EUR: Don’t Rule Out A Post-ECB Bounce

EUR: Don’t Rule Out a Post ECB Bounce

The title of our daily note yesterday was “Why Negative Rates Could Drive EUR Down 3%.” We provided charts and examples outlining the potential for a deep sell-off but if you read through the piece, our core argument was that the euro is completely different from the Danish and Swedish Kronas and therefore not likely to experience the same sell-off. In fact, the euro could actually bounce after the ECB rate decision if the central bank refrains from signaling plans to follow the move with Quantitative Easing. Back in November when the central bank cut interest rates by 25bp, EUR/USD collapsed on the day of the announcement but the bottom of 1.33 was also set on that very day. In the month that followed, the euro gained approximately 5 cents versus the U.S. dollar, rising to a high above 1.38. Interest rate cuts are suppose to drive a currency lower but in the case of the euro investors were impressed by the European Central Bank’s aggressiveness and believed that it would be enough to revive the Eurozone economy. Here are 5 reasons why easing by the ECB may not be completely negative for the EUR/USD:

1. The EUR/USD is a very liquid currency
2. Eurozone has a current account surplus in the billions and not millions
3. EONIA curve shows investors have completely discounted the move
4. Strong action by ECB could attract more investment flows
5. Anything short of a 4 pronged move (refi cut, depo cut, end SMP sterilization, LTRO) could help the euro

It is important to realize that the EUR/USD is an extremely liquid currency, which means there should be more two-way action with bargain hunters attracted by the decline for a currency with a current account surplus in the billions and not millions like Denmark and Sweden. For most of this year, euro was also supported by the return of funds that fled the region during the sovereign debt crisis and strong action by the ECB could make foreign investors more confident and willing to invest in Eurozone assets. At the same time, the EONIA curve shows that the market has already priced in easing by the central bank. In order to minimize the volatility caused by their decision, they have made their plans abundantly clear which means that the risk is for them to under-deliver. At this stage, they are widely expected to lower the refinancing rate, cut the deposit rate, end SMP sterilization and provide another LTRO for banks. Anything short of these 4 moves could end up lifting the euro. For EUR/USD to fall 3%, the ECB would need to signal plans to initiate a broad scale asset purchasing program or Quantitative Easing. While they are discussing this possibility, we don’t believe they are prepared to resort to this nuclear option. However if they suggest that it is becoming more feasible, EUR/USD will decline with a sell-off that should be limited to 1.35/1.3450.

Dollar Up on Stronger ISM and Optimistic Beige Book

The U.S. dollar traded higher against most of the major currencies Wednesday thanks to the reversal in U.S. yields. At the start of the North American trading session U.S. yields declined and remained under pressure after the softer ADP and trade balance reports. These initial releases raised concerns about the overall pace of growth in the U.S. economy and the potential of a weaker than expected non-farm payrolls report on Friday. According to payroll provider ADP, only 179k new jobs were created in the moth of April, down from 220k. This decline was larger than anticipated and consistent with the increase in jobless claims. Meanwhile the country’s trade deficit rose to its highest level in 2 years. However any negative sentiment was erased with the release of the non-manufacturing ISM index, which, rose from 55.22 to 56.3 in the month of May. Not only did service sector activity accelerate last month but employment, business activity and new orders all saw increases – a sign of improving economic activity. The dollar extended its gains after the relatively upbeat Beige Book report that validated the improvements that we saw in the ISM index. According to the 12 Fed districts, economic activity continued to expand at a modest to moderate pace with an uptick in jobs, increase in consumer spending, expansion in manufacturing activity, robust new vehicle sales, rise in house prices and pickup in lending activity. While there could still be some liquidation ahead of Friday’s payrolls report, for the time being, the recent increase in U.S. yields should keep the dollar in demand.

GBP: No Changes Expected from BoE

Unlike the euro, which is consolidating before a major event risk that will most likely trigger a big breakout in the currency, GBP/USD is consolidating because of the lack of surprises. Once again the Bank of England is expected to keep interest rates unchanged and when they choose to do so, the impact on sterling is limited. So while we expect EUR/GBP to move on the ECB’s monetary policy announcement, there may not be much volatility in GBP/USD. In fact the currency pair barely reacted to Wednesday’s economic reports. As indicated by our colleague Boris Schlossberg, “in UK the Services PMI came in at 58.6 versus 58.7 the month prior but still a bit better than 58.3 anticipated. UK economy continues to fire on all cylinders with service sector employment strengthening at the fastest pace in 17 years while other sectors remain at historic highs. Still cable saw little reaction from the data rallying only 25 points in the aftermath of the release as traders remain skeptical that the BoE will move to normalize monetary policy anytime before next year.”

CAD Extends Losses as Bank of Canada Sees Greater Risks

USD/CAD extended its gains against the U.S. dollar after the Bank of Canada’s monetary policy announcement. As everyone anticipated, the BoC left interest rates unchanged. Based on the monetary policy statement, the recent stabilization in the housing market and rise in annualized inflation was not enough to offset the central bank’s concerns about growth. The BoC said the weaker global outlook increases the downside risk for Canada, especially now that the U.S. economy is losing momentum. These uncertainties led the central bank to leave their assessment of inflation unchanged – they continue to see downside risks despite the positive impact of a weaker currency and higher energy costs. Considering that some market participants had been looking for the central bank to temper its concerns about inflation, Wednesday’s statement was positive for USD/CAD. Of course the big disappointment in the trade balance also contributed to the decline. Due to weakness in energy exports Canada reported its first trade deficit in 3 months. Economists had been looking for a small improvement but the data is distorted by a sharp upward revision for March. Canadian IVEY PMI numbers are scheduled for release Thursday and given the dovishness of the BoC and the weakness in trade activity, we are looking for another soft report. Meanwhile the Australian dollar extended its gains on the back of stronger data. According to the latest GDP report, the economy expanded by 1.1% in the first quarter, which translates into a significantly higher 3.5% annualized pace of growth. Service sector activity also improved, validating the RBA’s decision to maintain its neutral monetary policy bias. The country’s trade balance report was scheduled for release Wednesday night along with HSBC’s composite PMI report for China. Finally the New Zealand dollar extended its losses after ANZ confirmed that commodity prices tumbled in the month of May.

JPY: PMIs Confirm Recovery

There was very little consistency in the performance of the Japanese Yen. The Yen weakened against the British pound (GBP/JPY), U.S. and Australian dollars and strengthened against the euro, Canadian and New Zealand dollars. The rebound in Treasury yields, rise in U.S. and Japanese equities, helped to keep USD/JPY supported but 103 is a significant resistance level that will be difficult for the pair to break without a strong non-farm payrolls report. PMI numbers were released from Japan overnight and the latest reports confirm a continued recovery in Japan’s economy. The service sector PMI index rose to 49.3 from 46.4 while the composite index hit 49.2, up from 46.3. The recent sales tax increase has not prevented businesses from hiring and so far, incoming data reinforces the Bank of Japan’s view that the economy won’t experience a prolonged contraction. There were no major Japanese economic reports scheduled for release Wednesday evening – the only thing on the calendar was the weekly portfolio flow report from the Ministry of Finance.

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