By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Don’t be fooled by the fragile recovery in currencies because China is still in trouble and poised to bring greater pain for the financial markets. U.S. and European equities ended the day in positive territory as USD/JPY and high-beta currencies rebounded sharply. Investors completely ignored the decline in Chinese stocks overnight – the Shanghai Composite Index dropped 5.3% while the Shenzhen Composite fell 6.6% with both indices closing at their lows. However risk appetite seems to be tied to the currency and not equities. The on and off-shore yuan closed higher with the off-shore version seeing its strongest gains in 4 months. At the beginning of last week, both currency and equities were falling, creating the perfect storm for financial assets but overnight one stabilized, raising hope that the other will as well.
China will remain in focus this week overshadowing data and driving market sentiment. While the Chinese government chose to intervene in its currency Sunday night, they warned that there could be more two-way action against the dollar, which is why they suggest investors focus on the basket rather than the dollar. With that in mind, they will “appropriately limit daily CNY/USD volatility” which should mean more intervention. Chinese trade numbers are also schedule for release this week and the outcome will undoubtedly have a significant impact on the market and risk appetite.
Meanwhile there was very little consistency in the U.S. dollar's performance on Monday – it strengthened versus the euro and Japanese yen but weakened against commodity currencies. Aside from China, the focus for U.S. dollar traders this week should be on Fed speak. There are 7 Federal Reserve Presidents scheduled to make comments on the economy and/or monetary policy, 3 of whom are FOMC voters (Rosengren, Bullard and Dudley). Rosengren and Dudley are doves while Bullard has hawkish leanings. In terms of data, we’ll have to wait until the end of the week when retail sales, industrial production, producer prices and the University of Michigan consumer sentiment reports are scheduled for release.
The earnings season also gets under way and unfortunately it is estimated that fourth-quarter earnings will be 5% weaker than Q3 according to FactSet. Between the stronger dollar and weaker Chinese/global growth, earnings are expected to fall for the third quarter in a row. Traders should expect many companies to attribute their decline in revenues to currency translations.
It is a particularly busy week for the British pound. Industrial production numbers are scheduled for release Tuesday along with the Bank of England’s monetary policy announcement on Thursday. While no changes are expected from the central bank, the drop in energy prices and the volatility in the financial markets should make policymakers more nervous. Low inflation has been a big problem for the BoE – although the weaker currency helps to ease some of that pain, over the past month oil prices fell 14.6% while sterling only lost 3% of its value versus the euro and U.S. dollar.
We expect EUR/USD to range trade for most of the week. Considering that there are no major European economic reports scheduled for release and U.S. retail sales are not due until Friday, EUR/USD should remain confined between 1.07 and 1.1040. At the start of last week, euro weakened on risk aversion but by the end of the week, the selling in other markets became so severe that it triggered a reversal of funding currency trades, which sent EUR/USD sharply higher. For many investors, it is hard to figure out what matters more and the answer lies in positioning. According to the latest CFTC report, traders added to their short EUR/USD positions at the start of the year. At 160K contracts, short euro positions are two times greater than its 3-year average, which means if the markets continue to sell off, more traders could be squeezed out of their short trades, driving EUR/USD higher.
USD/CAD starts the new trading week with a fresh 12-year high. Weaker housing data contributed to the move but oil continues to be the main driver for the loonie’s decline. Crude prices fell more than 6% Monday to under $32 a barrel. This is the lowest level that we have seen oil prices at since 2003. The deeper the decline in crude, the more pressure it puts on Canada’s economy. With the mid 2003 high at 1.4190 broken, the next level of resistance for USD/CAD is 1.4290, the swing low from 2000 and the breakdown level from 2003.
The Australian and New Zealand dollars ended the day slightly higher versus the greenback despite softer economic data. In Australia, job advertisements fell -0.1% in December. While the pullback is nominal, it comes ahead of the broader labor-market report but we believe there could be an upside surprise with the manufacturing and service sectors reporting stronger labor conditions according to the latest PMIs. Building permits in New Zealand rose 1.8% in November, a slower pace of growth compared to October when permits rose 5.4%. Until Australian employment and Chinese trade numbers are scheduled for release, AUD and NZD will be driven by developments in China.