No fundamental data was needed to spur landmark price swings in the yen, euro, and dollar after the Italian election results, Moody’s downgrade of UK credit, and central bank comments took the markets by storm.
To say that Monday was an extremely active day in the foreign exchange market would be an understatement. The biggest mover was USDJPY, which fell more than 1.6% despite zero news. While this was the largest one-day decline for the currency pair in 2.5 years, it was a move that was not caused by changes in Japanese fundamentals.
Instead, the euro was under pressure for most of the day because of the Italian elections, which led to selling in all euro crosses, including EURJPY, which fell as much as 600 pips, or 5% intraday, which dragged USDJPY down with it.
When the 92 level in USDJPY was broken, stops were triggered, taking the currency pair below 91 in a matter of minutes. In other words, if you blinked, you missed the move. EURJPY and USDJPY were not the only yen crosses affected, however: AUDJPY, NZDJPY, and CADJPY all fell more than 2%, while GBPJPY and CHFJPY all dropped more than 1.6%.
However, the speed of the swan dive in the yen crosses suggests that a major hedge fund could have been unwinding its short yen position. It’s no secret that many big players are short the yen. Less than two weeks ago, the Wall Street Journal published an article about how major hedge fund players like George Soros and David Einhorn have made as much as a billion dollars shorting the yen. It wouldn't be a complete surprise if some funds decided to liquidate.
Have the fundamentals in Japan changed? No. Prime Minister Shinzo Abe still hasn't announced his candidate for Bank of Japan (BoJ) Governor, though it is now widely believed that Asia Development Bank head Haruhiko Kuroda will be chosen, and he is a well-known dove whose policies won't be kind to the yen. When the nomination occurs, we expect Kuroda to publicly affirm his commitment to aggressively easing monetary policy and reaching the BoJ's 2% inflation target within two years.
Also, we expect the rally in USDJPY to be renewed by Kuroda's official post-nomination comments. It is important to remember that the Bank of Japan has not changed monetary policy at all this year. Current BoJ Governor Masaaki Shirakawa's plan is to increase asset purchases in 2014, leaving the door open for the new Governor to make changes this year.
When then new central bank head takes office in April, he is widely expected to act aggressively, and that is when we expect USDJPY to trade above 95. Of course, this could happen sooner if the market starts to price it in. We believe that investors should look at the decline in USDJPY as an opportunity to buy at lower levels.
Euro Gets Crushed by Italian Election Mess
While USDJPY was the biggest mover, the primary focus on Monday was the Italian election, the results of which are a complete mess. While Pier Luigi Bersani appears to have won the lower chamber, former Prime Minister Silvio Berlusconi may have won enough votes in the Senate to block his win. Even these results are changing by the minute, and at the time of publication, there are even some headlines that say that comedian-turned politician Beppe Grillo may be leading Bersani in the lower house. This would be the worst-case scenario for the euro and Italian finances because it would mean a Berlusconi/Grillo-led government.
If Bersani wins the lower house and Berlusconi wins the Senate, new elections may be needed because the current results could make the country ungovernable, therefore prolonging the uncertainty for the euro. What is clear, however, is that the Italians have voted against Prime Minister Mario Monti and his austerity measures, a development that the markets have applauded.
We're not experts in Italian politics, so we quote the Wall Street Journal here, which wrote "The result is that Italy may, over the next few weeks, try to form a temporary government backed by a grand coalition of left- and right-wing forces with the sole aim of changing Italy's electoral law and then going to a vote again as early as summer. It isn't clear who would run such a short-lived government."
What we do know is that none of this is good for the euro. Italian bond yields have only increased slightly, but if Bersani loses completely, we expect the EURUSD to fall to 1.30. Even if he wins, it is hard to imagine that the market will cheer his slim victory. We don't expect the Italian election results to drive the EURUSD to 1.25, but it could have a bit more impact on the euro before the focus shifts and investors move on to growth and European Central Bank (ECB) monetary policies.
Will Fed Chairman Bernanke Add to the Pain?
The US dollar traded higher against all major currencies on Monday except for the British pound and Japanese yen. No US economic reports were released, but the desire for safety spurred demand for the greenback. EURUSD and USDJPY sold off aggressively, and the question now is whether Fed Chairman Ben Bernanke will ease or add to the pain with his upcoming comments.
Unfortunately, we can't see both currency pairs benefitting from Bernanke's semi-annual testimony. Thanks to the Federal Open Market Committee (FOMC) minutes last week, the US dollar soared against most major currencies. The mere possibility that the US central bank could start to taper off its monthly asset-purchase program as quickly as next month sent investors rushing to adjust their positions. While the unevenness of US data makes it hard to believe that the economy is strong enough to withstand less stimulus, New York Fed President and FOMC voter William Dudley made it clear that small adjustments could be made to ease the pain of stimulus withdrawal.
The question now is where Bernanke, our mild-mannered inflation dove, agrees. The head of the US central bank will be delivering his semi-annual testimony on the economy to Congress on Tuesday. It is always an interesting session to watch because of the colorful question-and-answer session, but if Bernanke confirms that changes to the monthly asset-purchase program could be made as quickly as next month, the dollar could extend its gains against the euro and other major currencies.
However, if he chooses to vigorously defend the central bank's ultra-easy monetary policy and downplays the need to slow or stop asset purchases, it could help the EURUSD find a bottom, but would also lead to additional losses in USDJPY.
Housing prices are due for release Tuesday along with consumer confidence. Based on the improvement seen in the University of Michigan consumer confidence report, we expect an increase in consumer sentiment. However, any improvement or deterioration will still take a back seat to Bernanke's testimony.
British Pound Holds Steady in Europe and North America
The British pound (GBP) held up incredibly well in light of the selloff in other major currencies and the downgrade by Moody's. The EURUSD and USDJPY have plunged, and yet, the GBP ended the day unchanged against the dollar.
Moody's dropped a bomb on the British pound half an hour before US markets closed for trading on Friday. For the first time ever, a rating agency stripped the UK of its prized AAA rating. When it comes to downgrades, what the market is most worried about is the impact on borrowing costs, and therefore, the decline in UK bonds reassures investors that the UK will not have to pay up for having a lower rating.
We still believe that sterling is headed lower in the near term because the downgrade increases the need for more stimulus to promote growth and fix fiscal finances. Moody's said the decision "to downgrade the UK's government bond rating to AA1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy."
Recent UK economic reports confirm that the recovery is losing momentum. Retail sales fell in January, showing a weak start to the year for consumer spending. In fact, consumption failed to increase for the past four months, and conditions are so worrisome that Bank of England (BoE) Governor Mervyn King voted with the minority this month in favor of more quantitative easing (QE). Therefore, Moody's concerns about economic growth are well placed, and if the UK government wants to reverse this trend, one way would be to encourage the BoE to provide greater cushion for the UK economy by increasing monetary stimulus. As a last resort, the UK could also print more money to finance its debt, which would be negative for the GBP. So while the GBPUSD held steady during the European and North American sessions, we are still looking for further losses in the pair.
Canadian Dollar Hit by Cautionary Comments from Carney
Weaker Chinese economic data and the turnaround in US stocks drove commodity currencies lower against the greenback. The losses were the most severe in the Canadian dollar (CAD), which fell to a seven-month low against the dollar on comments from Bank of Canada (BoC) Governor Mark Carney. "Economic data has been breaking to the downside," said Carney, and "Q4 growth may be weaker than the bank forecasted." While he still believes there's a need for withdrawal of stimulus, it is "less imminent."
The shift in the Bank of Canada's tone has driven the loonie sharply lower against the US dollar since the beginning of the year, and unless economic data starts to improve, there's nothing standing in the way of further losses in the CAD. Meanwhile, weaker-than-expected Chinese PMI numbers drove the Australian and New Zealand dollars lower. HSBC's Flash manufacturing PMI index dropped to 50.4 from 52.3 in the month of January, which was the first decline in five months. While the data may have been distorted by the Lunar New Year holiday, most of the components are still in expansionary mode, which should limit the damage to the AUD.
Reserve Bank of Australia (RBA) Deputy Governor Guy Debelle spoke in Adelaide and did not sound nearly as neutral on monetary policy as RBA Governor Glenn Stevens. Debelle says the central bank retains scope to lower interest rates if needed, and with the Aussie "somewhat on the high side, the RBA can cut rates to counterbalance pressure." The AUD fell on the headlines but recovered quickly thereafter. No major economic reports are expected from the commodity-producing nations on Tuesday.
By Kathy Lien of BK Asset Management