By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It has been a very busy week in the forex market with investors mostly focused on the British pound, Japanese yen and commodity currencies. But next week we think you should be trading the Euro. While it moved lower throughout this shortened week, there was very little meaningful Eurozone data on the calendar. ECB President Draghi set the tone on Monday when he reminded everyone that more easing could be necessary and his concerns were reinforced by Thursday's ECB minutes. However next week, the Eurozone has the busiest economic calendar and we see at least 3 reasons why everyone should be watching and trading its currency.
First and foremost, the February Eurozone flash PMI numbers will be released Monday morning -- these are some of the most important pieces of data for the EZ because they provide investors with direct insight into the latest performance of the manufacturing and service sectors. Unfortunately, we think the data will be ugly given the sharp decline in industrial production, factory orders, investor confidence and the stronger euro. Then on Tuesday, revisions to fourth quarter GDP and the German IFO report will be released and once again we are looking for softer data. Later in the week, Eurozone and German inflation numbers will be released, so by Friday we will have a good sense of whether the ECB's worries about the economy are validated. All of these reports come at a critical time for EUR/USD, which is trading right at its former breakout level of 1.1050. Not only was that level the range high for almost 2 months, but also where the 200-day SMA lies. If weaker data takes the EUR/USD below this support level, then 1.10 will most certainly be challenged. And if that breaks, the EUR/USD will be headed down to 1.08.
There was very little consistency in the performance of the U.S. dollar, which mirrored its uneven performance throughout the week. While ECB rhetoric and Eurozone data are giving the European Central Bank more reasons to act in March, the FOMC minutes and Friday's consumer-price report gives the market very little reason to believe that the Fed will raise interest rates in March. Consumer prices increased but price pressures isn't the only thing the Fed is worried about right now. This expected divergence has and should continue to put pressure on the euro and explains why EUR/JPY, a byproduct of EUR/USD and USD/JPY, fell to 2-year lows. There are also a number of U.S. economic reports scheduled for release next week but unlike the Eurozone, these will be mostly Tier-2 reports. Unless they are all consistently weak or strong, we don't expect the Markit PMI manufacturing index, house prices, consumer confidence, home sales, durable goods and revisions to Q4 GDP to have a dramatic impact on the dollar. Instead our focus will be on the prospect of cautious comments from the 8 Federal Reserve Presidents scheduled to speak next week.
During the European trading session, exceptionally strong U.K. retail sales numbers failed to lift the British pound as Brexit worries grow. But by the end of North America, investors were optimistic even as negotiations continued into the evening. We are surprised by how much weight U.K. investors are placing on the latest Brexit talks considering that we are at least 3 months away from the earliest date that a referendum could be held (and it may not even happen until 2017!). If these talks produce no tangible results, there's no question that more intensive discussions will be had in the coming months -- so this won't be the last EU Summit on UK. Indeed, Prime Minister Cameron doesn't want to return to London with just any deal and according to European Council President Tusk, "some progress" has been made but "a lot still remains to be done." In light of this, the U.K. retail sales report should have had a more meaningful impact on the British pound. Consumer spending rose 2.3%, which was the fastest pace of growth in 2 years. Consumption excluding auto fuel was just as strong, continuing the stretch of positive U.K. economic reports this week that should help sterling find a bottom not far from current levels. We believe that GBP should be trading higher because we don't believe that the weight of a Brexit is justified. So we're looking for a recovery in sterling in the coming week.
The Japanese yen traded higher against all of the major currencies Friday on the back of Chinese policy confusion. Sometime during the Asian trading session Bloomberg reported that rates were being increased for some lenders. But shortly later, China's central bank governor said he didn't hear about a RRR hike. The yen's strength has led to more comments from Japanese policymakers. Prime Minister Abe said Thursday night that steps need to be taken to boost wages to stimulate spending. BoJ Governor Kuroda said negative rates will help boost Japan's economy while Finance Minister Aso described rapid forex moves as undesirable. The big question for everyone is whether these concerns will be followed by action and at 113 USD/JPY, we think the answer is 'no'. But at 111, the risk increases significantly.
The Canadian dollar traded sharply lower Friday on the back of weaker economic data. Retail sales fell 2.2% in December, the largest decline since 2010. Consumer price growth increased but the larger downward surprise in retail sales and the decline in oil prices drove USD/CAD back above 1.38. While we believe that oil prices bottomed at $26 a barrel, this level may be tested before there is a stronger recovery.
The Australian dollar continued to remain weak after Reserve Bank of Australia's board member Edwards sent the currency tumbling overnight when he described it as "a bit too high" and he would be "more comfortable with a level around 65 U.S. cents." While he's not the governor or assistant governor of the central bank, the fact that AUD/USD is trading 6 cents above a level that most Australian policymakers would like to see gives us stronger reason to be bearish Aussie. We continue to look for a move back down to 70 cents, which may be driven by the speeches scheduled for RBA Assistant Governor Debelle and head of payments policy Richards next week.
The New Zealand dollar also moved lower but mostly in sympathy with AUD and CAD. There's a lot going on in China these days with the central bank struggling to get control of the economy and monetary policy between devaluation, liquidity injections and talk of changes to the Reserve Requirement Ratio. The bottom line is that China is trying to keep monetary policy accommodative while limiting the impact on the yuan. Chinese markets will continue to play a big role in market movements in the coming weeks.