Will ECB Kill the EUR Rally?

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Daily FX Market Roundup 05-01-13

Will ECB Kill the EUR Rally?
Dollar Ticks Up as Fed Ignores Payroll Disappointment
GBP – Lifted by Stronger Data
AUD – Major Contraction in Manufacturing Sector
CAD – Gold and Oil Prices Plunge
NZD – Chinese Manufacturing Activity Slows
JPY – Extends Gains on Stronger Data

Will ECB Kill the EUR Rally?

The euro has performed extremely well leading up to Thursday’s European Central Bank monetary policy announcement. In fact, it may be hard for some investors to believe that the majority of economists are looking for the ECB to cut interest rates by 25bp. Traditionally, expectations for easier monetary policy is negative for a currency but in the case of the euro, since the central bank started dropping hints about the potential for lower rates and economic data confirmed the need for more stimulus, the euro appreciated in value, rising to its highest level against the U.S. dollar in 2 months today.

The European Central Bank has done a great job of setting expectations for this month’s monetary policy meeting. They are known for preparing the market for any upcoming changes in policy with the hopes of minimizing volatility when the actual change is made. Since the last meeting, we have heard consistently cautious comments from policymakers who all sound as if they are warming to idea of more stimulus if data warrants it and it certainly does given the widespread weakness in German business, consumer and investor confidence along with the decline in manufacturing and service activity.

Therefore a simple rate cut by the ECB may not be enough to kill the euro rally. The key is what else the central bank says they will do. If the ECB indicates that they are one and done, meaning that one rate cut is all they plan to give and nothing more, the euro could actually rally because the real impact on yields would be nominal as the eonia or (Euro OverNight Index Average) rate has already been trading near zero for the past 9 months. However if the ECB suggests that they are willing to do more like accept a negative deposit rate, ease collateral rules on loans or Quantitative Easing, the EUR/USD could fall quickly but we think this scenario is unlikely. While there’s no question that the central bank will have grown more nervous about the outlook for the Eurozone’s economy, we believe that the chance of the central bank going above and beyond is slim because ECB President Draghi will want to leave pressure on individual governments to address core fiscal issues.

Dollar Ticks Up as Fed Ignores Payroll Disappointment

The Federal Reserve did not make any changes to monetary policy today but their FOMC statement triggered erratic price in the forex market. The U.S. dollar initially rebounded on the release then pulled back before trading higher once again into the close of the North American session. While the greenback still ended the day lower against the G3 currencies (euro, British pound and Japanese Yen), the Fed’s lack of concern about the recent deterioration in the labor market suggests that they haven’t dropped the idea of tapering asset purchases. The statement alluded to the possibility of the central bank going either way – the Fed said, “they are prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes,” but their unchanged assessment of the labor market suggests that they are looking beyond the recent deterioration in data. The only negative comment made was to point out that, “fiscal policy is restraining growth.” Kansas City Fed President George dissented for the third meeting in a row, favoring tighter monetary policy. Overall, this statement was not nearly as dovish as investors had feared and they have responded by taking the dollar higher.

Nonetheless, U.S. economic reports continue to surprise to the downside. According to ADP, private payrolls dropped from 131K in March to 119K in April. The ISM manufacturing index also fell to its lowest level this year. At 50.7 and down from 51.3, manufacturing activity in the U.S. economy is barely expanding. While this pullback in activity is not a significant surprise because regional indices have also fallen, it confirms that pace of recovery in the U.S. economy is far from desirable. Conflicting signals in U.S. data will only widen the diverging views within the central bank, forcing the Fed to hold monetary policy steady until September and more likely December. The real test will be Friday’s non-farm payrolls report – if job growth does not double in April, it may be difficult for the Fed to ignore the deterioration in labor market conditions and investors to buy the Fed’s optimism. Weekly jobless claims, Challenger layoff report and trade balance are scheduled for release tomorrow.

GBP – Lifted by Stronger Data

The British pound traded higher against the U.S. dollar for the sixth consecutive trading day. Despite all of the concerns about the outlook for the U.K. economy, data continues to surprise to the upside, quieting the talk of more stimulus from the central bank. This week’s PMI reports are expected to provide the market with a better read on whether the growth enjoyed in the first quarter extended into the second quarter. Based on the rise in the PMI manufacturing index, there’s hope for the U.K. economy after all. The index rose from 48.6 to 49.8, which was just shy of the 50 boom / bust mark. While some economists have argued that the mere fact that the index is below 50 means that activity in the sector remains weak, it is hard to ignore the reality that the economy is doing better than most had feared. Sterling traders have responded well to the latest U.K. economic report and if the PMI construction and service sector index also improve, the GBP/USD could muster a break of the 1.56 level.

AUD – Major Contraction in Manufacturing Sector

The Australian and New Zealand dollars fell sharply against the greenback today in what appeared to be a delayed reaction to overnight economic reports. With parts of Asia and most of Europe closed for May Day, the AUD/USD fell sharply at the start of the North American session. Australian manufacturing activity contracted sharply in the month of April, with the PMI index dropping to its lowest level in 4 years. The 7.7point decline from 44.4 to 36.7 was the steepest drop in a few years and shows how much deterioration has occurred in Australia’s economy over the past few months. While investors were relieved to see manufacturing activity in China continue to expand, albeit at a slower pace, it is still bad news for trading partners like Australia that rely heavily on Chinese demand. What was interesting about the sell-off in AUD/USD and NZD/USD was that it occurred shortly after the U.S. ADP numbers were released. Unfortunately the simultaneous slowdown in Australia, China and the U.S. were too much for the currencies to handle particularly on a day when commodity prices have plunged. No economic data was released from Canada but the loonie was pressured by the nearly 3% decline in oil prices. Australian building approvals, import and export prices are scheduled for release tomorrow along with Canada’s trade balance report. We don’t expect any of these reports to be materially positive for the commodity currencies.

JPY – Extends Gains on Stronger Data

The Japanese Yen traded higher against most of the major currencies thanks in part to better than expected Japanese data. Labor cash earnings fell at a slower pace of -0.6% in the month of March, up from -0.8%. Vehicle sales which we don’t talk about often since it is not a big mover for the Yen also rose 2% in April. This is significant because it was the first positive year over year sale since August 2012. This uptick is consistent with the increase in industrial production in March. Overall it has been a quiet week in Japan with many companies closed for Golden Week holidays. As a result, we have not seen and don’t anticipate seeing any major moves in the Yen, especially since the weekly flow of funds data from the Ministry of Finance has also been taken off the calendar. The FOMC rate decision did not have a significant impact on USD/JPY but the currency pair remained under pressure as a result of the lower ADP and ISM reports.

Kathy Lien
Managing Director

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