By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It was a volatile day in the foreign-exchange market with the Dollar Index falling to a 3-year low. This decline drove all of the major currencies higher and represented a strong reversal from the rally in Europe. While sterling was not the best performer during the dollar’s decline (that title goes to the Japanese yen), it hit a significant milestone when it breached 1.40 for the first time since June 2016. EUR/USD also broke above 1.23 but both moves failed to last as profit taking took over into the London close. This type of volatility is characteristic of 'Turnaround Tuesdays,' which doesn’t always happen but can take over with force given the right market environment. The dollar started the NY session up against all of the major currencies except for the yen as investors celebrated the short-lived U.S. government shutdown. The JPY marched to its own tune thanks to a small tweak the Bank of Japan made to its monetary policy statement. Instead of saying inflation expectations were weakening, they now feel that prices are skewed to the downside. With that in mind, they made no mention of the currency’s value, additional taper or rate hikes. So if USD/JPY falls further from here it will be driven by the market’s appetite for the greenback and expectations for BoJ policy. Although investors were encouraged by the temporary funding bill, the dollar’s rally did not last because in 3 weeks, Congress could be right where it started. Looking ahead, USD/JPY could remain under pressure but we still see the possibility of a further dollar recovery against the euro – ahead of the ECB meeting on Thursday – and the commodity currencies, which are vulnerable to a deeper correction.
Sterling hit a high of 1.4028 against the U.S. dollar on the back of stronger data, U.S. dollar weakness and the triggering of stops above 1.40. Public sector finances improved in December thanks in part to stronger VAT receipts and EU credit. The CBI total Trends survey also beat expectations with business optimism and selling prices rising strongly. Progress is being made on a Brexit deal with members of the European Parliament’s negotiating committee noting that UK officials have not objected to anything significant at the latest planning meetings. However GBP/USD failed to end the day above 1.40 and until that happens, it will remain the key level to watch. Wednesday’s UK labor-market report could decide if this resistance level is broken. Job growth should be decent according to the manufacturing and construction PMIs but the real test is wage growth. Average earnings rose strongly last month and are at risk for a correction that could take GBP/USD back to 1.3900.
The euro on the other hand continues to trade well ahead of Thursday’s European Central Bank monetary policy announcement. The currency’s recent strength did not dampen investor confidence according to the German ZEW survey. The current situation component of the report rose to its highest level ever while the expectations component hit an 8-month high. This report shows economic improvements overshadowing German political troubles and the currency’s strength. It’s a good way to start the year and bodes well for the PMIs and IFO report. The ECB will have to address the same issue when it meets on Thursday, which will hinge on whether economic improvements are strong enough to offset the increase in yields and rise in the euro. The possibility of less-hawkish comments should lead to profit taking ahead of the monetary policy announcement but EUR/USD traders could still hold out for the PMIs and sell later that day.
All 3 of the commodity currencies came under selling pressure on Tuesday but the Australian dollar was the only one that really held onto its losses. This is the most significant one-day decline that we have seen in AUD/USD in 2 weeks and it has led many investors to wonder if this is a top. There were no major Australian economic reports released overnight but a steep drop in Iron ore prices combined with earlier U.S. dollar strength helped to tip the pair lower. After this month’s strong moves, we believe that the Australian dollar will be hit by further profit taking that could take AUD/USD down to 79 cents. In contrast, the Canadian dollar recovered earlier losses to end the day higher against the U.S. dollar thanks in part to President Trump’s NAFTA comments. He said the talks are moving along well, which is a departure from his usually antagonistic stance on NAFTA and the solar import tariffs, which have infuriated Asia. The countries most affected are South Korea and China who could view this as the start of a trade war. The New Zealand dollar was also surprisingly resilient in the face of slower growth in the service sector.