The Big FX Week Ahead

FX: How to Position for the Big Week Ahead

By all counts, next week is an extremely important one for the forex market but currency traders are not the only ones at the edge of their seats waiting for the action to unfold.  Equities, commodities and Treasuries will also be affected by the secession referendum in Crimea this Sunday and the Federal Reserve monetary policy announcement on Wednesday.  Our colleague Boris Schlossberg wrote an extensive piece on what the Crimea Referendum Means for FX and in a nutshell it could result in increased military activity in the region.  Investors will not respond positively to increased geopolitical tensions.  There are only 2 choices in the referendum vote, to join Russia or restore the 1992 Crimean Constitution.  It is not clear what the 1992 Constitution refers to - it can either mean that Crimea will be an independent state or part of Ukraine depending upon whether it reflects the first or second version of 1992 Constitution.  Either way, if Crimea votes to secede from Ukraine, the initial fear about the consequences including a possible Russian invasion could send currencies and equities sharply lower in early Asian and European trade.  If the majority of voters oppose joining Russia, we expect a strong relief rally in currencies and equities.  Unfortunately the more likely outcome is the one that means uncertainty to financial markets.  By unanimously approving the referendum, the leaders of Crimea have shown their cards and their preference for ceding control to Moscow.  So how should we position for the Crimea referendum.  By the time this article is published, trading for the week would have ended.  Therefore the only opportunity is to trade the referendum reactively.  Russia probably won't react immediately to a vote to join the Federation so the follow through could last for days as they decide whether to take military or political action.  Even if a more peaceful means is eventually chosen, the initial uncertainty could provide opportunity to sell the EUR/USD and Japanese Yen crosses.  If Crimea votes against joining Russia, the EUR/USD and Yen crosses can be bought for a risk rally into the North American trading session as Russia may be forced to back off as the global community will use this as an example of their unwelcomed influence. 

By Tuesday the market will shift its focus to the FOMC rate decision.  We'll be publishing a preview on the Federal Reserve meeting next week but almost everyone understands the importance of this meeting.  Not only will it be the first led by Janet Yellen but she is expected to make major changes to forward guidance.  Given recent economic reports, a $10B reduction in monthly bond purchases is a near certainty. The central bank will also drop the 6.5% unemployment threshold in favor of more ambiguous qualitative guidance so the room for surprise lies in Yellen's confidence in the outlook for the economy. She will be delivering a post monetary policy-meeting press conference and in all likelihood, she will maintain a commitment to end QE this year.  Given how far USD/JPY has fallen, we believe this provides an opportunity to buy the greenback at a lower level ahead of the FOMC rate decision.  With the Fed committed to normalizing monetary policy, U.S. yields should resume their rise soon and at that time the dollar will stage a stronger recovery.

EUR: Will Take Cue from Crimea and Fed

The euro traded higher against the U.S. dollar Friday despite concerns about Crimea. Given the region's close ties with Russia, we continue to believe that the euro will be one of the currencies hit the hardest by increasing tensions between Russia and Ukraine. The currency has been extremely resilient this past week, shrugging off Draghi's concerns about the impact of a high exchange rate on inflation.  A lower euro helps to achieve many of the ECB's goals from boosting inflation to supporting exports because a weak currency only becomes a problem when inflation is too strong.  Weaker than expected U.S. data helped to fuel the gains in EUR/USD Friday with producer prices dropping in the month of February and consumer confidence falling to its lowest level in 4 months according to the University of Michigan consumer sentiment survey.  While the German ZEW survey and Eurozone current account balance are scheduled for release next week, the currency will take its cue from the outcome of the Crimea referendum and the FOMC rate decision.

GBP: Next Week - Budget, BoE Minutes and Labor Market Data

While there hasn't been much action in GBP/USD this week EUR/GBP extended its gains, climbing to the strongest level in 2 months. A larger than expected UK trade deficit contributed to the weakness in sterling.  Trade activity deteriorated significantly in the month of January as exports hit a 19 month low. When Finance Minister Osborne announces the annual budget next week, he is widely believed to introduce measures to help boost exports and increase business investment.  There are a number of important U.K. event risks on the calendar in the coming week but all of them are concentrated on Wednesday, which means that the first 2 days of trading could be quiet.  In addition to the annual budget, we have the U.K. employment report and the minutes from the most recent Bank of England monetary policy meeting scheduled for release. Based on the PMIs, the labor market data should be strong and for the most part we do not anticipate a change in the central bank's monetary policy bias because there has not been any major changes in the economy since the last meeting. According to the latest CFTC report, speculators reduced their long GBP/USD positions this week but their overall exposure remains near extreme levels, putting the pair at risk of a deeper correction. 

AUD: Trapped by Lower Copper Prices and Stronger Data

All three of the commodity currencies ended the day slightly lower against the greenback.  With no major economic reports released Friday, these moves represent nothing more than your typical end of week pullback after gains on Thursday.  Each one of the commodity currencies is behaving quite differently these days. The Australian dollar has been trapped in a narrow range between 89 and 91 cents.  Any enthusiasm caused by stronger domestic data has been offset by the slowdown in China's economy and persistent decline in copper prices. While copper is not as important as iron ore for Australia, it is oftentimes viewed as an indicator of Chinese demand and growth because they are the world's largest consumer of the commodity.  However copper is also a financing vehicle in China and the fear of default has also led to deleveraging.  This realization helped to limit the sell-off in the Australian dollar but with no major Australian economic reports scheduled for release next week, AUD will take its cue from the tone of the RBA minutes and the trend of commodity prices.  The New Zealand dollar on the other hand is holding onto its gains thanks to the RBNZ's plans to lift interest rates further this year.  Fourth quarter GDP numbers are scheduled for release next week and even though growth is expected to have slowed at the end of last year, we do not expect the GDP numbers to pose a significant threat to the NZD/USD rally.  For the comm dollars the bigger question is how the greenback will react to the FOMC rate decision. If the greenback soars, it could drive AUD and NZD lower even though longer-term fundamentals may support a continued uptrend in these currencies.  The Canadian dollar is also trapped in a range not far from its 4-year lows but unlike the AUD, the weakness is being caused by weaker and not stronger domestic data.

Behind the Sell-off in USD/JPY

All of the Japanese Yen crosses traded sharply lower Friday led by the sell-off in USD/JPY.  Over the past 36 hours, USD/JPY has blown through 103, 102 and is quickly closing in on 101.  This liquidation caught many traders by surprise especially after yesterday's better than expected spending and jobs data.  Producer prices fell unexpectedly this morning but this second tier inflation report did not accelerate the move. So if economic data is not to blame, then what is driving this steep sell-off in USD/JPY?  It is no secret that USD/JPY takes it cue from U.S. yields and over the past week yields have plunged. The upside surprise in non-farm payrolls, retail sales and jobless claims along with the prospect of tapering by the FOMC next week should be driving yields higher but the sharp sell-off in stocks and concerns about this weekend's referendum in Crimea triggered a flight to quality that drove bond prices higher and yields lower. If U.S. yields do not recover soon and drop to 2.5%, we could find USD/JPY trading at new year to date lows. Japanese stocks have also been performing poorly.  The initial sell-off was triggered by weaker data from China and a significant depreciation in the Yuan.  However the 230-point slide in the Dow on Thursday drove the Nikkei down 3.3% to a 1-month low overnight.  Although part of the weakness can be attributed to Yen strength, a sell-off in Asian stocks also puts pressure on risk appetite and USD/JPY.  It is generally very difficult for USD/JPY to rally without a rise in the Nikkei and U.S. yields.  According to the latest CFTC IMM report, speculators added to their long USD/JPY positions this past week which is surprising given the correction in the pair.

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