EURO - What Will Drive it Above 1.15?

Over the past 30 days, nothing has been more influential to currencies than risk appetite and equities. As the first full week of 2019 trade begins, this correlation continues to drive FX flows with the Dow up another 98 points after Friday's more than 700 point gain. The one thing that we learned from Fed Chair Powell at the start of the month is that despite strong job growth, the central bank is no rush to raise interest rates. But what is good for stocks may not be good for the U.S. dollar because a slower tightening cycle reduces the attractiveness of the greenback. With that being true, USD/JPY shrugged off softer data and extended its gains for the second day in a row. From last week's releases, we knew that manufacturing activity slowed significantly at the end of the year but service sector activity should have improved because non-farm payroll growth was very strong. Unfortunately that was not the case as the ISM non-manufacturing index dropped to a 5 month low of 57.6. This report will make the data dependent Fed even more cautious about tightening and encourage further V-shaped recoveries in high beta currencies.

The best performing currency today was the euro, which has its eye on 1.15 versus the dollar. Having consolidated in a 200-pip range for a large part of the past 2 months, the pair is prime for a breakout. Today's strength is particularly remarkable given renewed protests in France and Hungary. Not only does this unrest raise political and social concerns, it also inhibits the recovery in France and could restrain growth for the Eurozone as a whole. Euro traders were pleased to see the sharp recovery in German and Eurozone retail sales but the manufacturing sector continues to struggle with factory orders falling a steep 1% in November, against a forecast of -0.1%. Tomorrow's industrial production and Eurozone confidence numbers could hurt more than help the currency but what matters the most is risk appetite. If stocks continue to recover, EUR/USD could shrug off these reports and make a clean break above 1.15.

Meanwhile no one should find the underperformance of sterling surprising. The next 2 weeks is critical for not only Brexit negotiations but the economy and the currency. Parliament begins its debate on Prime Minister May's Brexit deal Thursday and the vote will be held next week. If she doesn't win the support that she needs, Britain will leave the EU on March 29th with no deal - a scenario that could drive sterling down 25% according to Bank of England Governor Carney. We suspect that he'll be sharing concerns about the consequences of a no deal Brexit in his online Q&A this Wednesday. There are a handful of UK economic reports scheduled for release this week, but none of it will be as important as Brexit.

All 3 of the commodity currencies traded higher today with the Canadian dollar leading the gains. In the past 4 trading days, USD/CAD has fallen from a high of 1.3665 to a low of 1.3279. Today, the combination of rising oil prices, a stronger IVEY PMI report and risk appetite took the pair to its lowest level in nearly a month. This nearly 4-cent move close to completing the reversal that we had been looking for in USD/CAD (the target in our 2019 forecast was 1.32) because come Wednesday we expect the Bank of Canada to repeat that the risks to growth have shifted from the upside to the downside so future moves will be data dependent.

Unlike Canada, Australian manufacturing activity contracted for the first time in more than 2 years in the month of December. The PMI manufacturing index dropped to 49.5 from 51.3, its lowest level since September 2016. This does not bode well for tonight's trade balance report and tomorrow's service sector activity report but none of that matter to AUD/USD, which closed above its 20-day SMA for the first time in a month. China-US trade talks are particularly important for Australia and New Zealand and judging from the rise in stocks today, investors are optimistic.