New Eurozone data shows continued economic contraction, while the US recovery remains unbalanced. Meanwhile, changing central bank policies in the US, Japan, and the UK will weigh heavily on major currencies.
1) Euro Sinks to Fresh Lows
Between the weaker Eurozone PMI numbers and the Fed's discussions about tapering down asset purchases, the EURUSD was hit from both sides this week. The currency pair fell to a one-month low Thursday and appears poised for a move down to its 100-day simple moving average (SMA) at 1.3120.
Back in December and January, the primary catalysts for the EURUSD rally were the improvements in European data and the quiet consolidation of the European Central Bank (ECB) balance sheet through long-term refinancing operations (LTRO) repayments. Now, economic data has taken a turn for the worse and the central bank is thinking about slowing the growth of asset purchases and maybe even shrinking its balance sheet by the end of the year.
While we can chalk up the contraction in fourth quarter Eurozone GDP growth to stale data, the new PMI numbers provide the most current assessment of Eurozone growth. The deeper contraction in the region's manufacturing and service sector activity is worrisome, particularly since new orders declined.
German economic activity is still expanding, but the pace slowed in the month of February. If Friday's German IFO survey shows a similar decline in business confidence, the EURUSD will extend its losses. However, the IFO is not only risk for the euro: the European Commission will also be releasing its latest economic forecasts.
See related: The 2 Strongest Drivers of EUR/USD Prices
The European Commission's growth, unemployment, and deficit forecasts will be extremely important considerations for traders and investors alike. While it’s possible that the Commission will look beyond the contraction last year and focus on the signs of growth in the coming year, there could still be concerns about deficits and the currency, especially after the weak PMI numbers.
Aside from the potential changes to growth estimates, we will also be looking to see if budget deficit forecasts are increased. If Spain's budget deficit is expected to exceed 8%, it could also raise the risk of a downgrade for the Eurozone's fourth-largest economy. If the forecasts remain largely unchanged, however, it would lend support to the euro.
2) US Dollar Gets Boost from Key FOMC Member
A number of US economic reports were released Thursday, but the primary driver of dollar flows continues to be the prospect for changes to the Fed's QE program. The central bank is getting more serious about phasing out asset purchases, which led many traders to reverse their short dollar positions over the past 36 hours.
Moreover, St. Louis Fed President and FOMC voter James Bullard said he was willing to consider altering monthly QE buying by $10 billion to $15 billion, even though he believes that interest rates should not increase until June 2014.
This view contrasts sharply with those of San Francisco Fed President John Williams, who believes that bond buying needs to continue well beyond this year, although Williams is not a voting member of the FOMC in 2013 like Bullard.
Yet, while the greenback extended higher against the euro, it gave up some gains against the British pound (GBP) and Japanese yen (JPY). This lack of follow through in other pairs may reflect some skepticism about the timing of the Fed’s actions. According to the FOMC minutes, the central bank will re-evaluate its asset purchases next month, but may not choose to taper asset purchases until later in the year. The slow pace of recovery in the U.S. economy and lack of significant inflationary pressures gives the Fed the flexibility to keep monetary policy easy, if so desired.
See related: Fed Hints About End of Quantitative Easing
Thursday’s CPI report showed consumer prices stagnating in the month of January and growing a mere 0.3%, excluding food and energy, driving annualized CPI growth down to its lowest level in six months. Jobless claims rebounded to 362k from 341k, and while the data is still being distorted by estimates, it is nonetheless consistent with a slow recovery in the labor market.
Existing home sales rebounded slightly last month, while leading indicators to growth slowed and the Philly Fed survey plunged. This was in contrast to the manufacturing sector survey in the NY region, which rebounded sharply in the month of February, while manufacturing activity in Philadelphia contracted at its fastest pace since June 2012.
The lack of consistent improvements in the US economy is one of the main reasons why we are skeptical about how quickly the Fed will start to pare down asset purchases. The focus now becomes Fed Chairman Ben Bernanke's speech next week, as investors will be looking for the Fed leader to affirm the central bank's new bias.
3) British Pound Rebounds on Stronger Data
After dropping to a fresh two-year high against the US dollar, the British pound rebounded to end the day slightly higher against all major currencies except for the Japanese yen. The pound has been performing very poorly of late due to weak economic data, the dovishness of the Bank of England (BoE), and the ongoing struggles of Chancellor George Osborne to meet the deficit target.
UK public finances improved last month, with public sector net borrowing dropping by -9.9B and public finances at -35.6B. January is normally a net repayment month because it is when the bulk of self-assessment income tax payments are made. This month's reading was higher than normal thanks to a special payment from the BoE's Asset Purchase Facility.
The Confederation of British Industry (CBI) new orders report also showed improvement in the manufacturing sector. The CBI index rose from -20 to 14 in the month of February on the back of stronger export orders. Anna Leach, CBI's head of economic analysis, said, "The rebound in manufacturing orders and expectations for output growth provide some further signs of improvement in the outlook for the UK economy." UK ten-year government bonds dropped the most this year following speculation that the BoE will increase its asset-purchase program, but today, ten-year gilt yields fell by 0.09%, to 2.11%.
4) Loonie Hit by Falling Oil; All Eyes on Retail Sector
The Canadian (CAD), Australian (AUD), and New Zealand dollars (NZD) extended their losses against the greenback, with AUD hitting four-month lows. No economic data was released from the three commodity-producing countries, but the more than 2.25% drop in oil prices hit the Canadian dollar hard. The correlation between the CAD and crude prices may have weakened in recent months, but Western Canada Select oil prices have also fallen, providing justification for the slide in the loonie.
Canadian consumer prices and retail sales are due for release on Friday, and there's scope for losses in the CAD if the data surprises to the downside. Based on the decline in wholesale sales, the odds favor weaker consumer consumption. CPI, on the other hand, is expected to rebound after dropping 0.6% the previous month.
The Bank of Canada (BoC) recently toned down its degree of hawkishness and we doubt they would have done so if data improved.
Meanwhile, Reserve Bank of Australia (RBA) Governor Glenn Stevens will also be delivering his semi-annual testimony on the economy, during which he could talk about whether the current level of monetary policy is appropriate. If he hints that a rate cut is possible, we expect further losses in the AUDUSD. If, however, he downplays the need for more easing, AUDUSD could rebound back up to 1.03.
With no data or speeches on the calendar for New Zealand, there's scope for a recovery in the NZD.
5) Prime Minister Abe to Name New Bank of Japan Governor Next Week
So, it’s official: Japanese Prime Minister Shinzo Abe won't be announcing his nominee for Bank of Japan (BoJ) Governor until he returns from his four-day trip to the US this weekend. Abe left on Thursday and will likely be back in Japan by Monday. This may only be a few days away, but the prospect of no nomination this week has led to profit taking on short yen positions.
According to Prime Minister Abe, who spoke about the nomination prior to leaving on his trip, "Experience at the Ministry of Finance will not hurt any of the candidates." This comment may be directed at Haruhiko Kuroda and Toshiro Muto, who were former members of the Finance Ministry. According to Yomiuri, a Japanese paper, Muto may be out of the race because he was rejected as a candidate in 2008. Four years ago, the opposition party was uncomfortable with the Ministry of Finance's affiliation with the government and feared that it would undermine the BoJ's credibility. Clearly, regardless of which candidate is chosen, they will be in the back pocket of the government.
Abe also said that foreign bond purchases weren't necessary, which would help Japan abide by its pledge to avoid competitive devaluation of exchange rates at this month's G20 meeting. BoJ candidate Kazumasa Iwata reiterated his commitment to easing monetary policy if selected as a BoJ Governor. He said the central bank has not eased enough in 2013 and should buy more long-term bonds. He also supported changing the law to make the central bank formally liable for reaching the inflation target. No Japanese economic reports are scheduled for release in the meantime.
By Kathy Lien of BK Asset Management