How Far Can EUR And GBP Rise?

How Far Can EUR And GBP Rise?

Kathy Lien  | Jan 12, 2018 15:18

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

We’re only a few days into the New Year and central banks made it clear that easy money will start to disappear in 2018. The U.S. dollar fell sharply this past week on the back of comments from the European Central Bank, Bank of Japan and China. Not all of these developments turned into policy action but they all hint of changes to come. As many of these announcements caught FX traders by surprise, they translated into big moves for currencies. U.S. dollar weakness was the primary theme with EUR/USD hitting a 3-year high, GBP/USD at a 1.5-year high, NZD/USD reaching 3-month highs and AUD/USD at a 2-month high. The Canadian dollar was the only currency that failed to benefit from the greenback’s weakness due to NAFTA worries. Until they are retracted, FX traders should take this new guidance from policymakers seriously because EUR/USD could extend its gains and USD/JPY’s losses could compound as the next key level for both pairs are approximately 150 pips away.

The latest sell-off in the greenback is not a new one. In fact, we closed out the fourth straight week of weakness for the Dollar Index. The move had nothing to do with Fed speak or U.S. data.
There were no market moving comments from U.S. policymakers and Friday’s stronger than expected inflation and consumer spending reports failed to have a lasting impact on the dollar. Consumer price growth slowed to 0.1% but excluding food and energy costs, price pressures accelerated. Retail sales growth also slowed to 0.4% from 0.9% in December but excluding autos, demand was greater than expected and core spending in November was revised sharply higher. While USD/JPY received a mild boost from the report, the dollar resumed its slide against other major currencies after giving up their initial gains because at the end of the day, these firmer releases will have zero impact on the Federal Reserve’s decision later this month. The January Fed meeting will be Janet Yellen’s last so we expect no material changes to the FOMC statement. Instead, worries about Chinese diversification and Bank of Japan taper will dictate dollar trade. Bonds are being sold, everyone is talking about the bear market and China’s threat to reduce or halt their purchases of Treasuries only compounds the pain. Therefore until there’s a legitimate reason for dollar bulls to return, the greenback will remain under pressure. Monday is a holiday in the U.S. and there are no major economic reports on the calendar next week outside of the Beige Book, which will most likely say that the economy is improving. We see USD/JPY breaking below 111 and extending down towards 110.

EUR/USDcould extend its gains up to 1.24 as long as there are no cautionary comments from European policymakers.
The greatest risk for the euro would be the European Central Bank’s concerns about the strong and rapidly rising currency. Since their last policy meeting mid December, EUR/USD is up 4 cents. This week’s rally was sparked by unexpected hawkishness from the ECB. According to the minutes from their December meeting, the central bank saw “some comfort” in wage dynamics and would consider a gradual shift in guidance starting in “early 2018” if reflation continues. These brief comments sent EUR/USD soaring above 1.20 with 1.21 broken on the back of reports that Angela Merkel is close to forming a new government with the Social Democrats. While the euro’s uptrend is very much intact for the time being, the biggest question is how the ECB’s views have changed since December. The economy continues to recover but the currency is 4 cents higher and German bond yields are nearly 30bp higher. Mario Draghi’s eagerness to alter their guidance may have also changed as market dynamics are very different today than 4 weeks ago. With that in mind, the near term trend for EUR/USD is still higher but investors will be focused on the ECB’s forward guidance at this month’s monetary policy meeting and we are on the lookup for any hints by European policymakers in the days ahead. ECB members Weidmann and Coeure are scheduled to speak this coming week. We already know that Weidmann believes that announcing a QE end date is justifiable so he’s not likely to be critical of the central bank’s policy. The only number to watch will be Eurozone CPI.

Sterlingrose to its strongest level since June on the back of U.S. dollar weakness and the prospect of a soft Brexit.
On Friday, there were reports that the Spanish and Dutch support a soft Brexit that keeps Britain more closely tied with the rest of the region. The EU Parliament is also looking to soften proposals on the forced relocation of clearing houses, reducing the risk that the UK might lose such lucrative business. We’ve said it before – 2018 will be the year that a Brexit deal gets done and these are all signs that progress is being made. With that in mind, next week, Parliament will debate Brexit on January 16 and 17th, so keep an eye out for market moving headlines. Sterling will be in play with UK inflation and retail sales data scheduled for release. Although we are looking for both reports to surprise to the downside, on a technical basis, there’s no major resistance in GBP/USD until the 38.2% Fibonacci retracement of the 2014 to 2016 decline near 1.3975. The trend is strong and further GBP/USD gains are likely.

The Australian and New Zealand dollars on the other hand are vulnerable to corrections.
Having raced higher this past week on U.S. dollar weakness and stronger Australian data, both of these currencies are overbought and momentum is waning. One of the greatest risks this year is softer Chinese growth and while their trade balance ballooned in December, the expansion was driven entirely by weaker imports. Economists expected import growth to slow to 15.1% from 17.6% but instead, they grew by only 4.5% which was the weakest pace of growth in a year. December is traditionally a softer month for demand but this report highlights the challenges that the country faces in 2018. If AUD/USD breaks above 79 cents, it could extend up to 80 cents but if it fails underneath that level, a move back down to .7775 becomes likely. Australian labor market numbers are due for release and weaker growth is expected for December after the strong gain reported in November. Chinese GDP numbers (due that same day) will also affect how AUD and NZD trade. It is widely believe that Chinese growth slowed in the last 3 months of the year. NZD/USD traders will be watching the dairy auction and manufacturing PMI. The New Zealand dollar has been in a relentless uptrend, rising 4 cents over the past month with very little retracement so if the downtrend in dairy prices continue, it could spark a more meaningful correction in the currency.

Last but certainly not least, the Canadian dollar will be the currency to watch with economists looking for a rate hike from the Bank of Canada on Wednesday.
Investors are pricing in 86% chance of tightening which is a dramatic increase from the 42% chance at the start of the year. Rising oil prices, strong retail sales, consistent job growth and rising price pressures are all of the reasons why the market expects the BoC to raise interest rates by 25bp. In their winter business outlook survey, the Bank of Canada also reported healthy sales outlook, stronger capacity and labor pressures, broad based plans by firms to boost investment and widespread plans to increase hiring. They also felt that production capacity pressure is the highest since the recession. However not every part of the Canadian economy experienced positive growth over the past month. Housing data was weaker with permits and starts falling, GDP slowed in October, the IVEY PMI manufacturing index plunged, the trade deficit widened significantly and manufacturing sales declined. Even though crude prices increased, the price of Western Canada Select, Canada’s largest commercial stream of oil declined so Canada isn’t exactly benefitting as much from the rise in crude as many would think. Also, the last time we heard from Governor Poloz was in mid December and at the time he stressed that they needed to take a cautious approach towards raising rates. So while we strongly believe that the BoC will be hawkish and is close to tightening, a rate hike this week is not a done deal. The loonie was also shaken this week by reports that two Canadian government officials see Trump pulling out of NAFTA in the very near future. However these comments have been denied by the White House and after telling the White House that “I understand that a lot of things are hard to negotiate prior to an election,” it is now widely believed that Trump will not make a decision on leaving NAFTA until after Mexico’s summer election. So in turn we believe that USD/CAD could trade down to 1.24 prior to the Bank of Canada’s rate decision.

Kathy Lien

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