How High Can the EUR Rise?

• How High Can the EUR Rise?
• USD: Busy Data Week Ahead
• GBP: Hit by Weaker Industrial Production
• CAD: Fourth Largest Trade Deficit Ever
• CAD: Weaker Housing Numbers
• NZD: Gold and Oil Up Nearly 1%
• JPY: Reports Second Largest Current Account Deficit

How High Can the EUR Rise?

It has been a great week to be long euros. The EUR/USD rose more than 2% against the dollar, to its highest level in 9 months. The rally from 1.3040 to 1.3365 took only a matter of 48 hours and was the strongest 2-day move for the currency pair since October 2011. The euro appreciated not only against the U.S. dollar, but also against all major currencies this week. For forex traders, the burning question in everyone mind’s is how long and how high can the EUR/USD rise.

To answer this question, we first examine what drove the euro higher in the first place and the answer is comments from the ECB. In yesterday’s note, we wrote at length about how the central bank is done easing. While they will keep monetary policy accommodative to support growth, they aren’t looking to do more this year. Without a threat of a rate cut, the EUR/USD has soared. On a valuation basis, the EUR/USD is overvalued by approximately 15%. However that doesn’t always matter because a currency can be under or overvalued for long stretches of time. The average value for the EUR/USD over the past 6 years is 1.3740 and from that perspective the EUR/USD still has room to rise. Yet the factors are not historical valuations or average prices but how the Eurozone economy will perform in the coming year. The ECB is worried about growth with Draghi warning about the downside risks but OMT has had a very positive impact on the financial markets and in 2013, we believe that it will feed into the real economy with the reduction in uncertainty boosting business and consumer sentiment. The second question is then how the U.S. economy is doing because EUR/USD will not be able to extend its gains if the Federal Reserve gets serious about ending asset purchases this year. For the time being, we don’t think the U.S. central bank is ready to pare back purchases, especially in the first quarter and because of that, we don’t expect U.S. monetary policy to pose much threat to the EUR/USD rally. Of course, a retracement after such a strong move is not unusual but overall, the EUR/USD should continue to rise.

Technically, there is stiff resistance in the EUR/USD at 1.35. Not only is this a psychologically significant level, but it is also where the 200-week SMA and the 50% Fibonacci retracement of the 2011 to 2012 sell-off converge. The currency pair also failed to break above this level last year. As a result, we cap near term gains in the EUR/USD at 1.35 and if it manages to clear that, then the door opens for a stronger move to 1.40.

USD: Busy Data Week Ahead

The U.S. dollar traded higher against all of the major currencies except for the euro and Swiss Franc today. With no major economic reports on the calendar this week, investors were too distracted by the big breakout moves in the EUR/USD and USD/JPY to give further thought to the Federal Reserve’s talk of ending asset purchases this year. While comments from 2 new members of the FOMC suggests that they are more inclined to vote for phasing out QE in 2013, underlying economic improvements are needed to sway the other central bankers and that’s where next week’s economic reports come in. The labor market has stabilized and now we need to see that translate into stronger spending. A number of U.S. economic reports are scheduled for release next week but retail sales and the Beige Book report will be the most important. According to the International Council of Shopping Centers, spending last month was strong which will hopefully drive an increase in retail sales. The Beige Book will provide us with a more up to date assessment on consumer spending and labor market conditions. In addition to retail sales, we anticipate reports on the manufacturing sector, the housing market, inflation and consumer sentiment. Next week we will get a much better sense of how the U.S. economy is faring and how realistic an end to QE3 in 2013 really is. Meanwhile in the month of November, the U.S. trade deficit rose from -$42.1B to -$48.7B to its highest level since April 2012. While the larger trade gap in the U.S. could cause a downward revision to Q4 GDP, the details of the report were not as nearly as grim as the headline number. Exports increased 1% while imports rose 3.8% to a record high in November. The strong demand for foreign goods reflects inventory stockpiling by U.S. retailers stocking up for the holiday shopping season. With the effects of Hurricane Sandy fading, demand for autos also rebounded. If not for the decline in oil prices, imports would have probably been even stronger and for the rest of the world, rising U.S demand is positive for growth.

GBP: Hit by Weaker Industrial Production

The British Pound weakened against most of the major currencies on the back of softer economic data. UK manufacturing production unexpectedly declined by 0.3% month over month in November indicating weakness in the economy towards the end of 2012. Manufacturing production was forecasted to grow by 0.5% after falling 1.3% the previous month. Industrial production rose 0.3% month over month reversing the previous month’s fall of 0.9% but missed the forecasted rise of 0.8%. Yesterday the Bank of England left its bank rate at 0.5% and bond-buying program on hold as it evaluates early signs of success in its credit-boosting plan. Based on recent economic data, they still have a lot of work ahead of them. According to the National Institute of Economic and Social Research, GDP output contracted by 0.3% in December. The estimates suggest a growth rate of a flat 0.0% in 2012, down from 0.9% in 2011. This sluggish manufacturing and industrial production data supports the case that GDP contracted in the fourth quarter. Inflation and retail sales figures are scheduled for release from the U.K. next week – these reports will play a central role in shaping monetary policy expectations in the first quarter.

CAD: Fourth Largest Trade Deficit Ever

The Canadian dollar ended the day unchanged against the greenback despite weaker economic data. For the month of November, Canada reported its fourth largest trade deficit ever. While imports also increased 2.7%, exports dropped 0.9%. As a country that is dependent on foreign demand, the decline in exports is bad news for Canada, especially since it is caused by weaker demand for energy and metal products. Exports to the European Union in particular dropped 19.4%. There have been a lot of inconsistencies in Canadian data recently with strong job growth in November and December failing to coincide with stronger economic activity. Yet with the IVEY PMI index rebounding in December after pulling back sharply in November, trade activity should improve next month. The Australian and New Zealand dollars on the other hand were hit hard by higher inflationary pressures in China – a colder than anticipated winter drove food prices higher and that means the PBoC will be less inclined to ease monetary policy, which investors have interpreted to be negative for Australia. Next week’s GDP, industrial production and retail sales number from China holds the key to the fate of the AUD. While hotter inflation is certainly not a good thing, what really matters is economic growth. If next week’s Chinese economic reports repeat the strength seen in the trade balance, the AUD could close above 1.06 for the first time since March.

JPY: Reports Second Largest Current Account Deficit

All of the Japanese Yen crosses climbed to fresh highs over the past 24 hours but only some managed to hold onto their gains. This includes EUR/JPY and CHF/JPY, which were led higher by the rally in European currencies. AUD/JPY and NZD/JPY on the other hand gave up all of their gains as the Australian and New Zealand dollars ended the day lower against the greenback. USD/JPY is closing in on 90, a psychologically and technically significant level. This is the strongest level we’ve seen USD/JPY in more than 2 years. Last night, Japan reported weaker than expected current account and trade deficits. The market had only been looking for a small current account deficit but a drop in exports and lower incomes caused the country to report its second largest current account deficit ever. With the trade deficit also rising more than expected, the pressure on the Bank of Japan to increase monetary stimulus this month has increased. The slide would have probably been deeper if not for the Y10 trillion in new spending announced by the Japanese government overnight. The total package which includes public loan guarantees exceed Y20 trillion is the second largest stimulus program since World War 2. The government expects the new stimulus to boost GDP growth by 2% and employment by 600k but most likely the contribution would be more modest, to the tone of 1-1.5% at best. While the uptrend in USD/JPY is becoming overextended, it remains intact for the time being.