By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The U.S. dollar regained momentum on Tuesday moving higher against most of the major currencies. New home sales increased by the strongest amount in almost 30 years, validating the Federal Reserve’s hawkish monetary-policy stance. Monday’s decline simply gave investors the opportunity to buy dollars at a lower level as the uniformity of comments from Fed Presidents shifted market expectations. As more central bankers say that 2-or-more hikes in 2016 is likely, the more investors start to realize that they are underestimating the Fed’s commitment to normalizing monetary policy. For the first time in 2 months, Fed fund futures are pricing a greater than 50% chance of a rate hike in July (it’s actually closer to 55%). We believe that Dudley speaks for the leadership when he hinted at a summer hike and we doubt that Yellen will counter these views in her speech on Friday. So we expect the dollar to extend its gains and look for USD/JPY to head toward 112.
The dollar's rebound drove euro to its lowest level in 2 months. The latest string of Eurozone economic reports were also mixed, adding pressure on the currency. According to the German ZEW survey, investors felt more comfortable with the current conditions in Germany’s economy, but were concerned about the outlook. The expectations component of the report dropped to 6.4 from 11.2 with the same measure for the region slipping to 16.8 from 21.5. Growth in Germany was confirmed at 0.7% for the first quarter but investment was revised higher while private consumption and government spending were revised lower. EUR/USD has been slow to participate in the dollar rally and it was only a matter of time before the single currency also fell victim to the greenback’s recovery. While the European Central Bank is not thinking about easing right now, it maintains a dovish bias and could certainly step up stimulus if Britain’s decision to leave the European Union results in significant disruption to the financial markets.
Meanwhile Brexit headlines continue to move the British pound. Monday's sterling traded sharply lower after the U.K. Treasury warned about the dire consequences of Britain’s exit from the European Union. On Tuesday the pound was up after Bank of England Governor Mark Carney said he doesn’t share the Treasury’s views on inflation and if the U.K. votes to remain in the EU, the next move for rates should be up. However the real takeaway is that U.K. policymakers including Carney believe that an exit would create significant uncertainty in the financial markets and the “BoE would take all necessary steps to ensure an orderly market”. While Carney stopped short of using the word 'recession', his colleague Martin Weale admits that the risk of recession would increase with Brexit. He was also surprised that wage growth has not picked up in the past 18 months, which along with the continued warning of Brexit risks, should limit the upside in GBP and continue the roller-coaster ride for the currency.
The Bank of Canada meets Wednesday and the Canadian dollar is trading higher ahead of the monetary policy announcement. No changes are expected but how USD/CAD trades in the days ahead could be largely determined by the central bank’s tone. After a week of steady gains, USD/CAD is beginning to lose momentum and continued optimism by the BoC could erase more gains. The last time it met, the BoC left interest rates unchanged and upgraded its 2016 GDP forecasts. However it may be difficult to remain optimistic in the face of slowing consumer spending and the wildfires in Alberta that could stall the recovery. The following table illustrates how Canada’s economy changed since the April meeting. Aside from the weakness in spending, jobs were lost, building permits and housing starts declined, the trade deficit widened and overall growth slowed. Yet consumer prices increased significantly with year-over-year CPI growth hitting 1.7%, manufacturing activity accelerated and Western Canada Select oil prices are up 30% since the last meeting. So there are still reasons for the central bank to be optimistic and that’s what makes predicting the BoC’s bias so difficult.
Unlike the loonie, the Australian and New Zealand dollars experienced fresh losses against the greenback with AUD/USD falling to two-month lows. The rise in oil prices failed to translate into gains for oil and copper. Comments from Reserve Bank of Australia Governor Stevens also added pressure to the currency. Stevens said AUD is doing what you would expect it to do (it's down 5 cents since the beginning of the month) and inflation is a bit too low, which suggests that he remains open to the idea of additional easing. AUD ended the day off its lows but as long as the currency pair is below its 200-day SMA, the downtrend remains intact and a move to 71 cents is likely. New Zealand’s trade balance was scheduled for release Tuesday evening and a much smaller surplus was expected. However with the manufacturing PMI index rising, the risk was to the upside for the report.