A Central Bank Game Plan Like No Other

DailyFX

The economic outlook and central bank policies in the US are vastly different than those seen elsewhere in the world today, and as such, the recent broad-based rally in the US dollar is likely to continue.

There are a number of stories grabbing financial headlines so far this week, but the one that affected currencies, equities, bonds, and commodities the most was the Wall Street Journal report from noted Fed watcher Jon Hilsenrath about the central bank's strategy for winding down asset purchases.

While it should be no surprise that the Fed is thinking about how to reduce bond purchases and may even have a game plan in place, the article was written and released at the perfect time, as investors were itching for confirmation that the Fed is still thinking about reducing stimulus.

The US dollar (USD) soared at the end of last week after US data showed that the economy and Fed policy are both moving in a completely different direction from other major economies. Monday's retail sales report confirmed US outperformance and increases the possibility of the central bank varying asset purchases as early as September, and at the latest, December.

The movements seen in the financial markets are the reactions to be expected if the Fed is really serious about reducing stimulus. Tapering asset purchases would be good for the dollar, negative for stocks, and positive for Treasury yields because it means that the central bank is cutting its support for the bond market and providing breathing room for yields. Over the past week and a half, US ten-year yields have soared from a low of 1.62% to above 1.91%.

Since commodities are priced in dollars, policy that would drive the greenback higher is also negative for commodities. This explains why the dollar extended its gains, but stocks failed to move higher despite stronger-than-expected retail sales.

In addition to bolstering bullish dollar sentiment, the latest retail sales data has also boosted GDP expectations for some economists, which is also positive for the greenback. While no major US economic reports are scheduled for release on Tuesday, we expect the dollar to remain bid nonetheless.

ECB Sends Clear Message to the Market

The euro (EUR) ended Monday lower against the US dollar but continued to hold above the critical 1.2950 level. As we noted before, there must be a lot of orders and option barriers below this level, as the currency pair refuses to move lower despite stronger US data and dovish comments from the European Central Bank (ECB).

See also: The Euro’s 3-Way Safety Net

Over the weekend, ECB President Mario Draghi reaffirmed the Bank’s dovish stance by saying it is considering buying asset-backed securities as another way to support lending and stimulate the economy. ECB member IgnazioVisco also said the central bank is "technically prepared" to introduce negative deposit rates.

The central bank is sending a very clear message to the market that it is willing and prepared to increase stimulus if the economy weakens further. Therefore, Tuesday’s German ZEW survey and Wednesday's first-quarter GDP reports will be particularly important for EURUSD.

While the recent ECB rate cut, rise in equities, and increase in German industrial production should boost investor confidence—and support the euro—if the ZEW survey surprises to the downside, EURUSD may finally see a sustained break below 1.2950.

Even if the data is good, however, we are skeptical about how long EURUSD can hold this key level. With the ECB moving towards more stimulus and the Fed moving towards less, it should only be a matter of time before 1.2950 in EURUSD is broken. Moreover, the reason why 1.2950 is significant is because there is no major support for the pair until 1.28 if that level is broken.

UK Housing Prices Rise for First Time in Almost 3 Years

The British pound (GBP) ended Monday lower against the US dollar and euro. No UK economic reports were released, but the action will heat up for sterling as this week progresses. The RICS house price balance was released early Tuesday, and the index turned positive in the month of April, as expected. It was the first increase in UK house prices since June 2010, a development that may help improve the outlook for the national housing market.

Meanwhile, Wednesday's inflation report and employment numbers are the central focus for the pound this week. Based on recent economic reports, the Bank of England (BoE) could be growing slightly more optimistic. In general, the fear of inflation has limited the support for more stimulus, and good data would further reduce the chance of easing.

The quarterly inflation report provides the market with the government's most up-to-date economic assessment as well as the outlook for inflation, which is usually a guide for monetary policy. No specific changes are expected to the GDP and inflation forecasts, however, so this quarter's release could still be a non-event for sterling.

AUD/USD: Parity Is in the Rearview Mirror

All three of the major commodity currencies weakened against the US dollar on Monday, but the largest selloff was in the Australiandollar (AUD), which closed below parity versus the greenback for the first time since June 2012.

This AUDUSD breakdown represents a sustained break for the currency pair, and with parity now in the rearview mirror, the next support for AUDUSD will be at 0.9870, which is where the 200-week simple moving average (SMA) resides.

The latest move lower was triggered by the combination of weaker-than-expected Chinese data and a decline in Australian business confidence. Given the performance of the global equity market and the recent rate cut by the Reserve Bank of Australia (RBA), business confidence was expected to hold steady and possibly even improve, but it instead dropped below zero for the first time in six months. Australian businesses are clearly concerned about the outlook for China's economy, and they have good reasons to be. While Chinese industrial production grew at 9.3% and retail sales growth hit 12.5% in April, both reports fell short of analyst expectations.

Also, translating the year-over-year gains to monthly changes, retail sales grew 0.9% last month compared to 1% in March. This slower pace of growth could weigh on Chinese GDP in the first quarter.

New Zealand data was mixed, but the NZDUSD weakened on the disappointing Chinese and Australian economic releases. New Zealand house prices grew at a slower pace in April, while food prices grew at a faster pace.

Retail sales were due for release Monday evening, and given the weakness in credit card spending, slower retail sales growth in Q1 was expected.

The Canadian dollar (CAD) fell alongside oil prices on Monday despite no new economic data from Canada.

USD/JPY Cleared for Move to 103

Monday was a mixed day for the Japanese yen (JPY), which traded lower against the US and Canadian dollars, but held steady or strengthened against other major currencies. Over the weekend, G7 finance ministers essentially green-lighted the ongoing yen selloff by avoiding criticism of yen weakness and Japan’s easy monetary policies, deemed “Abenomics.” It’s likely that policymakers are focused instead on continuing weakness in their own currencies, which may serve to explain their lack of concern about the yen and Japanese policies.

For the time being, we are still looking for further gains in USDJPY, especially after the sharp increase in US bond yields. Better-than-expected US data, new highs in the Nikkei, and consistent Japanese demand for foreign bonds should be enough to drive USDJPY to 103, and the only reason that hasn't happened already is because weaker Chinese data has fueled demand for safe-haven currencies including the USD and JPY.

By Kathy Lien of BK Asset Management

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