The two primary themes in the foreign exchange market today was sterling
weakness and U.S. dollar strength. In many ways, these two trends came
hand in hand as sterling’s losses were compounded by the rise in the
dollar while the dollar’s attractiveness was driven by problems in
Europe. Investors sought safety in the greenback but
improvements in U.S. data along with the prospect of a strong non-farm
payrolls report on Friday made the dollar shine brighter than any other
currency. The uptrend in the dollar is strong and corrections could be
shallow ahead of NFPs. No major U.S. economic reports were released on
Tuesday but comments from Fed President Mester certainly contributed to
the gains. If you recall, Mester was one of three Fed FOMC voters to
dissent from last month’s meeting and vote in favor of an immediate rate
hike. She believes that rates should rise in November, which may be
consistent with her hawkish bias but a move next month is unrealistic
especially with the U.S. Presidential election happening and Brexit back
in the headlines.
Sterling fell to 31 year lows versus the U.S. dollar today and 5 lows versus the euro.
The currency had been under pressure for the past few weeks but now
that key support levels have been broken, many are wondering if the
British pound will hit parity versus the U.S. dollar and/or euro. To
clear, in the past 45 years, sterling has NEVER traded at parity with
the euro or dollar – not after the ERM crisis in Britain when the Soros
broke the Bank of England and certainly not after the euro was launched
and it sank to a record low of 0.8440. The lowest that sterling has
fallen in the past 45 years versus dollar is 1.0520 and that was in
February 1985. The weakest it has ever traded versus the euro as 0.9805
in December 2007. For GBP/USD to hit parity it would need to fall
another 20% and for EUR/GBP to reach this same value, it would need to
rise 14%. Given how fast sterling has fallen in the past month, it does
not seem implausible but for that to happen, the process of Brexit
would need to decimate the U.K. economy.
While we believe that the U.K. economy will suffer from Brexit, we do not believe that it will destroy it.
First, recent U.K. data has been quite good with manufacturing and
construction sector activity improving significantly. U.K. PMI services
are scheduled for release tomorrow and between these upside surprises
and stronger consumer confidence, we believe this report will be firm as
well. Of course, investors are completely discounting all of these
reports as temporary blips because they remember how much these indices
fell after Britain voted to leave the European Union. But its important
to realize that the U.K. economy is growing right now and the
government’s top priority will be to protect that growth over the next
few months. Second, the 16% decline in GBP/USD over the past 3.5 months
is extremely positive for the economy. It will boost trade activity,
encourage tourism, support stocks and encourage cross border
acquisitions. Third, investors aren’t going to pull all of their money
out of U.K. assets – London is still a hot spot for investments by
foreigners and rest assured the May government will be incentivizing
businesses to keep operations in the U.K. starting with a lower
corporate tax that will be nearly 40% less than Germany.
So while we expect GBP/USD to reach 1.25 easily, a move down to parity may be a bit too ambitious for sterling bears.
Technically, the currency pair is deeply oversold with support coming
in at 1.25. For GBP/USD, the 2012 high of 0.8815 could provide some
resistance but the next major level is 90 cents.
The U.S. dollar should continue to outperform but after 6 straight days
of gains, traders should beware of a correction in USD/JPY ahead of
Friday’s non-farm payrolls report. Today’s rally took the
currency pair to 103 and a move down to 102.50 would give everyone a
great opportunity to reload their long positions. There are a number of
reasons to believe that this month’s jobs report will be strong
including the drop in weekly jobless claims, rise in consumer
confidence, uptick in withholding taxes and improvement in weather which
kept 50K people out of work in August. Non-farm payrolls will be in
focus tomorrow with ADP employment change and non-manufacturing ISM
reports scheduled for release. If these reports confirm the improvement
in labor market conditions, we could see USD/JPY take out today’s high
of 103, opening the door to a move to 105.
ECB headlines sent EUR/USD on a rollercoaster ride today. In the early North American trading session, broad based dollar strength drove the single currency sharply lower with the pair breaching its critical 1.1150 support level. At one point it looked like 1.11 would be tested as well but a report that said the ECB it is near consensus on the need to taper Quantitative Easing before it concludes sent the currency pair sharply higher, erasing all of its earlier losses in the process. Tapering before ending QE is not unusual process but investors were clearly surprised by a headline that focused on tightening and not easing. ECB President Draghi was quick to deny the statement, saying tapering was not discussed but the mere possibility that the central bank may be done easing was enough to limit losses in EUR/USD. We think the market over reacted to the headlines and we are still looking for further weakness in EUR/USD on the back of Deutsche Bank’s ongoing troubles, Brexit and the prospect of a strong U.S. jobs report.
The Australian, New Zealand and Canadian Dollars all ended lower against the greenback today. Last night the Reserve Bank of Australia left interest rates unchanged at 1.50%. AUD/USD shrugged off the announcement, as the decision was fully anticipated. The RBA’s view was mostly in line with new central bank Governor Phillip Lowe’s previous comments. He reiterated that the labor market data was mixed, saying that although the unemployment rate declined and indicators point to a growing labor market, the issue lies with growth being seen in part time jobs, with full time job growth being somewhat subdued. The RBA also expressed concern about low inflation and China. Lowe acknowledges that policymakers in China have been supportive to the global economy as a whole but the pace of growth in China was moderating which could spell issues further down the line. Meanwhile the New Zealand Dollar gave up all of its early gains after dairy prices dropped -3.0%, the first decline at an auction since August. The Canadian Dollar took a hit on news that Iran and Libya is increasing production, counteracting last week’s OPEC deal. The stronger U.S. dollar also drove oil prices lower. Australia reports PMI services and retail sales tonight and Canada reports International Merchandise Trade data tomorrow.