How 4% Drop in Oil Impacts FX

• How 4% Drop in Oil Impacts FX
• AUD Shrugs Off Stronger Business Confidence
• NZD Ignores Fonterra Supply Forecast
• Dollar Trades Higher on Rate Hike Talk
• Beware of Sterling Strength
• Euro: More Greek Drama on Eve of EU Fin Min Meeting

How 4% Drop in Oil Impacts FX

The biggest story today for the forex market and the financial community as whole was the sharp decline in oil.  The recent volatility in crude is driving the market nuts and a continued focus on the commodity should only lead to more volatility.  After last year's steep decline, oil is cheap but some bank analysts like the ones from Citi believe that WTI could fall as low as $20 a barrel.  We doubt that OPEC nations would let that happen but oil is weak for fundamental reasons and the market share war is not making the outlook any brighter.  The price of oil is important to every country but for some the decline is damaging while for others it is encouraging.  The latest pullback was driven by the International Energy Agency's warning that a dramatic increase in oil stocks could drive prices lower.  While today's decline is not a very big deal because WTI crude is trading in a range, how various currencies reacted reflects how the decline in oil impacts the country's monetary policy.  More specifically, the U.S. dollar traded higher because the Fed views the decline in oil as positive for the economy.  At the same time, it should be no surprise that the loonie was hit the hardest but the sell-off in CAD was also exacerbated by dovish comments from Bank of Canada Senior Deputy Governor Wilkins. She described the sharp drop in oil prices as a setback for Canada and expressed concerns that the oil price decline increases the downside risk to inflation. This outlook suggests that the BoC could be considering more stimulus and unless the volatility in oil subsides and the price of the commodity stabilizes, easier monetary policy could be likely. There are no major Canadian economic reports scheduled for release this week so oil will determine how USD/CAD trades.  However it won't be the only currency affected by the commodity. The Australian and New Zealand dollars also traded lower today despite an improvement in Australian business confidence and Fonterra's forecast that milk supply will decline this season. 

Dollar Trades Higher on Rate Hike Talk

Talk of tighter monetary policy drove the U.S. dollar higher against all the major currencies today with the exception of the British pound.  We heard from Lacker, Fisher and Williams, 3 voting members of the FOMC this year that seem to be warming to the idea of a rate hike.  Federal Reserve President Lacker was the most vocal. He said point blank that June looks like an attractive option for a rate rise. Lacker believes that the central bank needs to look past the transitory effects of lower gas prices because the economy is growing at a more rapid pace.  Fed President Fisher did not talk specifically about when rates should rise but he did not feel that low yields are a harbinger of deflation.  John Williams, who is typically viewed as a centrist also believed that the central bank is on track for a mid-2015 rate increase.  The recent rise in U.S. rates (10 year yields settled at 2% today) and these hawkish comments support our outlook for further strength in the greenback and we believe should only be a matter of time before USD/JPY tests and breaks 120. Unlike other central banks who see the decline in oil prices as a need to increase stimulus to avoid deflation, the Fed views the drop as a temporary drag to be offset by a pickup in consumption.  Retail sales is the only piece of U.S. data this week worth watching and while lower gas prices are expected to drive down the value of sales, excluding autos and gas, consumer spending is expected to rebound in the month of January.  A positive report would make the dollar even more attractive. Foreign demand for 3 year Treasuries hit their highest level in 5 years, a sign that investors are moving into the greenback.

Beware of Sterling Strength

What is interesting about sterling is that today, it was the only currency to outperform the dollar while yesterday, it was the only currency that failed to benefit from the dollar's decline.  The British pound traded higher despite a larger than anticipated drop in industrial production. Investors were not worried about this decline because manufacturing production increased and the National Institute of Economic and Social Research upgraded their GDP estimate.  However if you take a step back, sterling is just caught in a range against the dollar because both central banks are talking about tightening.  Against other currencies such as the Canadian dollar, Japanese Yen and euro it is performing extremely well. In fact GBP/CAD and GBP/AUD are both trading within a whisker of their 5 year high. Unfortunately those gains could be sapped if the Bank of England forecasts negative inflation and suggests that they could wait to raise rates. With CPI hovering at a record low of 0.5% in December, there is talk that the central bank could issue its first ever deflation forecast. The fear that low inflation will overshadow growth prospects poses a major risk to the currency.

Euro: More Greek Drama on Eve of EU Fin Min Meeting

More Greek drama left the euro unchanged against the greenback. With less than 24 hours to go before the EU Finance Minister meeting, Germany tempered expectations for a quick deal with Finance Minister Schaeuble saying there are no plans to discuss a new accord or give Greece an extension. Greek Finance Minister Varoufakis fired back by saying "If you are not willing to even contemplate the prospect of a rupture, then you don't really negotiate." We are still optimistic that a deal will be reached but in case it doesn't the euro could slip quickly below 1.10.  Placing an order to sell on a break of the 11 year low may not be a bad idea. As mentioned in yesterday's note, how the euro trades against the U.S. dollar this week will be determined by the Greek debt negotiations.  If Greece and Europe continue to play their game of chicken waiting to see who blinks first, the threats from both sides will keep the euro under pressure but if there's any sign of progress, we expect a particularly aggressive short squeeze in the EUR/USD.