Here’s Why USD’s Recovery Won’t Be Easy

Dollar: Three Reasons The USD's Recovery Won’t Be Easy

This was a great week to be short dollars but unfortunately over the past few months, investors have built up large-scale long positions. So rather than reap the profits of broad-based dollar weakness most market participants were hit with losses as the greenback weakened against all major currencies. By the end of the trading week, the selling subsided and the dollar recovered slightly but there’s still very little enthusiasm for the greenback. There are 3 primary reasons why the dollar has been under so much pressure – first the decline in U.S. yields made the buck less attractive, second investors are unimpressed by U.S. data and third, disappointing earnings triggered a sell-off in stocks that also prevented the buck from rallying.

Unfortunately many of these problems will continue to pose a risk for the dollar in the coming week and while yields have moved lower, investors are reluctant to short dollars in an environment where the Federal Reserve is tapering. The earnings season has just begun and expectations are very high for Monday’s retail sales report. In the past week we’ve seen how the dollar ignored the dip in jobless claims, rise in consumer confidence and uptick in price pressures. Retail sales will need to rise 1.5% or more to get investors excited and even that may not be enough to halt the rally in Treasuries. As long as yields are falling, the dollar will have a tough time recovering. The only hope lies with the Federal Reserve. If FOMC officials change the conversation from low rates for long to a rate hike in mid 2015, investors could be willing to buy dollars cautiously but if the Fed’s goal is to prevent yields from rising sharply as they reduce asset purchases, why would they risk saying anything that could shock the Treasury market. Of the long list of FOMC officials speaking next week – we are most interested in Yellen’s speech on Tuesday and Wednesday.

Meanwhile a possible contraction in Japan’s economy in the second quarter also puts pressure on USD/JPY. Since the beginning of the week the Nikkei 225 has fallen nearly 7% because the central bank refused to increase stimulus but if economic data starts to take a turn for the worse, the sell-off could gain momentum, putting USD/JPY at risk of falling to 100 before it makes its way back above 105 later this year.

EUR: QE or No QE?

As the euro closes in on its 2-year high against the U.S. dollar, the big question for EUR/USD traders is how serious the central bank is about Quantitative Easing. Two weeks ago, euro fell to a one month low versus the greenback after ECB President Draghi listed out all the conventional and unconventional tools at their disposal to increase stimulus. This week, euro recovered strongly after various policymakers made it clear that the chance of QE becoming reality for the Eurozone is slim but with so many ECB officials talking about low inflation and the downside risks, the central bank could still find alternative ways to increase stimulus. The ECB and BoE actually published a joint paper today discussing the merits of the European asset backed market, which would be the target of eventual ECB bond purchases. However structuring this program will take time and until the infrastructure is in place, QE won’t be the central bank’s preferred option. If inflation refuses to rise or economic data takes another turn for the worse, the central bank could still cut interest rates, drop the deposit rate to negative levels or narrow the rate corridor but the ECB will be all talk and no action in the near term According to central bank member Nowotny, the next big meeting will be in June when the policymakers have their latest economic projections. So from now until then, ECB policy won’t pose a risk to the euro unless ECB officials complain about the high level of the currency. The German ZEW survey is scheduled for release next week along with Eurozone consumer prices, current account and trade numbers.

GBP: Double Top at 1.68?

Thanks to better than expected economic at the front of the week, the British pound made a run for its 4-year high against the U.S. dollar. Unfortunately the rally fizzled at 1.68, leading investors to wonder if the currency pair is in the midst of forming a double top. So far economic data from the U.K. has been uneven but for the central bank the key is inflation. Consumer and producer prices are scheduled for release next week and the pace of inflation will dictate not only the central bank’s plans for monetary policy but also whether the February high of 1.6822 is broken. Unfortunately based on the British Retail Consortium’s report of lower shop prices and the decline in prices in the manufacturing and service sector, our bets are on a slowdown in CPI growth. With inflation comfortably below the Bank of England’s 2% target and expected to move lower, there’s little reason for the central bank to drop its dovish monetary policy stance. Another way of looking at this is that the BoE will not raise rates until inflation starts to rise and more specifically risks breaking above 2%. U.K. employment is also scheduled for release this week and in general, the labor market is healthy. Of course, U.K. data is not the only driver of the GBP/USD, so if the greenback extends lower, 1.6822 could still be broken for no reason other than the market’s desire to sell dollars.

NZD: Rebounds on Stronger House Prices

Unlike the AUD and CAD, which retreated after a week of strong gains, the New Zealand dollar resumed its rise against the greenback. Kiwi benefitted from a strong housing market report. According to REINZ, house prices rose 3.4% in the month of March, up from 2.1% in February. The decline in food prices also eased last month, a sign of stability in price pressures. While lower milk prices still pose a risk to New Zealand’s economy, as long as the central bank does not see a reason to slow tightening, dips in NZD/USD will be viewed as a buying opportunity. Inflation in China increased in the month of March but the rise was in line with expectations. Like many other parts of the world, price pressures are muted. The commodity currencies will be in play next week with Chinese retail sales, industrial production and first quarter GDP scheduled for release. Australia will also release its RBA minutes, Canada has a monetary policy decision and New Zealand will release its first quarter CPI report – all of these are important event risks that should make for interesting trade.

JPY: Nikkei Loses 7% in 1 Week

There was very little consistency in the performance of the Japanese Yen today. The rally in USD/JPY lifted EUR/JPY, NZD/JPY and CHF/JPY but provided no support for AUD/JPY, CAD/JPY and GBP/JPY. Part of the problem was the continued decline in Japanese stocks. After taking a one day break, the Nikkei fell another 2.38% overnight. Unfortunately Japanese equities are vulnerable to further losses as consumption tax starts to take its toll on Japan’s economy. The views of the market continue to be at odds with 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. Meanwhile the corporate goods price index came in slightly weaker but had no major impact on the Yen.

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