Tuesday's Euro Broke To The Upside

After consolidating below 1.3150 for the past week, the EUR/USD finally broke out to upside, rising to its highest level in seven weeks. What was interesting about the move was the lack of specific catalyst. The EUR/USD took its cue from U.S. equities, which recovered strongly Tuesday. The improvement in risk appetite even helped the euro shrug off the news that German investor confidence deteriorated significantly. It should be no surprise that 1.3150 is a key level in the EUR/USD and when it was finally broken, the currency pair jumped above 1.3180 in a matter of minutes. Afterwards the EUR/USD slowly grinded higher with the move extending all the way to 1.32. Although a number of policymakers took to the podium including ECB President Draghi, their comments had very little impact on the EUR. Draghi spoke about 90 minutes before the breakout and reiterated the potential for downside risks. The breakout actually occurred right as the European markets closed around lunchtime in the U.S., which suggests that end of day position adjustments may have been responsible for the move. The question now is whether the rally can be sustained and with no major euro-zone data on the calendar for the rest of the week, its sustainability will hinge upon Wednesday's Federal Reserve Beige Book report, U.S. earnings and equities. If U.S. stocks climb to new highs, the EUR/USD could find its way to 1.33. The next area of resistance in the EUR/USD is at 1.3220, the 50% Fibonacci retracement of the sell-off that occurred between February and April.

Yet the outlook for the euro zone itself leaves a lot to be desired. Aside from Draghi's cautionary comments investor confidence also plunged. The German ZEW survey dropped to 36.3 from 48.5 while the euro zone ZEW survey dropped to 24.9 from 33.4. Investor confidence clearly took a big hit in the moth of April as concerns about Cyprus, German data and possibly even U.S. data overshadowed the rise in equities. However investor sentiment can be fickle so the real question lies in business confidence but the IFO report is not scheduled for release for another week. In contrast to the ZEW survey, euro-zone CPI soared in the month of March. Consumer price pressures jumped 1.2%, up from 0.4% as energy costs rise. For the ECB, price pressures are not a major concern at this time and from a fundamental perspective, euro-zone fundamentals do not support the rally and therefore its sustainability hinges on the USD component of the pair.

USD: Look To Beige Book Report To See If Weakness Persisted
The U.S. dollar ended the day lower against all of the major currencies except for the Japanese Yen. Tuesday's data provided the Federal Reserve with little significant reasons to taper asset purchases in the near future. Inflation remains nonexistent while housing market indicators were mixed. Consumer prices dropped 0.2% in the month of March, which was the fourth time in five months that CPI either stagnated or declined. Core price growth also slowed to 0.1% from 0.2%. We are beginning to see unevenness in the U.S. recovery and given recent disappointments, the Fed needs to be careful with reducing stimulus prematurely. One month worth of weaker data doesn't make a trend but if these signs of slower growth persist the central bank won't be able to make any changes in monetary policy until the fourth quarter. FOMC voter Dudley who spoke this morning agrees -- he said he "favors continuing QE after the March job market slowdown" and cautioned against declaring victory "prematurely." Evans who is also a FOMC voter said the U.S. can't be complacent about the economic outlook -- he expects the fiscal drag to wipe out 1-1.25% from GDP. Duke on the other hand is more optimistic and said she would like to see rates higher since the economy is stronger. Aside from consumer prices, housing starts and building permits were also released this morning. Starts were strong - rising 7% in the month of March after a significant upward revision the previous month. February starts were revised from 0.8% to 7.3%. Unfortunately building permits dropped 3.9% that same month with the past month's report revised down to 3.9% from 4.6%. While the large increase in starts in February and March overshadow the drop in permits, it won't be enough to ease the Fed's concerns about the pace of the recovery. Industrial production increased 0.4% last month but manufacturing production dropped 0.1%. The Beige book report is scheduled for release Wednesday and we will be watching closely to see if the recent deterioration in data persisted into April.

GBP: BoE Minutes Should Reflect Continued Inflation Concerns
The U.K.'s consumer price report did not have a significant impact on sterling as the data came out right in line with expectations. Consumer prices grew 0.3% in the month of March, leaving the annualized pace of growth unchanged at 2.8%. Core prices increased slightly more than expected but this was offset by weaker than expected import price growth. Based on these numbers alone, inflationary pressures have not changed significantly over the past month. This leaves Wednesday's U.K. employment numbers and Bank of England minutes as the driver of volatility in the GBP. Based on the PMI reports, job losses could accelerate as the manufacturing and service sectors saw weaker labor market conditions. However the key is the BoE minutes and whether they reveal a central bank that has moved closer to restarting QE. Back in March, the central bank's worries about inflation overshadowed their concerns about growth. At the time the GBP/USD was trading below 1.50 and before the April 4th meeting, it was trading around 1.51. So as a result, we don't think that their currency driven concerns about inflation have changed much especially since manufacturing, service and construction sector activity improved in March.

CAD: Will BoC Drop Its Bias To Raise Rates?
All three of the commodity currencies rebounded against the U.S. dollar but the gains in the Canadian dollar were far more limited than the gains in the Australian and New Zealand dollars. The CAD is treading water ahead of Wednesday's Bank of Canada monetary policy announcement. While interest rates are expected to remain unchanged from its current level of 1%, there is a reasonable chance that the BoC will drop its call to raise interest rates. Since the last monetary policy meeting in March, Canada reported its largest one month job loss since the recession four years ago and an unexpected trade deficit. There has been good news as well including stronger retail sales, higher consumer prices and stronger manufacturing activity but that may not be enough to ease the concerns caused by the job losses and the slowdown in the U.S. recovery. If the Bank of Canada drops its bias to raise rates, we can expect USD/CAD to hit 1.03. However if they remain cautious but continue to say that, "some modest withdrawal will likely be required," losses in the CAD will be limited. Meanwhile the moves in the AUD and NZD were driven entirely by the recovery in risk appetite as investors ignored cautionary comments from the Reserve Bank of Australia. The level of the Australian dollar is clearly a big driver of monetary policy. In April the AUD/USD was trading just shy of 1.05 and this led the central bank to say that "the factors weighing on the economy -- including the high exchange rate, the waning growth of mining investment, and fiscal consolidation -- were likely to persist." The RBA stressed that while the economy is reacting to rate cuts, the inflation outlook gives scope to ease. Back in March when the AUD/USD was trading closer to 1.02, the central bank sounded far more optimistic which goes to show how large of a role the currency's value plays on their monetary policy stance. New Zealand consumer prices are also scheduled for release this evening. An increase in food and commodity prices in the first quarter point to hotter inflationary pressures.

USD/JPY: Bargain Hunting
With U.S. stocks rising more than 1%, all of the Japanese Yen crosses recovered smartly. The best performer was EUR/JPY, which rose more than 2% and was followed closely by CHF/JPY and NZD/JPY. Having traded below 96 on Monday, USD/JPY rose above 98 Tuesday but settled around 97.50. There were no major Japanese economic reports on the calendar and the only piece of data due this evening will be consumer confidence. We continue to believe that Japanese data will reflect the benefits of a weak currency and easy monetary policy. Bank of Japan Governor Kuroda spoke again last evening but his comments weren't particularly market moving considering that he was primarily asked about the central bank's exit strategies. Having just initiated their new phase in Quantitative Easing, exit strategies are far from their minds but of course as an astute politician, Kuroda was quick to say that they are always keeping the bank's exit strategy in mind with one possibility being higher rates on excess reserves. In our opinion, the Japanese Yen is in a long term downtrend and the recent sell-off in USD/JPY could be an opportunity to come in at lower levels for investors looking for a bargain.

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