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A Trusted Trade That Didn’t Work

A Trusted Trade That Didn’t Work

Kathy Lien and Boris Schlossberg,

The underperformance of the US dollar versus major currencies defies convention, as neither safe-haven demand nor renewed risk appetite produced gains in the currency.

The US dollar (USD) traded lower against all major currencies on Thursday, and its persistent underperformance during the North American trading session was interesting since stocks recovered and 10-year bond yields rose back above 2% after dropping below 1.97%.

The dollar barely budged, however, and most of its recovery against the Japanese yen (JPY) happened during the European session. The dollar did not benefit from safe-haven demand or the recovery in risk appetite, causing investors to wonder what's going on.

Afterall, the dollar generally performs well during periods of risk aversion, but investors had been gradually increasing their exposure to dollars since the beginning of the month, and when they de-levered, they sold the greenback this time instead.

The dollar weakness also had nothing to do with fundamentals, as US economic data including jobless claims, house prices, and new home sales all surprised to the upside. Overall, these reports should help support US yields and the greenback, and while we haven't seen the financial markets react, the implications for Fed policy are clear: good data will make the central bank more confident in dialing back asset purchases later this year.

New Data Drives EUR/USD Close to 1.30

A better-than-expected German IFO reading boosted investor confidence in Europe and helped to propel the EURUSD towards 1.3000 in Friday morning European trade. The IFO printed at 105.7 versus 104.5 expected, while the current assessment component also rose more than expected, to 110 from 107.2 forecast.

The latest IFO results led Klaus Wohrable, the deputy department head, to suggest that Q2 German GDP will be considerably better than the Q1 reading. Wohrable noted that construction activity picked up immensely in May, as pent-up demand came on line. He also stated that export orders continue to do well and that the latest rate cut by the European Central Bank (ECB) has had a positive psychological impact on the German business sector.

The improvement in German sentiment is not restricted to the business sector, either. Earlier in the session, the German GFK consumer sentiment survey registered its best reading in five years, printing at 6.5 versus 6.2 expected. Taken together, the two surveys suggest that conditions in Europe's largest and most important economy are clearly improving, and that bodes well for the rest of the Eurozone and could help pull the region out of recession as the year progresses.

The EURUSD pushed its way to 1.2990 in the aftermath of the news, but the rally stalled just ahead of the key 1.3000 mark. The 1.3000 level is a very stiff point of resistance for the euro, as it represents strong former support from which the unit tumbled over the past several weeks. Whether the pair can clear that hurdle will likely depend on Friday’s North American session, during which investors will have to reassess Eurozone growth prospects given the latest German IFO data.

New Facts of Life for Japan, USD/JPY?

In Japan, the placid Friday closing numbers from the Nikkei belied the massive volatility in stocks overnight. The index was up nearly 2% and then down 3% before finally closing a little more than 1% higher on the day. This strong turbulence may be the new fact of life in the Japanese financial markets as the massive Bank of Japan (BoJ) easing program is clearly triggering wild moves in the nation’s financial markets.

Japanese officials are trying to pacify the markets and make sure that Japanese government bond (JGB) yields do not gyrate wildly, but so far, policymakers have only used jawboning to stem the panic. Prime Minister Shinzo Abe noted that the BoJ is not buying government debt directly, while BoJ Governor HaruhikoKuroda emphasized that the central bank's primary focus is on deflation, not stock market valuations.

Still, if the volatility does not dampen soon, Japanese policymakers may need to take firmer steps to pacify the markets, and some analysts have even suggested that the BoJ may need to implement its own version of a longer-term refinancing operation (LTRO) in order to stabilize the sovereign debt instruments.

For now, USDJPY continues to mirror the volatility in other markets with the pair rising to a high of 102.89 only to tumble back to 101.08 in overnight trade. It appears that the 103.75 level will remain a near-term top while the pair consolidates its latest rally, but a further fall to 100.80 could trigger a deeper correction that could test the key 100.00-level support.

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British Pound (GBP) at the Mercy of the Market

The British pound (GBP) traded higher against the US dollar on Thursday while continuing its slide against the euro. The second release of first-quarter GDP numbers confirmed that the UK economy expanded 0.3% in the first three months of the year. Private consumption and government spending were slightly weaker, but imports and exports were revised higher, and there was not much in the way of new information in this latest GDP release.

After the surprisingly large decline in consumer spending data this week, we are looking at the possibility of even weaker UK economic growth in the second quarter, and this may explain why policymakers remained dovish despite upticks in the latest PMI numbers. With no major UK data on the economic calendar for Friday, we expect sterling to remain weak and sensitive to the market's overall risk appetite.

Commodity Dollars Rally from Lows

After falling to fresh multi-month lows against the US dollar, the Australian (AUD), New Zealand (NZD), and Canadian (CAD) dollars all ended Thursday sharply higher. Their respective recoveries have been impressive, but the AUD, NZD, and CAD need to see more gains before key resistance levels are broken.

Disappointing Chinese manufacturing PMI numbers caused the initial slide in the currencies. According to HSBC, manufacturing conditions China returned to contractionary conditions, ending a six-month stretch of expansion. Economists were not looking for a slowdown, so when the index showed a contraction, the AUD and other commodity currencies traded sharply lower but recovered during Thursday’s European and North American trading sessions, likely supported by the rebound in US stocks.

New Zealand trade numbers were scheduled for release Thursday evening, and given the rise in business and service PMI, we believe there is scope for an upside surprise that could fuel further gains in the NZDUSD. No economic reports are expected from Australia or Canada.

By Kathy Lien and Boris Schlossberg of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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