By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
There’s nothing more important to currency, equity and commodity investors right now than the outlook for oil. At the start of Thursday's North American trading session, Russia dangled the prospect of a production cut when it said Saudi Arabia proposed that each country cut production by 5%. The Energy Minister even told reporters that there were plans for a meeting between OPEC and non-OPEC countries. Shortly thereafter a senior Gulf OPEC delegate was quoted as saying that “the door is always open” for a deal. The headlines sent oil sharply higher with WTI Crude coming within 20 cents of $35 a barrel. Currencies and equities rallied in response, with USD/CAD falling below 1.40. However later in the day, OPEC delegates denied any plans for a meeting with Russia and said Saudi Arabia did not propose a 5% production cut. Oil prices erased their earlier gain and the Dow turned lower after trading up 175 points intraday.
Yet neither oil nor U.S. equities ended the day in negative territory because these conflicting headlines tell us one thing -- that many oil producers are uncomfortable with crude at $30 a barrel. Most currencies also held onto their gains because this nervousness confirms the view that oil bottomed on January 20 -- at $27.56 a barrel. While it remains to be seen whether OPEC nations will agree to production cuts, investors should anticipate more moaning and groaning if oil makes another move down to $30 a barrel. USD/CAD is the most sensitive to oil's wild swings, but every major currency is affected with oil rallies driving risk appetite higher and oil declines causing risk aversion.
Speaking of risk appetite, Thursday night's Bank of Japan’s monetary policy decision should help set the tone. If the BoJ eases, not only will USD/JPY rocket higher, but global equities will also rise in approval. However BoJ easing could actually drive other major currencies lower. On October 31, 2014, the BoJ surprised the market by increasing stimulus and as USD/JPY jumped more than 300 pips in response. One month later it was trading nearly 1000 pips higher than its pre-expansion levels. On that same day, EUR/USD dropped 100 pips, GBP/USD and NZD/USD fell 60 while AUD/USD shed 50. So even though BoJ easing is positive for risk appetite, it may not be positive for risk currencies -- outside of USD/JPY. If the BoJ leaves monetary policy unchanged, how the yen behaves will be determined by whether they signal plans to ease later or attempt to further jawbone on the Yen.
Ahead of it's decision, There were many reasons for the Bank of Japan to increase stimulus, even though it resisted doing so last year. Since the December meeting, we have seen the yen strengthen, inflation ease, retail sales fall, joblessness rise, industrial production decline and exports fall by the largest amount in 3 years. So while the trade deficit turned to surplus in December, manufacturing activity increased according to PMI and consumers grew more optimistic according to the Eco Watchers survey. However with the decline in commodity prices, China slowing and the see-saw moves in stocks that saw the Nikkei fall 10%, Japanese policymakers have a lot more to be worried about now than in December. Also, according to the CFTC’s latest report, last week saw the biggest yen buying spree by speculators since February 2012. The Bank of Japan is notorious for its attempts to “get the best bang for its yen” by intervening or, in this case, easing when speculators are long. With all of this in mind, most economists were not looking for the BoJ to ease because the Nikkei and oil are off their lows and the potential for a bottom could encourage policymakers to wait.
The U.S. dollar traded lower against all of the major currencies Thursday with the exception of the Japanese yen. Thursday’s economic reports had very little impact on the dollar with jobless claims declining, pending home sales growth rising far less than anticipated and durable goods orders falling sharply. The next 24 hours will be interesting with the Bank of Japan monetary policy announcement and fourth quarter U.S. GDP numbers scheduled for release. We all know that U.S. growth slowed at the end of the year, so much so that it was acknowledged in the FOMC statement. If the BoJ eases and GDP surprises to the downside, the largest impact of GDP will be on the other major currency pairs and not USD/JPY.
Sterling traded sharply higher against all of the major currencies Thursday on the back of the fourth quarter GDP report. The U.K. economy expanded by 0.5% in the last 3 months of the year up from 0.4%. On an annualized basis, the numbers look less rosy with U.K. GDP growth slowing to 1.9% from 2.1%. But given the recent trend of data, investors were bracing for an even weaker report. Thursday’s rally in the British pound amounts to nothing more than a short squeeze because at the end of the day, the U.K. economy is underperforming and the Bank of England is in no position to raise interest rates.
The euro also appreciated against the greenback despite softer confidence numbers and a sharp decline in consumer prices in Germany. The fact that EUR/USD is rising in the face of softer data indicates that like sterling, its move is also driven by short covering.