EUR: New Highs Or Will ECB Kill Rally?

Will ECB Drive EUR to New Highs or Kill the Rally?

For the first time since September 2011, the euro is trading north of 1.39 ahead of the European Central Bank's monetary policy meeting. The ECB is not expected to change monetary policy so any reaction in the euro will be to Mario Draghi's press conference and not the monetary policy announcement.  We know that Draghi and his peers at the ECB are not happy with the current level of the euro but the big question is whether the value of the currency is a large enough problem for the central bank to prepare the market for additional easing.  When the ECB last met in March, the euro sold off aggressively after Draghi spent most of his press conference talking about the possibility of additional easing and outlining the ways they could increase stimulus.  In order to send a stronger message to the market, he would need to indicate that the central bank is not only willing to ease, but preparing to do so within the next few months.  So the next logical question to ask is whether economic activity and uncertainty has increased enough over the past month to warrant a change in monetary policy -- we think the answer is no.

Yes the euro is trading higher but the main problem with a strong currency is the downside risk it poses to inflation.  The central bank has been battling low inflation for months now and if CPI continues to fall, they could justify another round of easing.  However as shown in the table below, headline and core prices increased in the month of April.  While inflation is still well below the central bank's 2% target, the recent uptick is encouraging and reduces the pressure to ease. At the same time, manufacturing and service sector activity accelerated.  Inflation and growth remains weak but this increase in activity combined with the uptick in inflation should discourage the central bank from signaling an imminent change in monetary policy. If we are right, the euro should hold onto its recent gains and maybe even make a run for its 2-year high of 1.3967.  However if the central bank ignores recent data improvements and intensifies their concern about the strong currency, euro could drop quickly and aggressively.  

USD: Top 10 Takeaways from Yellen's Testimony

If central bankers were measured by the lack of volatility that they inspired in the financial markets, then Janet Yellen's testimony before the Joint Economic Committee Wednesday was a big success.  The dollar ended the day unchanged versus the euro, Japanese Yen and British pound, 10-year Treasury yields were flat and the Dow Jones Industrials rose 117 points. The Fed Chairwoman did a fantastic job of telling the Congressional committee that the U.S. economy is rebounding but she also skillfully avoided providing any specific guidance on the timing of the first rate hike.  Unlike her first post FOMC meeting press conference where she said clearly that rates could rise 6 months after QE ends, Yellen stuck with generalities at Wednesday's testimony.  In fact her comment that the Fed will most likely raise the IOER rate before the main rate is a sign that when the time comes, they will be tightening monetary policy very slowly. The housing market remains an area of concern and while the central bank believes that inclement weather distorted the labor force participation numbers, the performance of the jobs market is far from satisfactory.  As a result their monetary policy plans remain unchanged and they will continue to taper asset purchases at a measured pace as long as the outlook improves.  Although Yellen's comments were relatively upbeat, her failure to provide more clarity on monetary policy could leave the downtrend in yields and the dollar intact.

Here are our Top-10 Takeaways from Yellen's Testimony

1. Low Inflation and Labor Market Slack Means High Degree of Accommodation Remains Warranted
2. No Timetable for First Rate Hike -- Backtracks on her March 6 month after QE Ends Comment
3. Fed will most likely raise IOER rate (Interest on Excess Reserves) before Main Rate
4. Taper will continue at current pace as long as outlook improves
5. If Labor Market Activity Improves, QE will end this year
6. Yellen Discounts Q1 slowdown as transitory because of weather factors, Q2 will be better
7. Not Satisfied with Labor Market Performance
8. Worried about Housing Market Activity -- Says Flattening Posing a Risk
9. Believes Labor Force Participation has been Stable because part of the decline is weather related
10. Optimistic about spending and productivity, expects stronger 2014 growth vs. 2013

AUD Hangs Tight Ahead of AU Employment and Chinese Trade

All of the major currencies including the Australian and Canadian dollars ended the day unchanged against the greenback with one exception -- the New Zealand dollar. NZD/USD sold off approximately 0.5% on the back of RBNZ Governor Wheeler's comments about currency intervention. With milk prices falling, the head of the central bank promised a group of Dairy famers that the high exchange rate, which adds to their pain will be a factor in their future monetary policy decisions and "if the currency refuses to fall in the face of worsening fundamentals such as weakening in export prices," they could "intervene in the currency market to sell NZ dollars." These comments indicate that Wheeler is taking the decline in dairy prices seriously but we believe that a pause in tightening is more likely than intervention.   Having unsuccessfully intervened in FX in past years, the RBNZ is not eager to fight an uphill battle that they lost on nearly every occasion.  Adjusting their course of monetary policy however can be very effective.  The focus was set to shift from the New Zealand dollar back to the Australian dollar with the release of Chinese trade numbers and Australian employment data Wednesday night.  According to last night's report, consumer spending slowed in the month of March.  Job growth is also expected to slow but a rise in the employment component of the manufacturing and service sector PMI indexes leaves open the possibility of an upside surprise.  A further improvement is also expected in China's trade balance, which should lend support to AUD.

GBP: No Surprises Expected from BoE

Thursday's Bank of England monetary policy decision is not expected to have a significant impact on the British pound.  The BoE is comfortable with the current level of monetary policy and in no rush to tighten despite improvements in manufacturing and service sector activity.  When policy is left unchanged a brief statement is released providing no details on the decision.  The BoE rate decision will not pose a threat to GBP/USD reaching 1.70.  Yesterday, the currency pair traded within 4 pips of this key level and we think its only a matter time before this psychologically significant technical level is broken.  The last time that one sterling was worth more than 1.70 U.S. dollars was in August 2009 and at the time, the value of the pound peaked at 1.7043.  Unlike 2009 the recent rally in the sterling has been slow and gradual while the move 4 years ago was sharp and choppy.  The improvements in U.K. data and speculation that the Bank of England will be the next major central bank to raise rates supports the uptrend but with long positions at extreme levels, we want our readers to understand that it won't take much to scare investors into taking profits. 

Japanese Yen Shrugs Off Sell-off in Nikkei

The Japanese Yen traded lower against all of the major currencies Wednesday despite the nearly 3% slide in the Nikkei 225 overnight.  After being closed for holidays on Monday and Tuesday, Japanese markets caught up to the previous weakness in U.S. equities.  Last night's economic reports were also surprisingly weak with service sector activity contracting in the month of April. The 5.8 point slide in the index pushed the composite release down to 46.3 from 52.8.  The Bank of Japan minutes on the other hand contained no surprises -- the central bank does not feel that additional stimulus is needed at this time, a line that policymakers have been repeating often. The impact on the yen was nominal.  No major Japanese economic reports were scheduled for release Wednesday evening but Chinese trade data could affect Asian trade.

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