By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
What a great week it has been for the U.S. dollar! The greenback took in gains against all of the major currencies, rising more than 2% versus sterling and the New Zealand and Canadian dollars. Key levels were broken all around with EUR/USD testing 1.05, USD/JPY hitting 114.50, GBP/USD cracking 1.2300 and AUD/USD breaking below 76 cents. These big moves give traders a taste of the volatility that they can expect this month as there are a number of high-profile events in March that could shake the financial markets. This coming week, for example, we have the European Central Bank’s monetary policy announcement and the U.S. nonfarm payrolls report. The following week is the FOMC meeting, press conference from Janet Yellen, the Dutch elections and the G20 Finance Ministers/Central Bankers meeting. Of course we can’t forget that U.K. Prime Minister May plans to trigger Article 50 by the end of the month. Each of these events could trigger big moves in currencies but with so much happening over the next 20 trading days, March will certainly be an exciting month.
The question being asked now is why the dollar fell after Yellen spoke and what could derail the rally. The move post Yellen was a classic buy-the-rumor, take-profits-on-the-news type of price action -- and we expect the dollar to trade back up in the next 2 weeks. As for the overall rally, we have seen how sentiment can change dramatically in just 5 days with the market going from doubting a U.S. rate hike in March to pricing one in almost completely. According to Fed fund futures, the odds of a rate hike this month sits at 90%, up significantly from 40% the week prior. Sentiment could also swing the other way if next week’s nonfarm payrolls report is abysmal or between now and March 15, if stocks crash. Of course both of these scenarios are unlikely because while market expectations have changed recently, underlying fundamentals have not. The U.S. economy is improving, the labor market is strong and Federal Reserve officials have taken every opportunity to say that rate hikes are coming soon. That was the backdrop 2 weeks ago and remains so today. The difference is that the bulls are finally listening to the cohesiveness of Fed officials who have been saying all along (doves and hawks) that conditions are prime for tightening. The manufacturing and service sectors are humming along and if next week’s U.S. labor-market report is satisfactory, a quarter point hike this month is almost certain. Fed Chair Janet Yellen said on Friday that a March hike is appropriate if the economy evolves as expected. Vice Chair Fischer said almost no indicator has come in badly and if there’s a conscious effort on rate expectations, he said he will join it -- which basically means if everyone is in favor of a March hike, he’ll vote for it as well.
As a basket, the commodity currencies were hit the hardest by U.S. dollar strength. After consolidating throughout February, the Australian dollar could no longer hold onto its gains. The currency fell sharply against the greenback following disappointing trade numbers and extended its losses on the back of a weaker PMI services report. Service-sector activity contracted for the first time in 5 months, offsetting the strength seen in the manufacturing sector. The latest trade-balance report was a sharp reminder of the damage that a strong currency can do to an export-dependent economy. The trade surplus shrank to 1.3B, less than a third of forecasted levels as exports fell 3%. These misses are important going into next week’s Reserve Bank of Australia monetary policy announcement. The RBA is widely expected to leave interest rates unchanged but it may start to sound less optimistic. The last time it met, RBA maintained an upbeat tone that included a positive outlook on consumption, non-mining business investment and growth. Since then, we’ve seen business confidence and manufacturing activity improve with Q4 GDP growth surprising to the upside while labor-market activity and consumer inflation expectations weakened significantly. In other words, there are new factors for the RBA to be concerned about and its bias will determine whether 75 cents breaks or holds.
Meanwhile, the New Zealand dollar was the week’s worst-performing currency. Softer trade numbers contributed to the move but NZD was also hit hard by U.S. dollar strength. When 71 cents broke, the currency pair fell quickly and aggressively down to 70 cents. What was interesting about the move and NZD’s underperformance was the fact that Reserve Bank of New Zealand Governor Wheeler was slightly less dovish when he spoke this past week. Rather than express his usual caution, Wheeler said he sees risks around future rate moves as equally balanced. He is still worried about the strong currency and global economy, but the housing market is strong and it's too early to say whether the moderation in prices will continue. There are no major New Zealand economic reports scheduled next week, which means NZD should take its cue from the market’s appetite for U.S. and Australian dollars. The Canadian dollar was also hit hard and was the second-worse performer for the week versus the greenback. There was not even one day of retracement in USD/CAD, which raced form a low of 1.31 to a high of 1.3437. As expected, the Bank of Canada left interest rates unchanged and its cautious views kept the loonie under pressure throughout the NY trading session. The central bank felt that there was persistent slack and subdued wage growth with exports facing ongoing competitive challenges. Although inflation is on the rise, the BoC said it would look through the temporary effect of higher oil prices, which implies that it will maintain a dovish bias that leaves the door open to additional easing. These cautionary comments overshadowed the stronger-than-expected GDP report. Next week will be a busy one for Canada with the country’s trade balance, manufacturing PMI and employment reports scheduled for release.
The European Central Bank also has a monetary policy announcement on the docket and while no changes are expected, the central bank will share its latest economic outlook and Mario Draghi will hold a press conference. There have been widespread improvements in the Eurozone economy since ECB's last meeting in January. Inflation is up significantly, the unemployment rate is down, and manufacturing and services activity is up. German business and investor confidence is down but that is related to political uncertainty rather than economic performance. French politics have dominated the headlines with more candidates dropping out of the race. The market is relieved that Independent Centrist Macron is gaining traction over far-right leader Le Pen and if that continues, we could see relative strength in the euro. While the ECB’s monetary policy announcement is the most important event risk on next week’s Eurozone calendar, revisions to Q4 GDP, German industrial production, factory orders, trade and current account balance are also scheduled for release.
Sterling fell hard this week as data took a turn for the worse. After a month of very narrow trading ranges, sterling finally broke down on the heels of softer data. Aside from slower service-sector activity, manufacturing activity also eased in February and between the stronger U.S. dollar, Scotland pushing for another referendum vote and Brexit's Article 50 later this month, it was only a matter of time before the bottom underneath sterling fell out. Now that support has been broken, we anticipate further losses in GBP.