By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
- EURO and the Risk of ECB Disappointment
- Dollar Comes Back, Hits New Highs Pre-ECB
- Sterling Losses Limited by EUR/GBP Buying
- CAD: How Will the BoC Respond to Lower Oil?
- AUD: Focus on Chinese Data Front of the Week
- NZD: Commodity Prices Rebound
EURO and the Risk of ECB Disappointment
Over the past few months, investors built up massive short positions in the euro and judgment day is quickly approaching. The highly anticipated European Central Bank monetary policy announcement is 4 trading days away. The question that everyone is now asking is whether the euro will turn into another big loser like oil, copper and EUR/CHF or a big winner that will save funds at the brink of collapse after the SNB pulled its peg. Smart investors won't wait that long for an answer because since June, the euro has fallen more than 15% against the U.S. dollar with approximately half of those losses incurred over the past 4 weeks. The European Central Bank has done a fantastic job of preparing the market for Quantitative Easing which for the most part is already priced in. The euro is trading on the 1.15 handle, having dropped below it intraday, bond yields are at record lows and the stock market has been holding up well.
As a result, the conversation has now shifted to the size of the debt-buying program. It is widely believed that the European Central Bank will announce a €500 billion program but at this stage this could be the minimum that the ECB needs to do to satisfy the market which is where the challenge lies. There is a serious risk of ECB disappointment on Thursday. There is a small chance that there is not enough support for quantitative easing. The decision has never been easy for the ECB because unlike other central banks, there are 18 countries within the Eurozone and selecting how much of each sovereign bond to buy could be politically challenging especially given the risk of holding Greek debt. Yet the ECB can't sit by the sidelines and do nothing because falling prices has deepened concerns about inflation at a time when growth is very slow. If there is enough support for QE, the ECB could still not have the details of the program worked out so soon including things like size and scope. Preannouncing QE like ABS purchases may not satisfy the market. The real test for the ECB is the size of the program. In order to impress, the ECB needs to commit to buying a trillion euros worth of sovereign bonds or more. Investors are already questioning whether 500 billion euros will be sufficient to drag the EZ out of its sluggish state of growth and low inflation. So as you can see, the bar is set very high for Thursday's ECB meeting.
For traders, the price action of the EUR/USD could be particularly dicey around the ECB rate decision. In the early part of the week, we expect the euro to weaken further but in the hours before the rate decision, EUR/USD could bounce on profit taking. The potential for disappoint could trigger short covering right before the rate decision. How the euro trades afterwards will of course hinge on the power of the central bank's announcement. If they shock the market with a 1 trillion euro bond-buying program, the euro should collapse. However if they provide no details or come in below 500 billion mark, the disappointment could lead to a short squeeze.
Dollar Comes Back, Hits New Highs Pre-ECB
The US dollar traded sharply higher against all of the major currencies Friday. Demand for the greenback was so robust data that it drove euro to a fresh 11-year low and the Canadian dollar to a fresh five-year low. Friday morning's US economic reports were mixed with consumer prices falling 0.4% and industrial production dropping 0.1% in December. Normally this would be negative for the greenback but with a stronger than anticipated rise in annualized CPI and a sharp increase in consumer sentiment the dollar shined compared to its peers. According to the University of Michigan consumer sentiment report confidence in the US rose to 11-year high thanks to the drop in gas prices and better-than-expected US data played a big role in boosting the attractiveness of the greenback. The recent volatility in the financial markets and specifically in the foreign exchange market is making the dollar a more attractive safe-haven play that is supported by improving US economic conditions. Ten-Year Treasury yields also rose as much as 10 basis points Friday giving investors yet another reason to buy dollars. While we may not see much additional upward momentum in yields if investors continue to buy US treasuries but don't expect this to stop the dollar from rising because the demand for Treasuries could boost the dollar. The US economic calendar is light next week giving the market plenty of reasons to focus on to the euro. We expect the dollar to trade primarily as a safe haven depending upon the markets reaction to the ECB meeting and equity flows. The deep loss taken by financial institutions on the EUR/CHF trade could lead to further deleveraging volatility in the financial markets. With this in mind it is important to know what is on the calendar and so we have housing starts, building permits, jobless claims and existing home sales scheduled for release.
Sterling Losses Limited by EUR/GBP Buying
The British pound traded lower against the USD Friday and would have probably performed worse if not for EUR/GBP selling. With the ECB gearing up to announce Quantitative Easing, some investors are moving their money into sterling. Unlike the ECB, the Bank of England does not feel that the drop in inflation is urgent enough to warrant a response. At the same time however, we are certain that the drop in oil prices affected their plans for tightening. As a result, the doves will coo louder and express their reservations about raising interest rates in 2015. Next week's economic reports are important enough to affect sentiment but the main focus will be on the BoE minutes. If fewer policymakers vote in favor of tightening, we could see a big move in sterling. Meanwhile the U.K. employment and retail sales reports are on the docket and based on other indicators like the PMIs, labor market conditions remain healthy but spending could be weak. How sterling trades in the coming week could continue to be determined by EUR/GBP flows.
CAD: How Will the BoC Respond to Lower Oil?
The Australian dollar traded higher Friday but the Canadian and New Zealand dollars weakened on the heels of the rising greenback. There were no economic reports released from any of the 3 countries and commodity prices rebounded. Considering the risks of investing in Europe, we don't expect major weakness in AUD and NZD as the yield differential and relatively steady economic prospects keeps both currencies in demand. Chinese retail sales, industrial production and GDP numbers are scheduled for release in the beginning of the week. Healthier data should revive the rally in commodity currencies. Aside from the euro, investors will also be watching the Canadian dollar very closely next week. Oil prices rebounded which is positive for the loonie and the most important factor in the outlook for USD/CAD is how the BoC views that change. With consumer prices expected to fall sharply in December, driving headline and core prices lower, the Bank of Canada may cite growing risks of lower crude prices. Back in December, they balanced their concerns for growth and risks with the observation of less economic slack and rising exports and investment. Economic conditions have worsened in the past month and we would be surprised if the BoC held onto this same level of optimism. Aside from CPI, retail sales are also scheduled for release.