Can Yuan Overtake U.S. Dollar And Euro?

With no U.S. economic data scheduled for release on Tuesday, profit taking drove the dollar lower. One of the most interesting stories in the FX market was the report that the Chinese Yuan overtook the euro in trade finance to become the second most heavily used currency behind the U.S. dollar. This trend has been slow in the making but represents what could quickly become a new reality for currencies. According to SWIFT, one of the leading global transactions organizations, the Yuan now carries a market share of 8.66% compared to 1.89% in January 2012. Increased trade with China has led to higher demand for the Yuan and this trend is not expected to change. In fact, China could hold the number two slot for most actively used currency permanently because trade with China will only increase as the economy becomes more consumer driven. At the same, the Yuan's share is still dwarfed by the dollar, which accounts for 81.08% of all transactions. We are going to see a lot more of these reports from the Bank of International Settlements and other agencies in the coming years. While actual trading in the currency remains miniscule compared to the majors, the use of the currency for trade is increasing rapidly especially as China searches for ways to remove exchange risk and reduce the use of dollars. At the same time, the Yuan is also becoming an increasingly popular contract currency, a trend that is not expected to change.

Meanwhile the market's focus will begin to shift to the U.S. labor market Wednesday with the release of ADP, non-manufacturing ISM and the Federal Reserve's Beige Book report. These are three of the most important leading indicators for Friday's non-farm payrolls report. Originally, payrolls were expected to rebound strongly in November after falling sharply in October. However to everyone's surprise job growth in October accelerated and now economists are looking for a pullback this month. Our forecast for payrolls hinges on Wednesday's releases. Last month, the employment component of non-manufacturing ISM increased, accurately forecasting the sharp rise in payrolls. If it extends higher in November, then we will be looking for another month of 200k plus payroll growth. However if it declines, then there's a good chance payrolls will rise by less than 175k. At this stage, we believe that the odds favor a stronger release because confidence has improved since the last report. A strong non-manufacturing ISM report could easily revive the dollar's rally as traders readjust positions in favor of earlier tapering. The Beige Book report is also important. While there are no clear benchmarks for the Beige Book, the description of the labor market from the 12 Fed districts could also affect the market's expectations for NFPs.

USD/CAD Trades At 3-Year High Pre-BoC
USD/CAD climbed to a fresh 3-year high ahead of the Bank of Canada's monetary policy announcement. The BoC is widely expected to leave interest rates unchanged but as usual, the bias of the central bank is key. A few months ago, the Canadians dropped their call to raise rates and despite the improvements in the Canadian economy over the past month and half, we do not expect the central bank to alter its outlook. With that in mind, it may not be long before we hear some optimism from the BoC. Manufacturing conditions have improved, the trade deficit narrowed, consumer spending rebounded and job growth accelerated. The recent decline in the Canadian dollar will provide even more support to Canada's economy and this is coming at a time when U.S. demand is also recovering. As such, we expect growth in Canada to strengthen in Q4 and Q1. When this happens, USD/CAD could reverse its rise as positive data drives speculation about tightening from BoC. Meanwhile the Australian and New Zealand dollars also traded higher against the greenback despite slower retail sales growth and a wider current account deficit. The Reserve Bank of Australia left monetary policy unchanged and expressed their comfort with the current level of monetary policy. While they still felt that the AUD was uncomfortably high, the statement was largely unchanged from November with the RBA maintaining its easing bias. However that has not stopped the AUD from slipping lower versus the NZD. There was no economic data from New Zealand but the disappointments in Australian data have weighed heavily on the pair. Australia's PMI services and third quarter GDP reports were due for release Tuesday evening. Given the drop in manufacturing activity, service-sector activity should have slowed but stronger spending in Q3 was expected to drive up GDP growth.

GBP: Star Of The Show
Thanks to stronger than expected economic data, the British pound continues to be one of the FX market's shining stars. The economy is doing very well with manufacturing and construction sector activity accelerating quickly in the month of November. In fact, due to a rise in homebuilding, construction activity grew at its fastest pace in 6 years. If Wednesday's PMI services index also increases, the trifecta of improvements could drive the GBP/USD to 1.65. The outperformance of the U.K. economy is expected to continue in the coming year thanks in large part to the ongoing support that the government has provided to the housing market. In October the U.K. government brought forward its Help to Buy scheme which was originally planned for January 2014 to ensure a continued recovery in the sector and for this reason, we believe that the economy is well positioned for stronger growth in the first half of 2014. The Bank of England previously admitted that their unemployment rate target could be hit a year sooner than they previously forecasted and if the country's PMI reports continue to surprise to the upside, not only will investors position for even earlier tightening by the BoE but the central bank may have to start dropping its dovish bias. The market is currently pricing in 2 rate hikes in mid to late 2015 but these expectations could easily shift to late 2014, early 2015 if the data supports it. The faster the unemployment rate falls, the stronger sterling will rise.

EUR Back At The Top Of Monthly Range
After a 2-day decline, the euro rebounded strongly against the U.S. dollar Tuesday. The currency pair is now trading within a whisker of its one-month high but a break of the October 3rd high of 1.3640 would be needed to alter the technical outlook for the pair. The rally in the EUR/USD, Tuesday, was driven entirely by U.S. dollar weakness because euro zone producer prices declined more than expected. PPI fell 0.5% in October pushing the annualized producer price growth rate down to -1.4%, its weakest level in nearly 4 years. Considering that the CPI report had been released ahead of PPI, the decline should not be much of a surprise. However the drop in price pressures explains why the central bank decided to ease last month because prices are falling too quickly. We have highlighted the vulnerabilities of the euro-zone economy on numerous occasions and yet the EUR/USD refuses to fall. Part of this resilience can be attributed to diversification but uncertainty about how quickly the Fed will taper asset purchases is also affecting price action. Looking ahead, the final PMI services and Q3 GDP numbers are scheduled for release along with euro zone retail sales. Revisions to previous data are always difficult to handicap but consumer spending could fall for the second month in a row given the softness in German and French consumer demand. The outlook for the EUR/USD will hinge on how serious the ECB is about negative interest rates -- we'll hear from Mario Draghi on Thursday and if he suggests that more easing is possibly the EUR/USD could drop below 1.35.

Yen Crosses Retreat But GBP/JPY Still Headed Higher
With U.S. equities selling off on Tuesday and bond yields edging lower, nearly all of the Yen crosses ended the day in negative territory. However this was not before GBP/JPY, EUR/JPY and CHF/JPY rose to fresh multiyear highs. Unfortunately these currencies failed to hold onto their gains as USD/JPY slipped back towards 102. Given the lack of Japanese data, we want to take this opportunity to talk about one of the strongest trending currency pairs in the forex market. Since the beginning of the year we have seen solid gains in GBP/JPY. Over the past 11 months, the pair appreciated nearly 20% to its highest level in 5 years. At bare minimum, we expect the currency pair to hit 170 with a 70% chance of the move extending to 175. 180 may be a bit of a stretch but not out of realm of possibility. To understand why another 5% rise in GBP/JPY is possible, lets take a look at the outlook for the currency pair from fundamental, technical and positional perspective. From a fundamental perspective, the British pound has reasons to rise and the Yen has reasons to fall. This morning another piece of strong U.K. data pushed GBP/JPY to fresh multi year highs. With manufacturing and construction sector activity accelerating in the month of November, the outlook for the U.K. is looking brighter by the day. In contrast, Japanese fiscal and monetary policies should keep the Yen in a downtrend. The unprecedented amount of stimulus provided by the Bank of Japan this past year and Abenomics has and should continue to provide support for the Nikkei as well as the Yen crosses. From a technical perspective, we have to turn to the monthly chart to find resistance in GBP/JPY. With the former 2009 high of 163 behind us, the next resistance level for GBP/JPY is right below 170, the 38.2% Fibonacci retracement of the 2007 and 2008 sell-off. Above that is the 200-day SMA at 178.80 but the psychological importance of 175 could make this level a stopping point. From the perspective of positioning, the latest IMM report showed short Yen positions near a seven-year high. Speculative positions continued to build over the past few weeks with Yen short or long USD/JPY positions increasing. Sterling positions on the other hand are flat which suggests that there is still scope for speculators to build long GBP and GBP/JPY positions. The only risk is that whenever we have Yen short positions at such extreme levels, the currency is very vulnerable to profit taking but so far we have not seen that. As a result, we are still looking for further gains in GBP/JPY in the coming year.

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