Behind the Big Moves in Commodity Currencies

• Behind the Big Moves in Commodity Currencies
• CAD: Bank of Canada Could Cut Forecasts
• NZD: Dragged Lower by Dairy Prices and CPI
• GBP Outlook Hinges on BoE Minutes
• Euro: Beware of a Short Squeeze
• Dollar Soars on Rate Hike Talk

Behind the Big Moves in Commodity Currencies

It is a new trading week and currencies are on the move. The Canadian and New Zealand dollars saw the largest swings intraday with the yen pairs not far behind. USD/CAD rose to its strongest level in 5.5 years ahead of the Bank of Canada's monetary policy announcement. While the BoC is not expected to lower interest rates, the decline in oil prices, job losses in December, slowdown in manufacturing activity, drop in housing starts and building permits gives them plenty of reasons to be concerned about the outlook for their economy.  Since their last monetary policy meeting on December 3rd, oil prices dropped more than 30% and this morning we learned that manufacturing sales dropped for the second month in a row.  The last BoC monetary policy statement was nicely balanced with the central bank offsetting concerns about lower crude prices with optimism for the export sector.  This month, we expect more distress than cheer that should translate into lower growth and inflation forecasts.  If the BoC cuts their outlook for the economy like we anticipate, we can expect USD/CAD to extend its gains for a possible move to 1.22/1.23 or higher.  Economic data is released with a lag and we are at the beginning of what should be a series of weaker economic reports. The New Zealand dollar also nose-dived after this morning's global trade auction. Dairy prices rose 1%, which was less than the 3.6% increase at the last auction.  While prices could have risen more, in our opinion, three back to back increases is good news and signals a potential bottom in dairy.  As New Zealand's biggest export earner this increase will bolster the confidence of the RBNZ who meets next week.   New Zealand consumer prices fell 0.4% in the fourth quarter but with the rebound in prices in Q1, this quarter's report should be stronger. In the long run, we believe that the stabilization in dairy prices should leave the RBNZ comfortable with the current level of monetary policy.  This sentiment and 3.5% interest rate will prevent NZD from falling much further and lead to a recovery in the near future especially if the ECB rolls out Quantitative Easing, forcing investors to look elsewhere for yield.  Meanwhile the decline in the Australian dollar was a fraction of that seen in the CAD and NZD. AUD was supported by the rise in gold prices and stronger than expected Q4 GDP numbers.

GBP Outlook Hinges on BoE Minutes

Unlike many other major currencies, sterling has been stuck within a narrow range against the U.S. dollar for the past 2 weeks.  That should change however in the next 24 hours with the release of the Bank of England minutes.  If policymakers continue to press for a rate hike, the currency pair will break above the January 14th and 15th high of 1.5270.  If they hum and haw about the decline in oil prices and the downside pressure that it puts on CPI, GBP/USD could break its 1 year low of 1.5035. Over the past few weeks, investors have pared back their expectations for BoE tightening amidst weaker manufacturing, service and construction sector PMIs. Yet not every corner of the economy weakened - retail sales and average hourly earnings rose, giving the BoE some cause for optimism.  In a nutshell, we know that the BoE minutes are important and should trigger a big reaction in sterling but it is difficult to predict the direction of their bias.  With this in mind, a hawkish bias should have a greater impact than a dovish bias because there are very few central banks looking to raise rates this year and the BoE's commitment to doing so will be extremely positive for sterling.  Aside from the minutes, the latest employment numbers are also scheduled for release.  According to the PMIs, labor market conditions continued to improve.

Euro: Beware of a Short Squeeze

Despite stronger than expected investor confidence, the euro traded lower against the U.S. dollar. Investors are clearly pressing the currency further ahead of the European Central Bank's monetary policy announcement.  While we believe that a bit more weakness is possible, as the ECB meeting approaches, the chance of a short squeeze increases. According to the latest CFTC report, speculators hold massive short positions in the euro and the risk of a disappointment by the ECB could lead to profit taking ahead of the rate decision. Aside from the small possibility that there may not be enough support for Quantitative Easing, at this stage a €500 billion program could be the minimum that the ECB needs to do to satisfy the market. The decision has never been easy for the ECB because unlike other central banks, there are 18 countries within the Eurozone and selecting how much of each sovereign bond to buy could be politically challenging especially given the risk of holding Greek debt.  Yet the ECB can't sit by the sidelines and do nothing because falling prices deepened concerns about inflation at a time when growth is very slow.   If there is enough support for QE, we could still find the ECB working on the details such as size and scope and unfortunately preannouncing QE like they did ABS purchases will not be enough.  The real test for the ECB is the size of the program. In order to impress, the ECB needs to commit to buying a trillion euros worth of sovereign bonds or more.  The bar is set high for Thursday's ECB meeting. 

Dollar Soars on Rate Hike Talk

The U.S. dollar appreciated against most of the major currencies on the back of reports from the Wall Street Journal that the Federal Reserve remains committed to raising interest rates. According to Hilsenrath who conducted an interview with Fed resident Jim Bullard, the Fed needs to get going with rate increases.  Although Bullard is NOT a voting member of the FOMC this year, he votes in 2016.  Bullard indicated  "There has been a global bond rally over the last year and I think most of that is due to the specter of ECB quantitative easing. At the beginning of 2014 people were expecting the euro area to have a relatively good year. It was supposed to be the year of recovery and growth. When we got to midyear it was not so much and the inflation numbers in particular continued to decline and that just got worse. So the probability of the ECB going to unconventional monetary policy started to get higher and higher. I think that has been the primary driver of the global bond rally and that has pulled U.S. rates down with it." He also added that "I still think we should get off zero (interest rates). The kinds of things we're observing now, it is not the constellation of data that would be consistent with a zero policy rate. I think it is important to get started and to start normalizing policy. Even once we start to normalize, interest rates would still be extremely low. We're talking about levels of 50 basis points or 75 basis points. That is still extremely low and that would still be putting upward pressure on inflation even if we did that. So I'd like to get going. I don't think we can any longer rationalize a zero interest rate policy."