- Fundamentals have not yet caught up with the euro and Australian dollar.
- The British pound is the silent bull waiting for the next Inflation Report.
- The Canadian dollar has stopped losing ground for now.
There was a lot of action last week in the foreign exchange market. This piece is a quick update on how I have adjusted and/or maintained positioning in select currencies: the euro (NYSEARCA:FXE), the British pound (NYSEARCA:FXB), the Canadian dollar (NYSEARCA:FXC), and the Australian dollar (NYSEARCA:FXA).
Last week on April 3rd, the European Central Bank (ECB) rolled out its latest update on monetary policy. President Mario Draghi reminded markets that risks in the euro area remain to the downside. There were some other points that caught my interest.
Investors continue to show interest in euro area assets. This interest no doubt explains at least some of the stubborn strength in the euro.
"The growth of the narrow monetary aggregate M1 remained robust at 6.2% in February, after 6.1% in January. The main factor supporting annual M3 growth continued to be the increase in the MFI net external asset position, reflecting the keen interest of international investors in euro area assets."
The ECB's analysis of inflation expectations continues to reassure markets that deflation is still not a real concern even as Draghi points out that the longer low inflation persists the higher the risk of deflation:
"…the economic analysis confirms our expectation of a prolonged period of low inflation followed by a gradual upward movement in HICP inflation rates towards levels closer to 2%." (HICP = the Harmonised Index of Consumer Price)
Draghi also pointed out that 70% of the drop in inflation from 2.7% in the first quarter of 2012 to 0.5% now has come from a decline in energy and food prices. This drop in inflation "…supports the real disposable income especially of those people who have a fixed nominal income."
I believe the clincher for the euro came during the Q&A period when Draghi confirmed that the ECB's Governing Council discussed the possibility of implementing QE. Draghi also re-emphasized the importance of the exchange rate, an emphasis I think has been largely missing until now…even if the exchange rate itself is still not a "policy target":
"The exchange rate is very important for price stability, so much so that we have made an explicit reference to it in the introductory statement, as you have seen, where we say that '… the Governing Council sees both upside and downside risks to the outlook for price developments as limited and broadly balanced over the medium term. In this context, the possible repercussions of both geopolitical risks and exchange rate developments will be monitored closely'. But, as I have said several times, it is not a policy target. It is an increasingly important factor in our medium-term assessment of price stability, but it is not a policy target. In this sense, we do not link our medium-term assessment to a precise level of the exchange rate. It is part of the overall information that comes into play when we undertake our medium-term assessment."
The euro sold off against the U.S. dollar in the wake of the Q&A and continued dropping into Friday. I used this opportunity to lock in profits on my EUR/USD position while holding my remaining euro shorts. Per the on-going approach, I will look to (re)fade the next euro rally. The charts below show the daily action and zoom in on the 15-minute view to make the catalyst clear on the latest sell-off.
The euro fades after a trigger-finger surge in reaction to the start of Draghi's Q&A session
The euro is on the move lower again, but the general uptrend from last year's lows remains unbroken
I do not think there is much to say abut the British pound right now. Economic data are generally supporting the recovery theme for the UK. The reaction to the February Inflation Report was very bullish as Governor Mark Carney strongly affirmed the strong UK outlook calling the recovery one of the strongest among developed nations. Since we are already two months out from that report, I will not do my quarterly summary. I hope to be more timely for May's report. In the meantime, GBP/USD generally meanders along. The currency pair is trading exactly where it was to start 2014, making for good setups for bears and bulls. Since I am bullish, I have regularly and enthusiastically bought dips (and sold into subsequent rallies). The overall trend for GBP/USD remains up and to the left four months into a breakout from the post-2009 downtrend.
The British pound continues to meander in a very slow-moving uptrend
The Canadian dollar has had a strong comeback since getting slammed by the Federal Reserve's March monetary policy announcement. The gains in USD/CAD from that day have been reversed and then some. I am back into accumulation mode although it seems the upward momentum for the currency pair has stalled out for now. The Canadian jobs report was a bit stronger than "consensus": 42.9K jobs created versus 22.5K expected and an unemployment rate that ticked down to 6.9% versus an expectation to stay steady at 7.0%. I see nothing to change the fundamental thesis that I have promoted in previous posts for over a year now that are now consistent with the overall upward trend in USD/CAD.
The upward momentum in USD/CAD looks done for now
The Australian dollar is firmly in breakout mode against the U.S. dollar (AUD/USD). However, its run against the Japanese yen (AUD/JPY) finally seems to be ending. I post charts at the end of this section. If AUD/JPY confirms a top, I think the Australian dollar will finally start to falter against other currencies like the U.S. dollar. The robust and bullish forecasts for export revenues continue to be one of the more interesting developments for the Australian dollar. I have long accepted that the terms of trade for Australia peaked in 2011, but I start to wonder when I see forecasts like those produced in the Resources and Energy Quarterly-March Quarter 2014, produced by the Bureau of Resources and Energy Economics (BREE).
Energy and resource earnings are projected to keep growing for another year or twoSource: the Bureau of Resources and Energy Economics
Sure this rise is supported by expanded production capacities and the demand to absorb it. However, if I had not know the expectations for a peak in the terms of trade, I would have looked at this chart and assumed the terms of trade remained bullish. Instead, it seems that a continued decline in commodity prices will help support robust export activity, helped along by a decline in the Australian dollar. Case in point is the BREE's projection for the exchange rate on the Australian dollar:
"Higher resources and energy commodity export earnings as a result of both higher volumes and a more favourable Australian dollar exchange rate will also support GDP growth in 2013-14…
…Although lower than the first quarter of 2013, the Australian dollar-US dollar exchange rate remains high by historical standards. Since depreciating in the second half of 2013, the Australian dollar-US dollar exchange rate has remained relatively stable through the first quarter of 2014 and traded at around 0.89 USD/AUD for most of the quarter. Through the remainder of 2014 the exchange rate is forecast decline in response to further tapering of the US' QE3 bond purchases, lower commodity prices (and subsequently declining terms of trade) and more bearish sentiment over economic growth in China. For the financial year 2013-14 the exchange rate is forecast to average 0.90 USD and then depreciate to average around 0.85 USD over the remainder of the outlook period."
So, on balance, I am staying net short the Australian dollar rather than switching to match the bullish technicals that defy the fundamentals. I was using currency pairs like AUD/JPY to buffer the bearish positions. I stopped making that trade a few weeks ago, ever more surprised at how the rise in AUD/JPY flew against the what seemed like an aversion to risk in the U.S. stock market with the decline in high-tech and momentum stocks. AUD/JPY remains one of my key signals to watch for underlying biases in market sentiment.
The Australian dollar is defying expectations against the U.S. dollar
The Australian dollar finally showed some weakness against the Japanese yenSource for charts: FreeStockCharts.com
Be careful out there!
Additional disclosure: In forex, I am net short the euro, Australian dollar, and Canadian dollar; net long the British pound