By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The two primary themes in the foreign-exchange market Tuesday was sterling weakness and U.S. dollar strength. In many ways, these two trends came hand in hand as sterling’s losses were compounded by the rise in the dollar while the dollar’s attractiveness was driven by problems in Europe. Investors sought safety in the greenback but improvements in U.S. data along with the prospect of a strong nonfarm payrolls report on Friday made the dollar shine brighter than any other currency. The uptrend in the dollar is strong and corrections could be shallow ahead of NFPs. No major U.S. economic reports were released on Tuesday but comments from Fed President Mester certainly contributed to the gains. If you recall, Mester was one of three Fed FOMC voters to dissent from last month’s meeting and vote in favor of an immediate rate hike. She believes that rates should rise in November, which may be consistent with her hawkish bias but a move next month is unrealistic especially with the U.S. presidential election happening and Brexit back in the headlines.
Sterling fell to 31-year lows versus the U.S. dollar today and 5 lows versus the euro. The currency had been under pressure for the past few weeks but now that key support levels have been broken, many are wondering if the British pound will hit parity versus the U.S. dollar and/or euro. To be clear, sterling has in the past 45 years NEVER traded at parity with the dollar or the euro -- not after the ERM crisis in Britain when the Soros broke the Bank of England and certainly not after the euro was launched and it sank to a record low of 0.8440. The lowest that sterling has fallen in the past 45 years versus dollar is 1.0520, and that was in February 1985. The weakest it has ever traded versus the euro as 0.9805 in December 2007. For GBP/USD to hit parity, it would need to fall another 20% and for EUR/GBP to reach that same value, it would need to rise 14%. Given how fast sterling has fallen in the past month, it does not seem implausible, but for that to happen, the process of Brexit would need to decimate the U.K. economy.
While we believe that the U.K. economy will suffer from Brexit, we do not believe that it will destroy it. First, recent U.K. data has been quite good with manufacturing and construction-sector activity improving significantly. U.K. PMI services are scheduled for release on Wednesday and between these upside surprises and stronger consumer confidence, we believe this report will be firm as well. Of course, investors are completely discounting all of these reports as temporary blips because they remember how much the data fell after Britain voted to leave the European Union. But it's important to realize that the U.K. economy is growing right now and that the government’s top priority will be to protect that growth over the next few months. Second, the 16% decline in GBP/USD over the past 3.5 months is extremely positive for the economy. It will boost trade activity, encourage tourism, support stocks and encourage cross border acquisitions. Third, investors aren’t going to pull all of their money out of U.K. assets -- London is still a hot spot for investments by foreigners and rest assured the May government will be incentivizing businesses to keep operations in the U.K., starting with a lower corporate tax that will be nearly 40% less than Germany.
So while we expect GBP/USD to reach 1.25 easily, a move down to parity may be a bit too ambitious for sterling bears. Technically, the currency pair is deeply oversold with support coming in at 1.25. For EUR/GBP, the 2012 high of 0.8815 could provide some resistance but the next major level is 90 cents.
The U.S. dollar should continue to outperform, but after 6 straight days of gains, traders should beware of a correction in USD/JPY ahead of Friday’s nonfarm payrolls report. Tuesday’s rally took the currency pair to 103 and a move down to 102.50 would give everyone a great opportunity to reload their long positions. There are a number of reasons to believe that this month’s jobs report will be strong including the drop in weekly jobless claims, rise in consumer confidence, uptick in withholding taxes and improvement in weather which kept 50K people out of work in August. Nonfarm payrolls will be in focus on Wednesday with ADP employment change and non-manufacturing ISM reports scheduled for release. If these reports confirm the improvement in labor-market conditions, we could see USD/JPY take out Tuesday’s high of 103, opening the door to a move to 105.
ECB headlines sent EUR/USD on a rollercoaster ride. In the early North American Tuesday trading, broad-based dollar strength drove the single currency sharply lower with the pair breaching its critical 1.1150 support level. At one point it looked like 1.11 would be tested as well, but a report that said the ECB is near consensus on the need to taper quantitative easing before it concludes sent the currency pair sharply higher, erasing all of its earlier losses in the process. Tapering before ending QE is not unusual process but investors were clearly surprised by a headline that focused on tightening and not easing. ECB President Draghi was quick to deny the statement, saying tapering was not discussed but the mere possibility that the central bank may be done easing was enough to limit losses in EUR/USD. We think the market over reacted to the headlines and we are still looking for further weakness in EUR/USD on the back of Deutsche Bank's (NYSE:DB) ongoing troubles, Brexit and the prospect of a strong U.S. jobs report.
The Australian, New Zealand and Canadian dollars all ended lower against the greenback today. On Monday night, the Reserve Bank of Australia left interest rates unchanged at 1.50%. AUD/USD shrugged off the announcement, as the decision was fully anticipated. The RBA’s view was mostly in line with new central bank Governor Phillip Lowe’s previous comments. He reiterated that the labor-market data was mixed, saying that although the unemployment rate declined and indicators point to a growing labor market, the issue lies with growth being seen in part time jobs, with full-time job growth being somewhat subdued. The RBA also expressed concern about low inflation and China. Lowe acknowledges that policymakers in China have been supportive to the global economy as a whole but the pace of growth in China was moderating which could spell issues further down the line. Meanwhile, the New Zealand dollar gave up all of its early gains after dairy prices dropped -3.0%, the first decline at an auction since August. The Canadian dollar took a hit on news that Iran and Libya are increasing oil production, counteracting last week’s OPEC deal. The stronger U.S. dollar also drove oil prices lower. Australia was set to report PMI services and retail sales Tuesday evening and Canada reports International Merchandise Trade data on Wednesday.