EUR/USD: It's A Tug Of War

The Tug of War in EUR/USD

A tug of war is shaping up in the EUR/USD with jawboning by European policymakers putting downside pressure on the pair and the recent decline in U.S. yields providing upside support. Both of these forces are strong and significant enough to keep EUR/USD confined within a 1.36 to 1.40 trading range. Based on this weekend’s comments from ECB officials, European policymakers do not want to see the EUR/USD trade above 1.40 and if it gets there, the chance of ECB easing will skyrocket. The central bank may not be serious about Quantitative Easing but they are very serious about talking down their currency. In fact Mario Draghi’s comment that “the strengthening of the exchange rate requires further monetary stimulus” is one of the central bank’s strongest warnings against a rising currency. The big problem created by the strong euro is low inflation, which if you recall, was the primary reason motivation for the ECB’s interest rate cut in November. According to an estimate provided by the ECB 2 weeks ago, inflation is reduced by 0.4% for every 10% rise in the euro. If not for the currency’s appreciation, inflation would be closer to 1% now instead of 0.5% according to ECB member Noyer. So while policymakers have made it clear that QE is an option in theory, in reality they have a number of ways to ease monetary policy including a reduction in the refi or deposit rate, narrowing the interest rate corridor and ending SMP sterilization. If the currency pair resumes its rise above 1.39, we see an 80% chance of more stimulus in June.

Jawboning by policymakers and the risk of more stimulus should be enough to put a top in the EUR/USD but unfortunately there are other factors at play that are out of the ECB’s control. With the European Sovereign Debt crisis in the distant memory, capital inflows are returning to Europe, creating demand for euros. At the same time, there is very little upside momentum in U.S. yields even after today’s strong retail sales report. For EUR/USD to break out of its 1.36 to 1.40 trading range the ECB needs to ease or U.S. yields need to recover, sending EUR/USD sharply lower but if 10-year Treasury yields drop below 2.5%, the central bank may not be able to prevent EUR/USD from rising above 1.40.

Retail Sales Should be Positive for the Dollar but…

Today’s stronger-than-expected U.S. retail sales report should have been overwhelmingly positive for the greenback and while we did see the dollar appreciate against the Euro, it held steady against the Japanese Yen and other major currencies after the release. Investors have to look no further than Treasury yields for an explanation on the lack of momentum in the dollar. After the initial release of retail sales, 10-year Treasury yields rose as much as 3bp, which is anemic to begin with but since then yields have pulled back and are up only 1.6bp on day. Despite back-to-back improvements in U.S. data, investors are unimpressed. As long as the U.S. economy recovers at a steady pace, the Federal Reserve will continue to taper and bring asset purchases down to zero by the end of the year. Last month, Fed Chairwoman Janet Yellen said rates will increase 6 months after QE ends but since then, traders have dialed back expectations after policymakers stressed the need for low rates. Until more Fed officials get on board with the idea of tightening, the dollar will have a tough time recovering. Nonetheless, this does not draw away from the strength of today’s consumer spending report. Retail sales beat expectations, rising 1.1% in the month of March compared to a 0.9% forecast. Although the February figures were also revised up to 0.7% from 0.3%, we pointed out in our Friday note that sales needed to increase 1.5% or more for investors to be excited about buying dollars. Excluding auto and gas purchases, sales rose 1.0%, the strongest pace since February 2012. Taking a look at the overall increase in spending since the beginning of the year, retail sales will contribute positive to GDP growth in the first quarter. While the positive report lifted U.S. stocks the greenback won’t be able to rise without an increase in yields. Stocks are performing well today but if earnings continue to surprise to the downside, the rally could recede, adding pressure on USD/JPY. The only hope for the dollar at this stage would be comments from policymakers like Janet Yellen but the Fed wants yields to remain low and therefore we doubt they will say anything to threaten the downtrend.

GBP: CPI to Provide Clues on Timing of Rate Hike

The British pound ended the day unchanged against the U.S. dollar and stronger versus the euro. An increase in house prices during the month of April provided support to the currency ahead of Tuesday’s consumer price report. The housing market in London continues to gain momentum with house prices rising to record levels throughout the city. In the rest of Britain, prices also increased which is a sign that the strength in the capital is beginning to spread. A strong housing market along with relatively healthy economic data has many investors banking that the Bank of England will be the next central bank to raise interest rates. However the BoE still maintains a dovish bias and the speed of tightening depends largely on inflation and wage growth -- 2 pieces of data that will be released this week. CPI comes first on Tuesday and unfortunately price pressures are expected to ease, which would delay tightening. As long as CPI remains comfortably below the central bank’s target and wage growth is minimal, there will be no urgency to raise rates. So if CPI growth slows tomorrow, we could see a deeper correction in GBP/USD.

AUD: No Surprises Expected from the RBA

After a one-day respite, the Australian Dollar resumed its rise against all major currencies. There was no Australian economic data released but the lack of upside momentum in the greenback helped to fuel the rally. Investors also expect relatively optimistic RBA minutes. If you recall, when the central bank last met, they had nothing new to say about the economy or monetary policy. The RBA did not mention that the exchange rate was uncomfortably high and instead described it as only high by historical standards which investors interpreted as positive for the currency. As long as this tone is maintained in the minutes, AUD could make another run for fresh 5-month highs versus the U.S. dollar. The New Zealand Dollar ended the day unchanged despite a sharp improvement in the PMI Services index. Service sector activity grew at its strongest pace since 2007 and while New Zealand is a manufacturing driven economy, this boost supports the case for additional tightening. The Canadian dollar on the other hand shrugged off stagnant house price growth in March to trade higher against the U.S. dollar. 1.10 is a tough resistance level for USD/CAD and today’s sell-off could be nothing more than a technical reaction to a key level.

JPY: Risk of Further Nikkei Weakness

With the Nikkei and U.S. yields stabilizing today, USD/JPY along with many Japanese Yen crosses rebounded today. There was no economic data released from Japan overnight and the calendar is relatively quiet this week. The most important event risks for the Yen will be BoJ Governor Kuroda’s speech on Wednesday and Thursday. If he continues to see no need for stimulus stocks could see further losses. Last week the Nikkei lost approximately 7% of its value and with the consumption tax expected to take a deeper toll on Japan’s economy, a steeper slide in the Nikkei poses a major risk for USD/JPY. Investors aren’t nearly as optimistic as the BoJ who believe that “consumer spending will remain firm after sales tax hike due to improvement in job market and wages” according to the March meeting minutes. Only time will tell so we’ll have be patient and wait to see if consumers are as resilient as the central bank expects.

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