This past week marked a turning point in the financial markets. The U.S. dollar ripped higher against all of the major currencies as Treasury yields soared and stocks plummeted.
More specifically, the dollar appreciated 3.7% against the Japanese yen, Australian and New Zealand dollars, 1.85% against the British pound and 1.7% against the euro. Ten year U.S. Treasury yields topped 2.5% intraday on Friday, reaching its highest level since August 2011 while the S&P 500 dropped below 1,600 adding to losses that now exceed 5% since May.
The strength of the dollar drove many of the major currencies to key levels, most notably the commodity dollars. The Canadian dollar is now at its weakest level in 1.5 years and the Australian and New Zealand dollars are at their weakest in 2.5 years. While no major milestones were reached in the EUR/USD, GBP/USD or USD/JPY, these 3 currencies still experienced big moves this past week. By now, everyone knows that the rally in the dollar and U.S. yields were caused by Bernanke’s plans to slow bond buying this year and end asset purchases completely by the middle of next year.
Given how the markets have responded, this was a tectonic shift in expectations. With U.S. yields soaring, investors and traders around the world rushed to reverse their dollar funded carry trades, a trend that is likely to continue in the coming weeks, albeit at a more moderate pace. The next step would be to initiate long dollar positions, which we expect to occur over the next few weeks. Previously the majority of market participants had expected the Fed to taper next year with a minority looking for this to occur in December. Now everyone has to rush to reset their expectations and positions for the strong possibility of Fed action in September, which means the potential for further gains in the dollar.
In terms of levels, there is a significant support level in the EUR/USD at 1.3075, where the 38.2% Fibonacci retracement of the July 2012 to January 2013 rally converge with the 50,100 and 200-day SMAs. If this level is broken, the EUR/USD should tumble to 1.3000 but we do not expect significant losses beyond 1.2925 because European data is improving.
The same is true for the GBP/USD, there is support at 1.54 and below that at 1.52. USD/JPY on the other hand is headed for 100 in our opinion but a move to 103 would require Japanese investors to finally begin investing in foreign bonds. The sell-off in AUD/USD this past week stopped right at the 38.2% Fibonacci support of the 2008 to 2011 rally that took the currency pair from 60 cents to 1.10. For the time being, this level is holding but if it breaks, then AUD/USD could tumble quickly to 90 cents.
EUR – Hit by Weaker Data and Political Troubles in Greece
The euro fell sharply Friday against the U.S. dollar and is close to giving up nearly all of the gains that it incurred this month. Weaker than expected economic data, political trouble in Greece and the persistent rise in the U.S. dollar have contributed to a sell-off in the currency. While the euro was one of the day’s biggest losers, its overall decline is still modest compared to the AUD and NZD. There are bright spots in the Eurozone economy but we need to see more evidence, which will hopefully come this week with the release of the German IFO, unemployment and retail sales reports. Friday morning’s eurozone current account number on the other hand was disappointing with the region’s surplus shrinking to 19.5B from 25.9B.
This wasn’t a major surprise though, considering that Germany also reported weaker results for the month of April. In Greece, the country’s small Democratic Left Party threatened to pull out of the ruling coalition, destabilizing the country’s political outlook. The IMF also threatened to suspend aid to Greece at the end of June if eurozone leaders do not close the financing gap in the Greek aid program. Unfortunately eurozone Finance Ministers avoided addressing the issue at their meeting on Thursday.
Looking ahead, while the euro could be vulnerable to additional losses against the U.S. dollar, we expect its outperformance against other currencies to resume. According to the latest CFTC data, speculators turned net long euros after being net short since mid May.
GBP – Loses its Grip, Extends Lower
Friday’s sell-off in GBP/USD could be a catch up move after Thursday’s resilient performance but we still expect the losses to be limited because compared to other global economies, the U.K. is on firmer footing. The UK’s public financing needs were less than expected in May. Public borrowing remained high over the past year and the data showed total public net debt rising to record levels in May.
A report by the Office for National Statistics revealed that net borrowing excluding temporary support for banks was 12.7 billion pounds compared with 15.6 billion pounds the previous year. The data suggests that the government is on track to meet its targeted budget this year. The report comes as Chancellor of the Exchequer George Osborne prepares to outline 11.5 billion pounds of cuts to the government departmental budget for the 2015-16 fiscal year after weak growth forced him to extend his austerity program. On Friday, Prime Minister David Cameron’s spokesman, Jean-Christophe Gray, said, “Today’s data demonstrate that the government is getting a grip on public spending. It shows the deficit-reduction plan is working. Obviously that needs to be stuck at. That’s exactly what this government is doing.” First quarter current numbers and revisions to Q1 GDP are the only noteworthy U.K. economic reports on the calendar next week.
CAD – Hit Hard by Disappointing Retail Sales
The Canadian and New Zealand dollar extended their losses against the greenback while the Australian dollar licked its wounds and trickled higher. Inflation in Canada increased less than expected in May due to a drop in transportation costs that offset the rise in gas prices. Retail sales in April also increased less than expected raising speculation that the expansion in growth could be slowing.
Statistics Canada revealed that CPI rose 0.7% in May year-over-year and 0.2% month-over-month. According to the report, “shelter and food components were the main upward contributors to the rise in CPI, while the transportation component was the main downward contributor.” Despite significant improvements in the labor market, Canadian retail sales grew only 0.1% in April and excluding autos consumption fell 0.3%. Bank of Canada Governor Stephen Poloz said that the economic recovery requires “stability and patience.” The BoC sets its interest rates to keep inflation contained between 1% and 3%. These weaker reports will keep monetary policy steady and limit the optimism of Bank of Canada Governor Poloz. Canadian GDP numbers are scheduled for release next week along with New Zealand trade figures.
JPY – No Major Concerns within the BoJ
The Japanese yen ended Friday lower against the U.S. dollar and mixed against other major currencies. Bank of Japan Governor Haruhiko Kuroda spoke Thursday night and warned that uncertainty surrounding Japan’s economy remains high. Although he stressed that the markets will stabilize over time, reflecting expansion in its economy.
Kuroda said, “Japan’s economy is likely to resume a moderate recovery as overseas growth picks up moderately and domestic demand remains resilient due to the effect of monetary easing and various stimulus measures. We will make policy arrangements as needed, examining both upside and downside risks to the economy and prices.” These comments suggest that there is very little motivation within the central bank to take steps to calm the volatility in Japanese markets.
Prime Minister Shinzo Abe is also assembling fiscal and monetary stimulus to lift the economy from its decade-long deflation era. In April the BoJ caught the market off guard when it pledged to pump in $1.4 trillion into the economy in less than two years to achieve its 2% inflation target. Japanese government bonds rose to one-month highs with 20-year rose to 1.760% and 30-year rose to 1.880%, however, Vice Finance Minister Shunichi Yamaguchi said in Parliament that Japanese long-term interest rates are not necessarily spiking when viewed from a long-term standpoint. Yamaguchi also said that he trusts that the BOJ will react properly to any bond market volatility with flexible market operations.
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