USD, GBP and Power of Short Covering

Daily FX Market Roundup 05.25.16

One of the best performing currencies this month, this week and even today is sterling. The British pound climbed to its strongest level against the U.S. dollar in 3 weeks and its highest level versus the euro, Australian and New Zealand dollars in 3 months. There was no economic reports or central bank speak to take credit for the move higher which means there’s only one explanation for the persistent strength of the currency – short covering. U.K. data hasn’t been great but traders have been net short sterling since November and their positions haven’t changed much despite the bottom set in late February / early March. In fact the total amount of short positions reported by the CFTC are roughly the same now compared to 3 months ago. But what changed is that investors are worried about the upside and the possibility (or reality in our opinion) of U.K. voters regaining their senses and choosing to remain within the European Union. Everyone from the politicians at home to the ones abroad (like US President Obama and ECB members) talked about the dire consequences of Brexit and it appears that not all of these warnings have fallen on deaf ears. More importantly with the market leaving so heavily towards a weaker pound, the growing possibility of U.K. avoiding disaster has been enough for GBP/USD bears and EUR/GBP bulls to reduce their positions. It is rare to see EUR/GBP experience such strong moves without major shifts in positioning.

The discussion of short covering is important because that’s one of the greatest risks that USD/JPY faces right now. Even after the recent rally, speculative long yen positions are near record highs. We saw a little bit of short covering above 109.50 but very little above 110 and this leads us to believe that the stops are either sitting at 110.75 or 112. Either way, speculators are extremely short USD/JPY and as the currency continues to rise, the motivation to cover grows. At some point we’ll see a sharp squeeze higher that could rival the rally on April 22, when USD/JPY jumped 250 pips in 1 day and the move could have the same type of continuation as what we’ve seen in GBP/USD. However the dollar did not extend its rise today because the latest string of U.S. economic reports were mixed. The trade balance narrowed but service sector activity slowed, causing the Markit PMI Composite index to fall to a 3 month low.

EUR/USD bounced today and while it would be easy to attribute the rally to the stronger IFO report, the rebound did not happen until well after the NY open. Nonetheless German businesses were more confident about the current and future outlook for the Eurozone’s largest economy. Consumer confidence also increased according to separate survey from GfK. The bottom line is that Germany is doing well even as the rest of the region is struggling along – the only question is whether that will be enough for the ECB who meets next week. Ultimately we are still looking for the U.S. dollar to rise and as long as EUR/USD remains below 1.1250, the risk of a stronger recovery is limited.

The Canadian dollar soared after the Bank of Canada’s monetary policy announcement. Interest rates were left unchanged which was widely anticipated and while the central bank admitted that wildfires in Alberta shaves 1.25% off Q2 GDP growth, they expect growth to rebound in the third quarter. In our opinion, the BoC statement was slightly more dovish. Aside from the comment about GDP, the central bank also noted that business investment and intentions remain disappointing. However some investors thought the BoC would downgrade their growth outlook more significantly and when they didn’t the Canadian dollar soared. Yet it was the large drop in inventories that sent oil prices towards $50 a barrel and USD/CAD to the day’s lows. The 1.3000 support level looks shaky and if it is broken, USD/CAD could drop as far as the 50-day SMA near 1.2920.

The Australian and New Zealand also traded higher and thanks to healthier trade numbers, NZD outperformed AUD. As we expected, the pickup in the manufacturing PMI index and rise in diary prices accurately foreshadowed the improvement in trade activity. Exports increased while imports held steady, lifting the trade surplus to 291M from 188M. Economists had anticipated a decline to 25M. Australia reported a small increase in skilled vacancies but the second tier report had very little impact on the currency. Instead it was the improvement in risk appetite that led to gains for AUD/USD.

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