How The Rising Dollar Affects Stocks

Everyone is talking about USD/JPY and the big breakout move that it experienced over the last 48 hours of the trading week and while we do not underestimate the significance of breaking 100, we think that it is extremely important for investors to realize that this is not a USD/JPY story but a broader story of U.S. dollar strength. The greenback has soared against all of the major currencies and ended the week at 4 year highs against the JPY, 1 month highs against the EUR and NZD, 10 month highs against the AUD and 8 month highs against the CHF. No U.S. economic data was released Friday but the dollar extended higher after a speech from Bernanke. Traders were relieved that Bernanke did not say anything to imply that the Federal Reserve will rejoin the currency war by increasing stimulus or talking down its currency.

Just as equities can have an impact on currencies, currencies can also affect equities, which is why the move in the dollar is getting so much attention from stock traders. We know that a strong currency hurts exporters and benefits importers but the foreign earnings of multinational corporations will also be negatively affected by a strong currency.

In fact, many U.S. companies blamed the strength of the dollar for weaker earnings in the first quarter and the impact was seen in companies across different industries. Three high profile examples are 3M (MMM), Phillip Morris International (PM) and Avon (AVP). The cigarette maker took a 7-cent hit on currency fluctuations, which actually turned their 1 cent profit into losses in Q1. Avon, which generates over 85% of their total revenue from outside of the U.S., saw currency fluctuations shave 4% off of earnings. If the dollar continues to rise due to diverging monetary policy directions, we can expect more disappointments in Q2 earnings. As a result, it will be extremely important for U.S. investors to look beneath the hood and examine more carefully where the companies they are invested in generate most of their revenue – domestically or abroad.

The rally in USD/JPY in particular has benefitted some foreign companies listed on U.S. exchanges and hurt others. Two NYSE listed stocks that come to mind are Toyota (TM) and LG Displays (LPL). Toyota is a Japanese company that will benefit from the latest weakness in the Japanese yen and LG is a Korean company that will be hurt by yen weakness because they compete heavily with Japanese companies. Over the past month, the Korean won has increased more than 7% in value against the yen, which basically means that Korean goods have become 7% more expensive.

Will EUR/USD Hold 1.2950? Data Will Tell

The euro ended the day Friday below 1.30 and while this is important, we have long said that the key level for EUR/USD is 1.2950. The currency pair did breach this level intraday but rebounded shortly thereafter. If the EUR/USD closes below 1.2950, there is no major support for the pair until 1.28. If EUR/USD was meant to break below 1.2950, we believe it will happen next week as we’ve got a tremendous amount of eurozone and U.S. data on the calendar.

The week starts off with one of the most important releases – U.S. retail sales. We know that the Fed is optimistic, job growth has rebounded and the outlook is bright thanks to weekly jobless claims but the real question is whether all of this has translated into stronger retail sales growth.

Consumer spending is the backbone of the U.S. economy and a necessary element in sustaining the downtrend in the EUR/USD. Handicapping this month’s report is tough because the International Council of Shopping Centers reported a steep rebound in spending but the Johnson Redbook survey reported a decline. Economists expect retail sales growth to fall, which would be negative for the dollar and in turn stabilize the euro. If spending turned positive last month and we still think it could, 1.2950 could be tested. If U.S. retail sales don’t do the trick, we also have the German ZEW survey, first quarter German and eurozone GDP along with U.S. housing and manufacturing data that could drive a more sustained move lower in EUR/USD.

What will also be interesting is how this weekend’s G7 meeting transpires – the G7 may have previously been OK with yen weakness but given the latest moves they may have grown more concerned.

USD/JPY 103 Hinges on Japanese GDP and MoF Data

Being long USD/JPY in the second quarter has been a true test of patience but it has also been one of our favorite trades because of the fundamental divergence in monetary policy direction. In early April, the Bank of Japan unleashed the world’s most intense burst of stimulus for their economy. They pledged to pump $1.4 trillion over the next 2 years to boost inflation to 2%.

Their initial announcement drove USD/JPY to 99.95 but the currency pair failed to break 100 and treaded water for the next few weeks even as the Fed’s optimism about the U.S. economy kept discussions of tapering U.S. asset purchases alive. Now USD/JPY has taken out 100 and almost touched 102 intraday. Earlier this month, we said there are 3 criteria for USD/JPY to break 100 and sustain a move towards 105. The first was a rise in U.S. yields, the second was new highs in the Nikkei and the third is Japanese purchase of foreign bonds.

According to the Ministry of Finance’s latest weekly portfolio data, Japanese investors have finally become net buyers of foreign bonds after selling them for 6 weeks straight. As a result, as long as this trend continues, which we believe it will, USD/JPY will extend even higher. If the BoJ is successful in achieving its 2% inflation target, it would be consistent with a USD/JPY level of 104/104.50. Over the past 7 months, USD/JPY already appreciated nearly 30%, leading many investors to wonder how much higher can it rise.

Considering that the Bank of Japan has just begun easing, we think there’s a lot more room to the upside. The pair’s ten-year average is 100, and given the magnitude of the BoJ’s actions, at a minimum, we expect USD/JPY to hit 103 with a very likely extension to 105. The moves in USD/JPY frequently overshoot fundamentals and for this reason, we think a first target of 103 and a second target of 105 is reasonable. The 110 level however, may be a stretch. On a technically basis, 103 is significant because it is the 38.2% Fibonacci retracement of the 1999 to 2011 sell-off in USD/JPY and 105 is significant psychologically, so many stops and take profit orders are likely to be sitting at that level. This coming week’s Japanese GDP numbers and weekly MoF data will help determine whether USD/JPY reaches our initial target of 103.

AUD Hits Parity

The Australian and New Zealand dollars have also been hit hard by U.S. dollar strength. The AUD even dipped below parity against the U.S. dollar intraday Friday, before settling slightly above it at the end of the North American trading session. Both AUD and NZD have seen steep losses and while NZD fell the most, it was AUD that hit the bigger milestone.

Further losses are possible in the Australian dollar after the Reserve Bank cut its inflation outlook. However the economic calendar in the coming week is light for both countries so further weakness would hinge upon broad dollar strength. Of all the major currencies, the one that fell the least against the USD was the CAD. This shouldn’t be a huge surprise considering that Canada benefits significantly if Americans have stronger purchasing power. Canadian employment rebounded less than expected in the month April. After seeing 54.5K jobs lost in March, Canada gained back 12.5K jobs in April. All of the jobs were full time as part time employment fell by 23.6K. The unemployment rate remained unchanged at 12.5K.

In 3 weeks time, Canada gets a new central bank governor with ties to the export sector and he is likely keep monetary policy easy especially after seeing the latest employment numbers. The most important releases from the commodity producing countries will be New Zealand and Canadian inflation numbers.

GBP – Quarterly Inflation Report Expected Next Week

Despite an improvement in the U.K. trade balance, on Friday, the British pound traded lower against the U.S. dollar and euro. The country’s trade deficit shrank from -9.165 billion to -9.056 billion in the month of March.

This improvement is small but with the upward revision to last month’s report, the data should contribute positively to Q1 GDP. What was interesting however is the upward revision to construction output that should erase the triple dip recession from the record books. This coming week will be a busy one for the British pound with the country releasing its employment numbers and the Bank of England’s Quarterly Inflation report. This report provides the government’s up to date assessment of their economy and outlook for monetary policy. Given recent economic improvements, we don’t expect a major shift in the central bank’s views.