considering that the dollar declined broadly, we can't really attribute anti-dollar flows to positive developments outside of the U.S., with the one exception being the Australian dollar, which was affected by the RBA monetary policy decision. However taking a quick look at how global bond yields moved over the last 24 hours we can see that while the 10-year Treasury yield rose 2bp to its strongest level in nearly 4 weeks, European bond yields are up more significantly. Italian and Spanish yields of the same maturity rose 27bp Yuesday while French yields rose 9bp and German bund yields rose 6bp. Both UK gilt and Australian bond yields were also up more than 10bp, which explains why the modest increase in Treasury yields held the dollar back. The following chart shows how EUR/USD took its cue from the German-10-year-U.S.-yield spread intraday. To the frustration of the European Central Bank, European bond yields have actually been on a tear lately. All the buying failed to pressure yields lower and instead some rates hit their highest level in months.
However the EUR/USD is rising for the wrong reasons. European bond prices have fallen sharply and yields have been driven higher because the Greek debt deal talks have gone nowhere. There may be a new negotiation team but they have made zero progress. In fact, Tuesday morning, we learned that there could be a major disagreement between the IMF and EU over the conditions Greece needs to meet to receive its next bailout payment. Apparently the IMF wants the pension system to be overhauled and the labor market deregulated while the EC wants to focus on the primary surplus. Either way, the talks are breaking down and it is looking increasingly unlikely that a deal will be reached at the next Eurozone Finance Ministers meeting on May 11. There have been some improvements in Eurozone data but we believe that EUR/USD should be trading lower especially since higher yields will hurt Europe at a time when the U.S. is expected to grow more swiftly, paving the way for a rate hike by the Federal Reserve in September. Eurozone retail sales are scheduled for release Wednesday along with revisions to the PMI services report. Given the steep slide in German demand in March, the risk is to the downside for the report.
What About USD/JPY?
One consequence of the underperformance of the U.S. dollar is that USD/JPY is trading back below 120. Having risen to its strongest level in 3 weeks, USD/JPY looked poised to hit 121 at the start of the North American trading session. However there is a lot of resistance for the currency pair above current levels and without unambiguously positive data, USD/JPY would not have the momentum to break above the April high of 120.85 and then the March high of 122.02. Tuesday's U.S. trade balance report was very weak with the deficit hitting its highest level in 5 years. Economic optimism also weakened according to the IBD/TIPP index but service sector activity rebounded in April after pulling back in March. As one of the most important leading indicators for non-farm payrolls, the ISM report is key and while we are encouraged to see the uptick in activity, we were also disappointed by the modest rise in employment. The subcomponent of the report rose from 56.6 to 56.7, a modest increase that suggests the labor market did not gain significant momentum in April. The ADP report is scheduled for release Wednesday and if we don't see greater upside surprises in labor data ahead of non-farm payrolls, economists could lower their forecast and expectations. We are still looking for a good number and therefore view a further decline in USD/JPY as an opportunity to buy at lower levels.
AUD Soars 1.3% Post RBA
The best-performing currency Tuesday was the Australian dollar, which rose more than 1% versus the greenback, Japanese yen, euro, Canadian and New Zealand dollars. The move was unexpected considering that the Reserve Bank cut interest rates by 25bp Monday night, bringing the country's lending rates to its lowest level ever. While it can be said that Aussie traded higher because the decision was widely expected by economists and market participants, few will argue that it was a close call. Domestically, there were more improvements than deterioration in economic conditions but abroad, especially in China, activity was weak. For this reason, the central bank wrapped some positive comments around the rate cut. According to Glenn Stevens, while public spending and business capital expenditure could see some weakness, there were "improved trends in household demand over the past six months and stronger growth in employment." The statement was slightly less dovish with no mention of the need for additional easing. Of course, that could come when the RBA minutes are released later this week. We believe that the RBA is done for now but the Australian retail sales and employment reports along with the Chinese trade balance pose a risk to the currency. Meanwhile the Canadian dollar saw a relatively modest gain as the 3% rise in oil prices was offset by weaker trade data. The New Zealand dollar also shrugged off a decline in dairy prices. According to the global dairy trade auction, prices fell for the fourth straight time by -3.5%. NZD/USD was set to be in play Tuesday night with Q1 employment numbers scheduled for release.
Sterling Bounces as Election Nears
The British pound traded higher versus the U.S. dollar Tuesday despite weaker than expected construction activity. According to Markit Economics, the PMI index fell to 54.2 from 57.8, the lowest level in almost 2 years. This time in 2010, GBP/USD had already started to drip lower ahead of the General Election. It is extremely interesting that this price pattern is not repeating even though the election is close and a hung Parliament is likely. There's some talk that the parties will reach a deal quickly but we are not optimistic and even if that were to occur, initially, a divided government would send sterling sharply lower. We are still looking for GBP/USD to break 1.50. The election poses a major risk for sterling and Wednesday, we'll outline the different ways to play it. For now, lets just remember that on the last Election Day, GBP/USD fell 400 pips followed by another 500 pip slide in the 2 weeks that followed. U.K. service sector PMI numbers are scheduled for release on Wednesday.