‘Exceptional’ quarter for currency trade with more on the way

The first quarter was exceptional for currency trading. For some trading pairs there was significant investor activity, while others showed no change at all.

There was overreaction to some events and complete indifference to other news. Broad-based waves of market sentiment had a large effect on gold, the US dollar and Canadian dollar (USDCAD), and Australian dollar and US dollar (AUDUSD), leading to overreaction by investors and some extreme moves.

The largest one-month increase in USDCAD in two years was registered in January. This was followed by gold in February recording the largest improvement in six months. The Australian dollar benefited by an extreme move over the quarter, recording the strongest performance since 2012. In contrast, the euro-US dollar (EURUSD) changed just 1 per cent over the three months. This was the smallest first quarter change for the euro against the dollar in the 15-year history of the currency pair.

The EURUSD was dominated by a lack of any strong sentiment or speculative demand in the first quarter. At the start of the year the US Federal Reserve and the European Central Bank (ECB) had different approaches. The Fed began its tapering process and its balance sheet continued to grow further, while the ECB continued to unwind its balance sheet with no further easing, despite the risk of rising disinflation in the euro zone. The US economy was expected to improve, while the euro zone was not. As a result the consensus of economists forecast was for a much lower euro in the first quarter.

But investors’ perception of the euro zone was not as negative. Their optimism was proved correct, so while the professional investor community sold any improvements in the euro and built up large short positions, other traders bought any pullbacks in the currency, giving an overall change of just 1 per cent in the three months from the start of January.

This stagnation should not persist in the second quarter and there is potential for the EURUSD to make an extreme move. Volatility is low at 6.3 per cent, with many traders’ positions little changed in the first quarter. But new events could easily change this. More than 24 per cent of all currency trading is on the EURUSD, so interpreting whether this move will be higher or lower is extremely important.

The latest euro-zone inflation figures show a significant decline. The euro zone’s year-on-year consumer price inflation fell to 0.5 per cent last month, while February’s figure was revised down again to 0.7 per cent.

This shows that inflation is slowing at a rate faster than forecast by the ECB. The Centre for European Economic Research German sentiment index slipped for the third consecutive month, declining from 62.0 to 46.6, reaching its lowest level since the middle of last year. In the euro zone, the centre’s economic sentiment reading posted the third negative score at minus 9.1 in March.

The IMF sent a direct message to the ECB, saying that it must act soon before it was too late to fight disinflation. The IMF has urged the ECB to cut the interest rate, announce a third round of long-term refinancing operation or buy government bonds. But it still appears the ECB will ignore this.

So could we expect foreign exchange volatility in the second quarter? The answer is yes. Hopefully we will not have the same issues affecting the emerging market currencies, but it would be sensible to look at the Australian dollar.

After extreme trading in the first quarter, the AUDUSD rose by 2.5 per cent. A change in investor sentiment could easily be prompted by new fundamental news or the absence of it. Gold will also be highly sensitive to speculation and is likely to have a further extreme move in the next three months, most likely higher again. In the history of the EURUSD, periods of consolidation have never lasted any longer than one quarter.

In the second quarter there is great potential for a strong new direction, which at this stage most analysts believe could be lower. If, as the IMF wants, there is a move to negative interest rates by the ECB or another round of LTRO this could be the catalyst for a new wave of bearish sentiment, ending the stagnation and leading to an extreme move lower in the second quarter.

Max Knudsen is the chief market strategist at ADS Securities

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