USD Down As Economy Improves

USD Down As Economy Improves

Kathy Lien  | Feb 18, 2016 08:17

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

While Wednesday's big story was oil, the main focus was the FOMC minutes, which failed to excite. According to the details from last month’s meeting, U.S. policymakers saw increased downside risks and a more uncertain outlook for inflation. Their concerns stemmed from tighter financial conditions and the possible drag on the U.S. from China. While they foresee a solid labor market in 2016, they also saw moderation. Their view that tighter financial conditions may be “roughly equivalent to firmer monetary policy” confirms our view that the Fed is unlikely to raise interest rates next month. However the muted reaction in the dollar shows that none of this was a surprise. There’s a tug of war happening in USD/JPY right now with slower Fed tightening dragging the currency lower and risk appetite pushing it higher. However given the troubles in China and our outlook for the dollar, we still believe that the path of least resistance for USD/JPY is lower.

Wednesday morning’s U.S. economic reports were mixed with housing starts falling and producer prices rising. The increase in PPI caught the market by surprise because of lower commodity prices but the 0.1% headline increase and 0.4% rise in PPI ex food and energy cannot be ignored. The same can be said about industrial production, which rose at its fastest pace since July 2010 with capacity utilization ticking higher. These improvements should remind everyone that while the U.S. recovery is slowing, the economy is still improving. The Philadelphia Fed survey and jobless claims are scheduled for release on Thursday.

The euro sold off against the U.S. dollar for the fourth consecutive trading day. No major economic reports were released but ECB member Nowotny’s comments are worth noting. He expressed concern about the market’s expectations for March tightening, calling it as unrealistic as December when investors expected a lot more from the central bank. While EUR/USD traders ignored his words, we can’t help but wonder if the decision to increase stimulus will be a close one. We may get some clues from Thursday’s ECB meeting minutes but for EUR/USD traders, this means that if you want to sell the currency pair like we do, it would be best to wait for an ideal price above 1.12 or on a break below 1.10.

Sterling also traded lower despite what we view as relatively decent U.K. labor data. While everyone honed in on the slowdown in wage growth and lack of improvement in the ILO unemployment rate, over 14k people fell off unemployment rolls driving the claimant count rate down to 2.2% from 2.3% in January. The official ILO unemployment rate did not tick lower but remained at a decade low and earnings excluding bonuses increased, which is a sign of recovery in the labor market. The Bank of England won’t find any reason to raise interest rates from Wednesday’s reports, but between Tuesday’s uptick in consumer prices and the inkling of a recovery in earnings, the oversold sterling is due for a bounce.

By now it should be no surprise that aside from the Fed, the focus has been on oil. Crude prices jumped 7% Wednesday after Iran said it would support OPEC’s production freeze. While there has been some confusion as to whether “support” equals action, oil traders are simply relieved that the world’s fourth-largest holder of oil reserves is willing to cooperate. Yet after 3 years of Western sanctions, Iran is finally able to bring production up to competitive levels and it is on a campaign to increase output by at least a third this year. So it remains to be seen how willing it really is to limit output levels. With OPEC not scheduled to meet again until the summer, these positive headlines should fuel a stronger recovery in oil. The Canadian dollar has already responded well with other commodity currencies participating in the rally. Now that USD/CAD closed far below 1.3800, the next stop should be the 100-day SMA at 1.3600.

The Australian dollar was in play ahead of Wednesday night's labor data. Thanks to the rise in commodity prices and improvement in risk appetite, AUD was the day’s second-best performing currency behind the CAD. However the employment report could erase the gains in the currency. While the retail sector helped offset the losses in mining, Australian mining companies are now on the verge of bankruptcy and we could see thousands of layoffs over the next several months. According to the PMIs, weaker employment conditions were seen in the manufacturing and service sectors in January. Which signals that there was very little recovery in the labor market after net job losses in December. Given the importance of job growth, a soft report could trigger a meaningful correction in AUD.

We continue to be astounded by the resilience of the New Zealand dollar. NZD rose approximately 1% Wednesday despite Tuesday’s decline in dairy prices and weaker economic data. There’s no doubt that the currency is taking its cue from risk appetite, but should sentiment turn negative, it will be one of the hardest-hit currencies. Consumer confidence and inflation data were scheduled for release Wednesday evening -- we were looking for softer numbers but the impact on NZD should be limited.

Kathy Lien

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