- FX: Everyone Overreacted To Fed Minutes
- EUR: Hit By Talk Of Negative Rates
- GBP: Unfazed By Dovish BoE Minutes
- NZD: Drops More than 1%, Further Losses Depends On Chinese PMI
- AUD: RBA Reiterates Concerns About Strong Currency
- CAD: Hold Steady In The Face of Dollar Weakness
- JPY: No Changes Expected From The Bank of Japan
We believe investors in the forex market and financial community in general overreacted to the FOMC minutes. The price action in equities, treasuries and currencies suggests that there was major shift or revelation by the Fed but in reality the minutes contained very little surprises and did not say anything that we had not all already known. The Federal Reserve is likely to taper in the coming months based on better data and considering that the December, January and March meetings are all in the "coming months," the Fed's guidance is consistent with market expectations. Monetary policy committee members also discussed various scenarios under which it may be appropriate to begin tapering sooner and this is also not surprising because it is their job to discuss all options. The Federal Reserve saw very little changes in the economy from the September meeting. The recovery is continuing at a moderate pace with further improvement in the labor market. However the recovery in housing is slowing, fiscal policy is still restraining growth and consumer sentiment remains unusually low. While the downside risks to the economy have diminished, there are still "several significant risks."
In other words, even though the U.S. dollar soared, equities erased earlier gains to end the day lower and 10 year Treasury yields rose to a 2-month high, not much has changed. Before the minutes were released, there was an 80% chance that tapering would occur in January or March and those odds remain the same especially after Wednesday's sharp rise in yields. If 10-year Treasury yields are at 3% or higher come December U.S. policymakers will be reluctant to reduce stimulus prematurely and risk an even larger rise in yields. In fact, Fed Chairman Ben Bernanke told us with very little ambiguity last night that the decision to taper next month hinges largely on where U.S. rates are at the time. If 10-year yields are above 2.85%, the Fed will stand down. If rates are 2.7% or lower, pre Christmas tapering remains on the table. U.S. retail sales rose 0.4% in the month of October, the strongest pace of growth in 3 months and excluding auto and gas purchases retail sales rose a more than expected 0.3%. Not only were there broad based gains in spending but the September figures were also revised up from -0.1% to 0.0%. Despite the U.S. government shutdown, October has turned out to be a good month for the U.S. economy and this leads us to wonder how much stronger the recovery would have been if the U.S. government remained opened throughout this time. Between the sharp rise in non-farm payrolls, the increase in retail sales and the expectations for a snapback in November, GDP growth is expected to accelerate in the fourth quarter.
However even though we think the market overreacted to the FOMC minutes, we don't feel that the rally in the dollar is unjustified. We have long said that the trajectory of U.S. rates is higher and as long as this remains the case, the dollar will rise and its strength will be most pronounced against currencies whose central banks are still considering additional stimulus. Therefore we continue to look for the EUR/USD to drop down to 1.32 and for USD/JPY to reach 102. It may take some time for this to occur because the Fed could keep monetary policy unchanged next month, disappointing the markets but by the first quarter, the process of unwinding stimulus will have begun and by then, the dollar should be trading much higher.
EUR: Hit By Talk Of Negative Rates
With the Federal Reserve maintaining an open mind about tapering in December and the European Central Bank thinking about negative interest rates, the euro experienced its steepest loss against the U.S. dollar this month. European policymakers are going out of their way to make sure that investors are fully aware of their dovish monetary policy bias and willingness to increase stimulus if needed. Even before the headline about negative rates hit the wire ECB member Weidmann said the central bank have not "technically" exhausted their options and their task is not to guarantee returns for investors. According to a Bloomberg article that cites 2 sources close to the ECB, the central bank is considering a "mini deposit rate cut" that would take the rate to negative levels for the first time ever. While the ECB has always talked about the possibility of negative rates with central bank governor Draghi saying he had an open mind on the idea back in May, few investors believed that it would be possible because the recent interest rate cut provides enough stimulus. Yet with producer prices also falling in the month of October, if inflation does not stabilize, another move could still be possible. After the last rate cut, we said any EUR/USD rally would be capped at 1.3450. The retracement in the currency pair has obviously overshot that level but the reasons for why we believe the EUR/USD will extend its losses still hold. Even if the ECB ends up holding monetary policy steady, U.S. rates are headed higher and it should therefore only be a matter of time before the dollar gains upside momentum versus the euro.
GBP: Unfazed By Dovish BoE Minutes
Compared to other high beta currencies, the British pound held up exceptionally well Wednesday, falling only slightly against the U.S. dollar and rising strongly against the euro. What is remarkable about the currency's resilience was the fact that the Bank of England minutes were dovish. The BoE left monetary policy unchanged this month and according to the notes from the meeting, they are no rush to raise interest rates. The central bank previously said that their first move to tighten will be to raise interest rates however according to minutes achieving the 7% unemployment rate target does not automatically mean that rates will be increased. "There could be a case for not raising the bank rate immediately when the 7% unemployment threshold is reached." Instead at the time, the committee will "reassess what it had learned about the nature of the recovery." In doing so, the BoE is subtly backing away its forward guidance and letting investors know that 7% is a soft and not hard target. However even though the central bank is trying to manage down the market's expectations, as long as the unemployment rate continues to fall, investors will be interested in buying the British pound on the belief that the BoE is overly cautious and will adjust to the market's expectations.
NZD: Drops More than 1%, Further Losses Depend On Chinese PMI
The worst performing currencies Wednesday were the New Zealand and Australian dollars. Both currencies dropped over 1% against the U.S. dollar and Japanese Yen. The New Zealand dollar had initially rallied on the back of hotter producer prices but gave up those gains quickly, trending lower throughout during the Asian, European and North American sessions. The Reserve Bank of Australia's frustration with their strong currency is growing with Assistant Governor Debelle saying that a lower local currency would be preferable. While leading indicators ticked up in the month of October, policymakers are worried about the sustainability of the country's recovery and are trying to talk the currency down. There are also concerns about Chinese growth. HSBC's flash manufacturing PMI reports for China was slated to be released Wednesday evening and economists are looking for slower manufacturing activity in the month of November. A weaker Chinese PMI report would exacerbate the selling in both currencies leading to a retest of this month's lows for the AUD/USD and NZD/USD. The Canadian dollar on the other hand was the only major currency to outperform the greenback even though wholesale sales grew at a slower pace, signaling the possibility of weaker retail sales growth in the month of September. Looking ahead, the commodity currencies are vulnerable to further losses going into the Asian and European trading sessions but the extent of the losses will be determined by the Chinese PMI report.
JPY: No Changes Expected From The Bank Of Japan
The Japanese Yen traded higher against all of the major currencies Wednesday with the exception of the Canadian dollar. Wednesday night we had the Bank of Japan's monetary policy announcement. Despite a slowdown in GDP growth in the third quarter and a larger trade deficit, the BoJ is widely expected to leave monetary policy unchanged. Most BoJ officials expect growth to accelerate over the next 4 months and are therefore comfortable with the current level of stimulus. We don't expect the central bank to change monetary policy until the second quarter of 2014 at the earliest and only if the economy responds negatively to the consumption tax hike. In fact we would not be surprised if the BoJ statement is slightly more optimistic with the central bank feeling less concerned about the global economy. Without a doubt they will reiterate their pledge to buy bonds until their 2% inflation target is reached. As no major changes expected, the impact on the Yen should be limited. If Japanese stocks rise on the promise of continued stimulus, the move could lend support to the yen crosses. While a wider trade deficit in the month of October is bad news for Japan, the increase in imports and exports confirm that the recovery is underway. Imports rose a whopping 26.1% in the month of October while exports rose only 18.6% and unlike other times in the past when energy needs boosted exports, last month's rise was based on a real improvement in consumer demand.
Kathy Lien, Managing Director of FX Strategy for BK Asset Management.