No Love For USD/JPY And Underpricing A U.S. Hike

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

There was very little consistency in the performance of the U.S. dollar Monday leaving the Japanese yen as the currency that set the tone for trading. The yen moved higher against all of the majors despite significantly weaker economic data. The country’s trade surplus increased but exports dropped for the seventh straight month while imports declined at its fastest pace since 2009. In other words, external and internal demand is weakening. This report along with a lower manufacturing PMI release should have driven USD/JPY higher on the premise that fresh monetary and/or fiscal stimulus will be necessary but instead, USD/JPY dropped to a low near 109.30 after the G7 criticized Japan for even thinking about intervention. At the last G7 meeting in February there was a very clear goal from the other members to weaken the U.S. dollar. This time around the question was whether G7 members would approve of currency intervention by Japan. Of course this was a long shot as members have long agreed to avoid competitive FX devaluation but the U.S. took things one step further by refreshing its warning to Japan against intervention, with Treasury Secretary Lew adding that he did not view recent yen moves as disorderly. Technically, Japan doesn’t need anyone’s approval for currency intervention but if it was reluctant to step into the market when USD/JPY dropped to 106, it’s definitely not considering the idea at 109. Considering that most people don’t expect intervention at current levels, the prospect of higher interest rates in the U.S. along with more fiscal and monetary stimulus from Japan should prevent USD/JPY from falling much further.

According to Markit Economics, manufacturing activity in the U.S. expanded at its slowest pace on record in May, which is not surprising given the weakness reported by the Philadelphia and Empire State surveys. However the focus for the U.S. dollar continues to be on the likelihood of a Federal Reserve rate hike this year. Steady rates for June is pretty much a done deal but the odds of a rate hike in July have climbed to 48%. The message from U.S. policymakers have been extremely consistent — Monday morning Fed President Williams said 2 to 3 rate hikes in 2016 is appropriate. While he is a non-voting member of the FOMC, his optimistic views were echoed by voting member Bullard, who said the slow-rising path of interest rates is consistent with growth, touting the strength of the labor market while warning that keeping rates too low for too long could feed future instability. Everyone within the central bank from doves to hawks believe that the market is underpricing tightening and investors are finally starting to realize that maybe they shouldn’t be ignoring the uniformity of Fed comments. More U.S. policymakers will be speaking this week and their views should continue to be supportive of the dollar.

The euro is also a big focus this week with a number of important economic reports scheduled for release. Monday morning’s softer Eurozone PMI numbers drove the euro lower against the greenback. While service-sector activity expanded at a steady pace, manufacturing activity slowed, dragging the composite index lower. What’s interesting, though, is that German and French manufacturing — along with German and French service-sector activity — gained momentum, which means the weakness is peripheral. So the rest of this week’s Eurozone economic reports including the ZEW and IFO could still show strength because the region’s largest economy is humming along, according to the latest reports. Meanwhile, Greece was in the headlines Monday with Parliament approving austerity measures that would unlock fresh bailout funds that will help the country avoid default. The IMF believes that the plans fall short but judging from the performance of Greek bank stocks, investors are cheering the reform bill.

Sterling traded lower against the U.S. dollar Monday on fresh warnings about the consequences of Brexit. You can’t get a grimmer picture than the one from the U.K. Treasury, which said that Britain could lose as many as 820K jobs, fall into a year-long recession as its currency falls by as much as 15%. “A Brexit vote would result in a marked deterioration in the economic security and prosperity.” In the past warnings like this only lifted the pound by giving Britons a stronger reason to favor remaining in the European Union. However on Monday the sentiment was very different and ultimately, the uncertainty leading up to the referendum should lead to greater volatility for the currency.

Modest losses were seen in the Canadian dollar as the Australian and New Zealand dollars ticked up. The decline in oil prices helped USD/CAD rise for the fourth trading day in a row. The Bank of Canada meets this week and between the big drop in retail sales and wildfires in Alberta, the central bank has more to worry about in May than April. Persistent weakness in iron ore prices has kept AUD under pressure. Still, 72 cents held well with AUD/USD bouncing off that level on Monday. RBA Governor Glenn Stevens was to speak Monday night and his outlook for the economy could determine whether this key level is broken — or if 72 cents becomes a near-term bottom for AUD/USD. Yet despite the lack of economic data, the New Zealand dollar continues to outperform Australia’s with AUD/NZD falling to fresh 3-month lows.

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