By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
- What is Fair Value for the EURO?
- Dollar Bulls Refuse to Cede Control
- GBP/USD Breaks 1.50
- NZD Bounces after RBNZ Rate Decision
- AUD Hit by Weaker Chinese and AU Data
- USD/CAD Bounces off 1.28
What is Fair Value for the EURO?
Since the launch of the euro, there has not been such a swift and aggressive meltdown in the currency pair like the one happening now. At the beginning of the year, 1 euro was worth 1.21 U.S. dollars. As of Wednesday, it bought as little as 1.05 U.S. dollars. Before we know it, the euro could be at parity with the greenback -- a value not seen since 2002. Quantitative Easing has hit the euro hard, driving it to the weakest level against the dollar in 12 years and the weakest against the British pound in 7 years. In the past 3 months alone, the currency lost more than 12% of its value against its U.S. dollar, Swiss franc and Japanese yen, making it the worst-performing major currency year to date. Whenever we see such a steep decline, one of the first questions that everyone asks is what is fair value? For the euro, it's no less than 10% above current levels. From a valuation standpoint, the euro is cheap.
The most popular way to measure valuation is purchasing-power parity and, depending on which measure you use -- CPI, Big Mac or OECD, the EUR/USD is undervalued between 10% to 20% or (1.17-1.27). For those unfamiliar, PPP measures the relative price of goods and assets between 2 countries. There has always been a lot of debate on the accuracy and reliability of PPP and while short term there can be major deviations from purchasing-power parity, in the long run, the deviation still exists but rarely as large, especially between countries with close trade links like the U.K. and Eurozone. However it can take as long as 5 to 10 years for exchange rates to adjust and that time frame is too long for most traders and investors. The point that we want to make is that in the short term, fair value doesn't matter. Currencies can and will deviate significantly from fair value, especially in cases of undervaluation because meltdowns are generally more quick and aggressive than rallies. For the euro specifically, the widening divergence between Eurozone and U.S. monetary policy sets the stage for protracted underperformance. ECB QE has just started and Fed tightening has yet to begin. Growing expectations for a change in forward guidance by the U.S. central bank should drive further gains in the dollar ahead of next week's FOMC meeting. At minimum, we expect the EUR/USD to trade down to the 1997 low of 1.0350.
Dollar Bulls Refuse to Cede Control
Investors continue to buy U.S. dollars ahead of Thursday's retail-sales report. The greenback traded sharply higher against all of the major currencies with the strongest gains seen versus the euro and British pound. On Tuesday, the dollar was driven higher by risk aversion and while bond yields and stocks ended the day virtually unchanged, the broad-based rally in the greenback Wednesday, including USD/JPY, tells us that every other currency is losing its luster versus the dollar. Thursday's consumer-spending numbers will most likely reinforce its attractiveness as strong non-farm payrolls, rise in gas prices and increase in spending according to Redbook point to a stronger number. The bottom line is that the Federal Reserve is gearing up to raise interest rates regardless of whether it comes in June or September and that prospect has been and should continue to be extremely positive for the US dollar. While Fed tightening in 2015 is widely expected, a change in forward guidance next week will still lift the dollar and this event risk acts as a target for dollar bulls buying into the news. If retail sales surprise to the upside like we expect, it will harden expectations for a shift in guidance, which should send the greenback to fresh multi-year highs against many major currencies going into next week's monetary-policy announcement. We have been looking to buy dollars on dips but unfortunately we are not sure if we will be given the opportunity as dollar bulls refuse to let up control of the currency.
GBP/USD Breaks 1.50
The British pound broke below 1.50 level to trade at its weakest level since July 2013 on the back of softer economic data and dovish comments from U.K. officials. On Wednesay morning we learned that industrial and manufacturing growth declined in January, which was surprising considering the increase in the PMI manufacturing index. However the meltdown in GBP/USD did not occur until the NIESR GDP estimate was released. According to the National Institute of Economic and Social Research, GDP growth is expected to have held steady at 0.6% in February. That would not be so negative for Sterling if not for the downward revision to the prior release. Around the same time, BOE member Weale said the decision to raise rates is finely balanced, which some interpreted to mean that he is backing away from his hawkish bias. Yet his other comments that wage growth is accelerating and will strengthen the case for a rate hike suggests that he could still favor raising rates this year, just not quickly because the oil-price drop provides policymakers with some breathing space. Support in GBP/USD is now at the 2013 low near 1.4815 and for EUR/GBP, 70 remains the key level to watch.
NZD Bounces after RBNZ Rate Decision
All three of the commodity currencies traded lower against the U.S. dollar Wednesday but with the Reserve Bank of New Zealand holding a monetary policy meeting, the focus was on NZD/USD. As expected the RBNZ left interest rates unchanged but rates could move up or down depending on inflation expectations. The RBNZ cut its 2015 first-quarter GDP forecast and slashed its inflation forecast substantially. At first glance these comments and forecast changes suggests that the RBNZ could lower rates but in the accompanying press conference, central bank Governor Wheeler attempted to sound more upbeat, saying that New Zealand is in a different situation than many economies including those who cut rates. He sees inflation pickup up once the oil-price decline passes and he felt that this view justified a period of interest-rate stability. Instead of changing interest rates, they are now thinking about macroprudential measures to affect the economy. Meanwhile the Canadian and Australian dollars also fell sharply on the heels of U.S.-dollar strength and weaker data. For Australia, on the other hand, consumer confidence dropped 1.2% in March according to Westpac while home loans fell 3.5%. In China, retail-sales growth slowed to 10.7% while industrial-production growth slowed to 6.8%. This recent turn in data reinforces the need for another rate cut by the Reserve Bank of Australia. While AUD traded lower, the slope of its decline will hinge on Wednesday night's labor market report. If job growth drops for the second month in a row, we could see AUD/USD test 75 cents.