By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Dollar bulls remained in control Thursday with the greenback moving higher against most of the major currencies. EUR/USD spent the entire North American trading session below 1.09 while USD/JPY traded as high as 122.65. The recent reversal in the euro has many investors wondering whether the euro parity party is back on. Parity has always been a headline-grabbing target that main street likes to focus on but seasoned traders like ourselves know that these overstretched goals are hard to reach. However we believe that EUR/USD will see 1.05 at minimum. It is important to remember that weaker currencies drive stronger economies and at 1.05, the Eurozone stands to benefit significantly from the combination of ECB stimulus and a lower euro. But let's focus on the 4-to-5-cent opportunity in front of us now.
We expect the EUR/USD to fall to 1.05 and possibly even 1.03 in the next 6 months. While the Eurozone economy is beginning to see the positive impact of ECB easing, 2016 will be a difficult year for the region. Even with ECB easing, German businesses grew less optimistic according to the latest IFO report. Many argue that an influx of refugees will be net positive for growth but at the onset, the migrant crisis will cost a country like Germany billions of dollars. The situation is only expected to worsen with ISIS growing more aggressive. The risk of another terrorist attack is also high as the jihadist group targets Europe. This is all happening in an environment of excruciatingly slow growth. And while the ECB has taken big steps to try to turn things around, Europe will still experience a slow slog in the year end because Fed tightening could slow the U.S. and, in turn, the global economy. Unfortunately, China will only hold the Eurozone back further with the central bank forecasting even slower growth in 2016.
Meanwhile the Federal Reserve's plan to raise interest rates four times next year should keep the U.S. dollar bid. The greatest risk for the Fed is that it acts too aggressively or too quickly, causing pain for global equities and the global economy. While the U.S. may be the source of trouble in this scenario, risk aversion next year could drive the euro lower and the dollar higher. Thursday morning's softer U.S. economic reports failed to derail the dollar rally. Investors are wearing the Fed's rose-colored glasses and looking beyond the drop in the Philly Fed index, the expansion in the current account deficit and the uptick in continuing claims. Weekly jobless claims fell more than forecast but investors have become accustomed to claims below 300k.
The best-performing currency pair continues to be USD/CAD, which hit an 11-year high for a fifth out of six trading days. The rise in the dollar poses 2 big problems for the loonie as it drives oil prices lower and USD/CAD higher. Canadian CPI numbers are scheduled for release on Friday and given the sharp drop in the price component of IVEY PMI, the risk is to the downside for inflation. While the decline in the Canadian dollar will help to offset the decline in price pressure, inflation is expected to fall further before turning upwards. 1.40 is now an arms reach away.
GBP/USD dropped to its lowest level in 7 months. The persistent weakness of sterling is surprising considering that the Bank of England is next in line to raise interest rates. While the BoE is in no rush to hike, the latest economic reports show as much improvement as deterioration in the U.K. economy. Retail sales jumped 1.7% in November, more than 2 times stronger than expected. On an annualized basis, retail sales rose 5% all thanks to Black Friday discounting. Low gas prices and sales at department stores attracted more buyers as volumes increased 1.7% from October. According to the Confederation of British Industry, industrial trend orders also improved in December. Although wage growth and labor-market conditions appeared to have deteriorated, there's clearly strength in other parts of the economy.
The Australian and New Zealand dollars fell sharply Thursday on the back of broad-based U.S. dollar strength and lower gold prices. No major economic reports were released from either country besides Wednesday's strong NZ GDP numbers. U.S. dollar strength can be a powerful driver of currency flows but at the end of the day, Australia and New Zealand still offer a higher yield than the U.S. For the next 2 months the focus should shift away from a Fed hike, which should help AUD and NZD recover. We also believe that both the Australian and New Zealand central banks will leave interest rates unchanged in the coming year, which in the near term will help preserve their carry advantage.