Don’t Expect FX Volatility to Subside Next Week

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Don’t Expect FX Volatility to Subside Next Week
GBP: Hit By Dovish Comments from BoE Carney
EUR: Supported by Optimism from ECB Draghi
USD/CAD Retraces, Ignoring Drop in CPI
AUD: RBA Policymaker wants A$ at 80 Cents
NZD: Gold and Oil Unchanged
JPY: Hit Hard by Risk Aversion

Don’t Expect FX Volatility to Subside Next Week

At the beginning of the week, we warned our readers not to become complacent because of the lack of U.S. economic data. The abundance of key economic reports from other parts of the world along with the earnings season meant there could still be big moves in currencies. While data from China, Canada, Europe and Australia played a role in this week’s breakout in FX, today’s volatility was triggered by something we did not expect to occur this week – which was the massive liquidation out of emerging market assets. If investors continue to dump emerging market currencies in the coming week, the majors could be vulnerable to steeper losses. In addition to the moves in emerging markets, there’s also a heavy economic calendar to keep forex traders busy. The most important event risk of the week is the Federal Reserve’s monetary policy announcement. Ben Bernanke will have to decide at the final FOMC meeting of his career whether or not asset purchases should be cut by another $10 billion. He expected to do so back in December but that was before the shockingly weak non-farm payrolls report and mixed consumer spending numbers. We will spend a lot more time talking about what to expect from the FOMC next week but right now what is important for forex traders to realize is that the Fed policy uncertainty means continued volatility for currencies. With a RBNZ meeting on the calendar along with fourth quarter GDP numbers from U.S. and U.K., the IFO report, unemployment numbers and retail sales figures expected from Germany, it should be an active and exciting week in currencies. This means that we will be watching the key levels in EUR/USD, GBP/USD, USD/JPY and NZD/USD closely for breakouts.

We’ve got a major crisis of confidence in emerging market currencies and when that happens, the liquidation can last longer than most expect. There’s a reasonable possibility for another 5% move lower in EM currencies before everything stabilizes. In our 2014 outlook, we talked about how this will be the year of DM (developed markets) versus EM because slower growth in China will encourage investors to move money out of emerging market assets, particularly money that is parked in countries heavily reliant on Chinese growth like Brazil and South Africa who supply raw materials to China. Countries with massive current account deficits like Turkey are particularly vulnerable. With Chinese growth expected to slow for the next 5 years, emerging market currencies could underperform for some time to come. For the major currencies, an additional sell-off in global markets would lead to more risk aversion, which means a deeper sell-off in pairs such as USD/JPY, AUD/USD and GBP/USD ahead of next Wednesday’s FOMC rate decision. If the U.S. central bank decides to provide a bit more support to the U.S. and the global economy by keeping asset purchases unchanged this month, we could see a relief rally in EM and DM currencies but the chance is slim.

GBP: Hit By Dovish Comments from BoE Carney

The British pound traded sharply lower against the U.S. dollar on the back of comments from Bank of England Governor Carney. With the unemployment rate dropping to 7.1% in the month of December, Carney said they will consider a “range of options” for their forward guidance. He admitted that the 7% unemployment threshold will be hit earlier than the central bank anticipated but he reminded investors that it is a threshold and not a target. While there is evidence of a pickup in the global economy, Carney warned that the risks remain. For the U.K. he wants to see a sustained recovery in productivity, before considering a rate hike. The recent gains in sterling are a problem because it poses a risk to the export sector and growth. These are hardly the words of a central banker who has grown less dovish. In fact, it sounds like the 2.5 year high in the GBP/USD has made Carney slightly more concerned. Come February he faces the difficult decision of advancing the timing for a rate hike or lowering the unemployment rate threshold. Back in November, they said the unemployment threshold would be reached in the third quarter of 2015 but it now looks like it could be hit as early as next month. The market had been pricing in a rate hike in late 2015 but there are some economists are now calling for tightening in the first quarter of next year. So while Carney would like to see a weaker currency, he can’t ignore the general improvements in the U.K. economy. Next week’s fourth quarter U.K. GDP numbers are expected to show a significant acceleration in annualized GDP growth and for all of these reasons, we do not expect the sell-off in sterling to last for long.

EUR: Supported by Optimism from ECB Draghi

Of all the high beta currencies, the euro was one of the most resilient. Its value against the U.S. dollar was virtually unchanged and it rose strongly against the British pound and Australian dollar. The currency was supported by slightly more optimistic comments from ECB President Draghi and of course, yesterday’s better than expected flash PMI numbers. Speaking in Davos today, Mario Draghi said the risks have decreased all across the board since mid 2012 and we are finally beginning to see a recovery in the Eurozone. “Survey data has been more and more solid” showing evidence that “loose ECB policy is finally being passed on to the economy.” While he also said “the overall risks remains to the downside and recovery is still weak, fragile and uneven,” this is the first time in a while that we have heard optimistic comments from the central banker. On a day with more bad news than good, investors are latching onto Draghi’s comments. The sell-off in U.S. 10 year bond yields also drove investors out of dollars and the recent positive surprises in Europe has made EUR/USD more attractive. However that could all change next week if the Federal Reserve presses forward with tapering. For the time being, the levels to watch in EUR/USD continue to be 1.35 and 1.37 – today’s failed break of 1.37 makes this level of resistance even more important.

USD/CAD Retraces, Ignoring Drop in CPI

For the first time in 4 trading days, the Canadian dollar ignored the drop in consumer prices and overall risk aversion to strengthen against the U.S. dollar. This confirms that profit taking and liquidation is the main driver of flows in the foreign exchange markets today. Consumer prices dropped 0.2% in the month of December with core prices falling 0.4%. While all of this was in line with expectations, the annualized increase in CPI was only 1.2% compared to a forecast of 1.3%. The decline in inflation is consistent with the central bank’s concerns about price pressure but with speculators holding extreme amounts of short CAD positions, profit taking overshadowed data allowing the CAD to be one the day’s best performing currencies versus the dollar. Meanwhile the Australian dollar dropped to a fresh 3 year low against the greenback after Reserve Bank of Australia Board Member Heather Ridout said “AUD/USD around 0.80 would be a fair deal for everybody.” It is clear that even after the 4.5% slide since December 1st, the central bank wants to see a weaker currency. Ridout’s comment is even more dovish than RBA Governor Glenn Stevens who said last month that he preferred to see the currency near 85 cents. Either way, both policymakers seem to support another 2 to 3 cent move lower in AUD and that is where we expect the currency pair to go.

JPY: Hit Hard by Risk Aversion

Hands down, the best performing currency pair today was the Japanese Yen but unfortunately its outperformance meant severe underperformance for all the yen pairs. AUD/JPY and GBP/JPY were the biggest movers, losing another 1.7% in value. NZD/JPY was not far behind, falling by 1.6% while USD/JPY dropped 0.9%. The sell-off in the Nikkei and drop in U.S. yields contributed to the move but the story today is risk aversion. As our colleague Boris Schlossberg noted, “The unease over the risk in EM has spilled over into the majors with yen strengthening markedly as Nikkei futures plunged by -230 ticks while European stocks led by near 2% decline in the IBEX also fell sharply. Over the past 24 hours USD/JPY has now broken below the 104.00 and the 103.00 figures with 102.50 support barely holding (it has now been broken). The pair has seen a lot of technical damage this week as sentiment clearly shifted. The lackluster US economic data, the decline in US yields and now the new fears over EM stability have contributed to the downfall in the pair and the decline is unlikely to stop unless US data begins to improve reviving expectations of stable global growth this year.” Next week is a busy one for Japan with a number of key economic reports scheduled for release including the trade balance, retail sales, inflation and the jobless rate. According to latest CFTC data, traders have trimmed their bets on higher USD/JPY.

Kathy Lien
Managing Director

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