By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Is the sell-off in the U.S. equity markets a healthy correction or the beginning of a crash? It's too early to tell but what is unambiguously clear is that whenever there’s a global equity market sell-off, the U.S. dollar and Japanese yen are the best performers. That was the case this past week when we saw the yen and dollar skyrocket across the board. The yen always performs better than the dollar (unless the source of uncertainty stems from Asia) while the dollar outperforms other major currencies. The currency hit the hardest by the sell-off in U.S. equities was the British pound followed by the euro while the most resilient currencies were the New Zealand dollar and the Swiss franc. With no major U.S. data released, it was the sharp rise in volatility and deterioration in risk appetite that dictated dollar flows. Even if the correction is over, anyone complacent during the slow and steady rise in stocks got a brutal wake-up call this week that will make them reluctant to return to the market with the same enthusiasm. The main reason for the sell-off in stocks is the sharp rise in Treasury yields and with 10-year rates breaching 2.8%, the danger that the U.S. economy faces is very real as this directly impacts borrowing costs for homeowners, consumers and businesses. U.S. data is back on the radar next week with consumer prices and retail sales scheduled for release. But the movements of equities and Treasuries will continue to drive dollar and yen flows. If stocks fall further, the dollar and yen will extend their gains with USD/JPY breaking 108.00. If they stabilize, we should see consolidation instead of buying because investors will need to see a few weeks of recovery to be convinced that the losses are over.
The relative weakness of sterling is surprising considering that the Bank of England was unambiguously hawkish. In its Quarterly Inflation Report, the central bank upgraded its 2018 and 2019 GDP forecasts and said rates may need to rise earlier and faster than what they had seen in November. This degree of hawkishness caught the market completely by surprise as manufacturing and service-sector activity slowed in January. The BoE cited limited spare capacity, excess demand, rising wages, stronger productivity, lower unemployment and faster global growth as reasons for telegraphing more aggressive tightening. Unfortunately, softer data, U.S. dollar strength and Brexit concerns prevented the currency from rallying. After the rate decision, we learned that industrial production and trade activity deteriorated in December, casting doubt on the BoE’s hawkishness. More importantly, Brexit negotiations are not going well. The U.K.’s David Davis accused the E.U. of not acting in good faith and described the language in their commission document as discourteous. On Friday, the E.U.’s Chief negotiator warned that a “transition period” is not a given. So instead of making progress this week, Brexit negotiations have taken a step back and to the dismay of sterling bulls, this overshadowed the BoE’s hawkishness. Looking ahead, the UK’s inflation and retail sales reports are scheduled for release and if the data surprises to the downside like we expect, it may be difficult for GBP to rally. With that in mind, when sterling stabilizes, it should rally strongly as BoE policy returns to the forefront.
Although the Eurozone economy is one of the most resilient, it was only a matter of time before the currency buckled under the pressure of risk aversion and U.S. dollar strength. When EUR/USD finally closed below 1.24 after consolidating above it for most of last week, the selling intensified taking EUR/USD toward 1.22. This was not a move driven by data as better-than-expected German factory orders and industrial production offset weaker trade and current account activity. ECB officials also seem unconcerned about the euro’s rise and talked mostly about the importance of guidance going forward. Looking ahead, there’s not much in the way of market-moving Eurozone data, outside of Q4 German and EZ GDP numbers on Wednesday. There’s significant support for EUR/USD near 1.22 but risk appetite, not data, will determine whether that breaks or holds.
Of the 3 commodity currencies, the Australian dollar experienced the greatest losses this past week followed by the Canadian and New Zealand dollars. AUD/USD traders responded negatively to the country’s weaker retail sales and trade balance reports along with the tone of the Reserve Bank of Australia’s monetary policy statement. The RBA left interest rates unchanged and emphasized its neutral bias by saying that inflation will remain low for some time, rising only gradually due to the strength of A$. Although non-mining investments improved, they felt that household consumption remained a key source of uncertainty. These worries could be compounded by next week’s labor-market report, if it shows slower job growth. Gold and copper prices have also been falling, adding pressure on the currency. At the end of the day, however, regardless of data, the performance of U.S. stocks will determine whether AUD/USD holds or breaks 78 cents and after the close on Friday, we could see a relief rally early next week.
The Canadian dollar fell to its weakest level in 6 weeks on the back of falling oil prices and weaker economic data. Everything from Friday’s labor-market report to the trade balance and IVEY PMI index missed expectations. A total of 88K jobs were lost in the month of January. Not only was this significantly worse than the consensus forecast for 10K job growth, but it was also the largest one-month loss since 2009. The deterioration was so significant that it drove the unemployment rate back up to 5.9%. USD/CAD shot higher in response but failed to hold onto those gains as investors found some comfort in continued full-time job growth. Although 137K part-time jobs were lost, 49K full-time jobs were added, which could be a sign of a healthy rotation in the labor market. Nonetheless, the trade deficit also took an unexpected turn for the worse, growing to its largest level in 5 months on the back of weaker non-energy exports while the IVEY PMI index dropped to its lowest level in 8 months. Looking ahead, there are no major Canadian economic reports scheduled for release. USD/CAD has significant resistance near 1.26 so if there’s a time and place for a turn, it would be in the week ahead, but that would require U.S. stocks and risk appetite to stabilize.
The New Zealand dollar was the best performer thanks to higher dairy prices, stronger labor-market data and the central bank’s nonchalant view on the rising currency. Economists expected the jobless rate to rise but instead, employment grew by 0.5% in the fourth quarter, driving the unemployment rate down to 4.5%. Although the Reserve Bank of New Zealand cut its GDP forecasts to 0.8% from 1.2% in the first quarter, Deputy Governor Spencer dismissed the rising currency by saying it hasn’t moved too much and they are not concerned about the level. Assistant Governor McDermott, who is also the head of economics, emphasized their neutral policy and warned that a drop in inflation expectations could trigger a rate cut. Regardless, these cautious views did not stop the New Zealand dollar from bouncing off its lows toward the end of the week. Business PMI is only New Zealand economic report scheduled for release in the coming week and given the currency’s recent strength, it should continue to outperform other major currencies.