By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The euro rebounded against the U.S. dollar on Monday for the first time in 11 trading days, ending the longest stretch of EUR/USD weakness since January of 2015. The recovery was driven by profit taking on long dollar positions and the pullback in U.S. yields. Ten-year German bund yields also edged higher, moving the yield spread in favor of a higher EUR/USD. The 2-year yield spread, which hit a 10-year low last week, is deeply oversold so it's not surprising to see a bounce at the start of this shortened U.S. trading week. The recent surge in the U.S. dollar has been quick and aggressive, making a pullback not only possible but extremely likely. However, we believe that EUR/USD is still headed for 1.05 for the following reasons:
- Political Troubles in Europe Continue to Group with French Fillion beating Juppe in first round of Republican primary votes
- Italian Referendum Risk
- Markets Pricing in 100% Chance of December Fed Hike
- Dollar Still a Buy after Fed Hawkishness
- Risk of Lower German PMIs, IFO
Political troubles in the Eurozone continue to grow. In a weekend surprise, Francois Fillion beat Alain Juppe in the first round of the Republican primary. Juppe and Sarkozy were the favorites, but after the Trump victory voters ticked the boxes for a more extreme candidate. Mr. Juppe ran on an integrationist message against Sarkozy’s more hard-lined stance. Fillon put himself right in the middle, taking in 44.1% of the vote versus Juppe’s 28.3%. Since there was less than a 50% majority, a second round of voting will take place on Sunday November 27. French politics are in disarray and there’s a very good chance that next year, the Republican nominee will be running against Marine Le Pen, the leader of the far right National Front. There are many parallels between her campaign and U.S. President Elect Donald Trump’s, including a crackdown on immigration, French nationalism and anti-globalization. The uncertainty of French politics should hang over the euro for the next week and possibly even the next few months.
In the near term, the Italian referendum on Senate reform scheduled for December 4 poses the greatest near-term risk for EUR/USD. No polls are permitted 15 days ahead of the vote and the last survey showed the 'No' vote firmly ahead. The referendum is aimed at streamlining Italy’s government decisions by reducing the role of the Senate and regional governments. Prime Minister Renzi also pledged to quit if the vote is rejected, which would create another political crisis in Italy -- especially as the vote has been viewed as a referendum on EU membership. These political troubles will keep EUR/USD under pressure and should drive the currency pair toward 1.05. Meanwhile, the U.S. dollar is still a buy on dips as investors have now priced in a 100% chance of a rate hike next month. Lastly, the only data of any consequence this week from the Eurozone will be the PMIs and the German IFO reports. Given the drop in German factory orders and industrial production, the risk is for a negative number that will weigh on the euro. Mario Draghi spoke Monday and while his comments were relatively benign, EUR/USD broke 1.06 after his speech.
Meanwhile, as USD/JPY hit a fresh 6-month high above 111, the U.S. dollar traded lower against other major currencies. With no major economic reports on the calendar during this shortened holiday trading week, profit taking is expected in the dollar after such a strong move. Not only did we see Monday's dollar pullback, but U.S. rates also fell. However the path of least resistance is still higher for the greenback, especially now that the market is pricing in a 100% chance of a rate hike next month. U.S. stocks also climbed to a record high, supporting the risk-on rally in USD/JPY. The latest Japanese trade and supermarket spending numbers were very strong -- Japan reported its second consecutive monthly trade surplus but the positive reading was driven by a larger fall in imports. Should USD/JPY, pullback and we think it will, the first level to buy would be near 100.25. U.S. existing home sales are scheduled for release Tuesday and a dip is expected after the rise in October.
Monday's best-performing currency was sterling, which soared above 1.25 versus the U.S. dollar. The abrupt move caught the market by complete surprise and can only be explained by the triggering of stops in GBP/USD and GBP/JPY. No U.K. economic reports were released Monday and 10-year gilt yields fell by approximately the same amount as treasuries. Prime Minister May said she would not delay triggering Article 50 past March 2017 and will be looking to exit from the European Union by March 2019. We are surprised that sterling ignored this headline as a large part of the currency’s previous strength was driven by reduced Brexit fears, which should soon return. Part of its resilience may have to do with May’s hint of a possible transitional deal for UK businesses with the EU after Article 50 is invoked. She said she was going to push for a deal that would work best for the U.K. and companies looking to do business in the U.K. Meanwhile, the biggest focus for sterling this week will be the Chancellor’s Autumn Statement on the budget Wednesday. It will only be market moving if major announcements relating to lower taxes or more spending are made.
All three of the commodity currencies traded higher on Monday with the Canadian dollar leading the gains. The Canadian dollar benefitted from a sharp rise in oil prices. The price of crude jumped nearly 4% despite the prospect of an output cut. Iraq oil minister Lualbi said on Sunday that the country plans to offer 3 new proposals this week at the cartel’s technical meeting. Putin also chimed in saying that a deal was imminent for OPEC and that Russia would follow suit with any plan for an oil freeze. Investors are clearly skeptical about a deal as OPEC failed to deliver at previous meetings and even if an agreement is reached, we’ve seen a number of oil-producing nations backpedal on their promises. On a technical basis, oil looks like it's headed higher, which will be negative for USD/CAD but the main focus Tuesday will be on Canadian retail sales. The sharp 1.2% drop in wholesale sales and the drop in full-time jobs signals a potential contraction in spending. Meanwhile, New Zealand reported an increase of 2.8% in credit-card spending for October, a slight fall from the 3.2% increase the previous month. No economic reports were released from Australia.