Why AUD and GBP are off to a Strong Start in July

• Why AUD and GBP are off to a Strong Start in July
• NZD: Gains Capped by Sharp Decline in Dairy Prices
• USD/CAD Drops to 6 Month Lows
• Strong Data Drives GBP to Fresh Highs                             
• Dollar and the Illusion of Strength
• EUR Rally Capped by Weaker Data
• Risk Appetite Drives Yen Crosses Higher

Why AUD and GBP are off to a Strong Start in July

The third quarter kicked off with a bang today for currencies and equities.  Many of the majors extended their gains against the greenback but the Australian dollar and British pound experienced the two strongest rallies. AUD/USD broke out of a tight consolidation to rise to its highest level in 7 months while GBP/USD extended its gains to a fresh 5-year high.  There's no doubt that the record breaking moves in equities played a big role in the gains in currencies. With the Dow climbing just a hair below 17k, investors are optimistic that global growth will accelerate in the second half of the year.  The simultaneous rise in U.S. stocks and Treasury yields also indicate that investors are becoming more comfortable with the U.S. recovery, which we discuss further in the dollar portion of our commentary.  While the risk rally helped to propel the Australian dollar and the British pound higher, they would not have been doing as well as they have today without the latest economic reports.  GBP is receiving most of the attention but between the two currencies, the Australian dollar was the bigger mover.  Last night, the Reserve Bank of Australia left monetary policy unchanged and contrary to widespread belief, the statement did not reiterate the dovishness seen in last month's RBA minutes. The market anticipated concerns about mining investment, commodity prices, the strong currency and fiscal tightening but none of that appeared in the statement.  Instead the central bank stuck to script and even sounded a bit upbeat which explains why AUD/USD spiked higher in relief.  Although manufacturing activity slowed in Australia, investors remained optimistic because manufacturing activity in China grew at its fastest pace this year.  While we expect further gains in the AUD/USD, there's quite a bit of resistance between 0.95 and 0.9550 (sterling's moves are discussed in the next section of this report). The Canadian and New Zealand dollars also performed well today but their moves were driven by nothing more than the market's appetite for risk. No economic data was released from Canada and in New Zealand dairy prices fell sharply after a brief respite, dropping to its lowest level since January 2013 according to the latest auction results.  So far the RBNZ has taken the decline in stride because demand from China continues to grow. 

Strong Data Drives GBP to Fresh Highs                             

With better than expected economic data validating the recent gains in the British pound, the currency extended to fresh 5 year highs versus the U.S. dollar.  Earlier this week we said the rally in sterling needed fundamental confirmation after mixed signals sent from Bank of England Mark Carney and today there's nothing more important than the PMI reports. According to the latest release, manufacturing activity accelerated in the month of June with the PMI index rising to 57.5 from 57.0. While economists had been looking for activity to weaken, this latest report increases the pressure on the BoE to tighten.  According to our colleague Boris Schlossberg, the data shows that the manufacturing sector "is enjoying its best growth in more than two decades. The employment index rose to 55.8 from 54.4 the month prior while new orders rose to 61.1 from 59.5. As analysts as Markit noted, "UK manufacturing continued to flourish in June, rounding off one of the best quarters for the sector over the past two decades. With levels of production surging higher, and order books swollen by a further upswing in demand from both domestic and overseas clients, job creation accelerated to its highest level in over three years. With UK data continuing to exceed expectations the pressure builds on BoE to hike rates this year rather than in 2015. The UK monetary authorities have consistently downplayed rate hike expectations on concerns that a strengthening pound would hurt the country's nascent export rebound. But given today's strong manufacturing results the impact of higher exchange rates appears to be minimal and the BoE is now in danger of losing its credibility if it does not act soon, especially if the data continues to surprise to the upside."  In the meantime, GBP/USD is on track to test its next resistance level of 1.7332, the 50% Fibonnaci retracement of the 2007 to 2008 decline.

Dollar and the Illusion of Strength

The simultaneous rise in U.S. stocks and Treasury yields suggest that investors are becoming more comfortable with the U.S. recovery, but judging from the performance of the dollar, forex traders are not convinced that the outlook for the U.S. has brightened.  The dollar traded higher against the Japanese Yen, euro and Swiss Franc but weakened against the British pound and commodity currencies.  The latest economic reports also highlight the ongoing challenges in the U.S. economy.  According to the ISM report, manufacturing activity slowed in the month of June.  With the exception of new orders and imports, all of the subcomponents held steady or declined. Thankfully even with the miss, manufacturing activity is still expanding near this year's strongest pace.  Yet other reports were also disappointing with construction spending growing only 0.1% in May and the IBD/TIPP Economic Optimism index falling in July.  So while it may be tempting to attribute today's rally in stocks to the U.S. growth story, the moves are more likely driven more by the prospect of easy monetary policy from Fed and a stronger recovery abroad.  On Wednesday we are the Challenger Layoff and ADP reports along with factory orders.  We do not anticipate any surprises and instead expect the data to show consistent improvements in the labor market.

EUR Rally Capped by Weaker Data

Unlike other high beta currencies, the euro failed to participate in today's rally.  The currency pulled back slightly versus the U.S. dollar on the back of weaker German economic data.  In contrast to the market's expectation for a 10k decline, German unemployment rose 9k in the month of June. This was the second month in a row that German unemployment increased unexpectedly, raising concerns that the Eurozone's largest economy is not doing nearly as well as earlier reports suggest.  While the unemployment rate remained unchanged at 6.7%, business and investor confidence tumbled last month.  Manufacturing activity was also revised lower and probably would have dragged the Eurozone PMI index down further if not for the upside surprise from Spain and France.  We are finally beginning to see some improvements in the periphery but with weakness in the core, it is hard to believe that the European Central Bank will shift from its dovish bias. In fact, we continue to expect the ECB to reiterate their willingness to ease again if the economy fails to improve in the coming months. EUR/USD's failure at 1.37 leaves the pair vulnerable for a run down to 1.3650.

Risk Appetite Drives Yen Crosses Higher

Between the record high in U.S. stocks, rebound in Treasury yields and the overnight rally in the Nikkei, it is no surprise that the Japanese Yen traded lower against all of the major currencies today.  There are a number of important Japanese economic reports scheduled for release from Japan this week but at the end of the day, the market's appetite for risk has been the primary driver of Yen flows.  Last night's Tankan survey was disappointing with large manufacturers reporting a deterioration in business sentiment.  The large manufacturers index dropped from 17 to 12 in the second quarter and while these same manufacturers were more optimistic about future activity, the outlook component of the report did not rise as much as economists anticipated.  We don't think that this report changes the outlook for stronger capital spending and hiring in 2014 because capex plans were revised up and most firms expect a net shortage of labors and capacities.  The Bank of Japan would have probably liked to see a stronger report, but the latest numbers should not affect their steady monetary policy stance.