Expect US Politics, Chinese Data To Dictate FX Flow

FX: US Politics And Chinese Data To Dictate FX Flow

While U.S. equities extended their gains, Friday, the performance of the dollar was mixed, a sign that currency traders remain skeptical about the progress in Washington and its impact on the greenback. Republicans are saying that their latest proposal is gaining traction but it is still not clear whether the Democrats agree. The government shutdown is expected to extend into the new week and this means prolonged uncertainty for the U.S. economy and a longer delay in U.S. data. There has only been a handful of U.S. economic reports released this week and most of them have been disappointing including Friday’s University of Michigan consumer sentiment index, which dropped to a nine-month low. We have heard from a number of U.S. policymakers and while they all confirmed that the decision to not taper last month was a close one, they also agree that the U.S.’ fiscal troubles hurts the economy and lowers the chance of tapering in October. We believe the chance of a reduction in asset purchases this month is zero. Central bankers have made it clear that their decision will be dependent on data and the longer the releases are delayed, the greater the chance that the central bank will keep its quantitative easing program unchanged for the rest of the year. The Beige Book is scheduled for release next week and we expect the 12 Fed districts to report a slowdown in economic activity as the fiscal debt crisis crimps business and consumer spending.

In the coming week, the showdown in Washington will continue to drive currency flows. If Congress agrees on temporary funding measures, we expect the dollar to rally in relief with USD/JPY breaking above 99. However if they continue to bump heads and reject each other’s proposals, the dollar will remain under pressure as investors position for the possibility of default. If the U.S. government defaults, the immediate reaction would be a weaker dollar. However we don’t expect the losses to be more than 2 to 3% because the main buyers of Treasuries and U.S. dollars are central banks who are less sensitive short term changes in the U.S. fiscal outlook. The Treasury market is still the largest market in the world and these central banks realize that a massive exodus out of Treasuries would cause U.S. bond yields to spike, leading to spillover affects into their own markets. Technical defaults are not new, especially for emerging market nations such as Peru and during the time they fell into default, the country’s sovereign debt rating was cut 1 notch and then restored back to prior levels immediately after the payment was made. If the U.S. were to miss a coupon payment or two, we expect any U.S. rating changes to be restored once the payments are made. Also when Standard and Poor’s downgraded the U.S.’ sovereign debt rating for the first time ever in 2011, the sell-off in the dollar index was limited to 1.5% because once the initial shock faded, investors realized that there were few alternatives to U.S. Treasuries. With this in mind, the Obama Administration still has options to avoid missing a bond payment, which they will consider more seriously before allowing the government to default.

Aside from the developments in Washington, investors will also be watching China in the coming week. Q3 GDP numbers are scheduled for release along with industrial production and retail sales. Economists are looking for GDP growth to accelerate in the third quarter and if they are right, commodity currencies could enjoy further gains.

EUR: ECB Talks Of Willingness To Increase Stimulus

With no major progress on the U.S. fiscal debt crisis and a quiet euro-zone calendar, the euro continued to consolidate against the U.S. dollar. The only pieces of euro-zone data released Friday were German consumer prices, which was confirmed to have stagnated in the month of September and France’s current account balance, which improved marginally in August. These reports had very little impact on the EUR/USD as the decline in U.S. yields supported the currency. A number of ECB officials also spoke Friday and their message was mixed with some seeing improvements and other weakness. However they all indicated that the central bank is ready to ease monetary policy on the first sign of meaningful weakness. According to ECB President Draghi, the economy bottomed out in the first half of the year and is now expected to gradually strengthen in the period ahead. ECB member Praet agrees that the cyclical upswing is now quite moderate. ECB member Coeure on the other hand feels that the recovery will remain weak over the next months as Europe lags other regions and for this reason, he believes monetary conditions need to remain accommodative for an extended period of time. In the coming week, the outlook for the euro will continue to be driven by the market’s appetite for dollars but within that context it is important to remember that the ECB is dovish.

GBP Outlook Hinges On Next Week’s Data Releases

The British pound resumed its slide against the U.S. dollar and euro on the back of weaker data. Construction output dropped 0.1% in the month of August, a sign that housing market activity could be slowing. However with the sharp upward revision to the past month’s report and the faster construction output growth on an annualized basis, the data is not nearly as weak as the headline report suggests. Yet sterling has been unable to rally alongside other major currencies because the move is no longer supported by positive data surprises. Whether the recent correction turns into a top will be determined in large part by next week’s economic reports. The U.K. has a very busy calendar that includes inflation, employment and consumer spending numbers. Economists are looking for unemployment rolls to decline and spending to grow but given the drop in the BRC retail sales monitor, the data could surprise to the downside.

CAD: Unemployment Rate Drops To 4-Year Low

The continued improvement in risk appetite helped to fuel additional gains in commodity currencies. The New Zealand dollar was the best performer thanks to the central bank’s hawkish monetary policy bias but the Canadian dollar was the only currency whose rally was supported by data. Canada’s labor market continues to improve with the unemployment rate dropping to its lowest levels since 2008. At 11.9k, the absolute amount of job growth was modest but all of the jobs were full time, which is great news. In fact, 23.4k full time jobs were added in the month of September, offsetting an 11.5k decline in part time jobs. Even though August was an even stronger month for job growth with a whopping 59.2k jobs added, nearly all of that was part time. Between the improvement in the unemployment rate and full time job growth, Friday’s report should have been unambiguously positive for the CAD. Unfortunately Canada’s labor market still has problems with the participation rate declining because young people are dropping out of the workforce. Therefore the improvement in the unemployment rate is distorting and masks slow job creation. This explains the muted reaction in USD/CAD and should encourage the Bank of Canada to keep monetary policy unchanged. No economic reports were released from Australia or New Zealand but both currencies will be in play next week with the busy Chinese calendar.

JPY: BoJ Confidence In Monetary Policy

With stocks powering higher and USD/JPY extending its gains, all of the Japanese Yen crosses performed well over the last 24 hours. The strongest gains were seen in NZD/JPY and CAD/JPY. Based on the comments from Japanese central banks this week, the BoJ is comfortable with the current level of monetary policy and confident that it will be sufficient in bolstering the economy. By keeping monetary policy easy, the central bank is slowly pulling the country out of deflation in a way that is keeping confidence and growth tilting upwards. Bank of Japan Governor Kuroda is a “firm believer” that Japan will regain confidence and growth and he believes it is “premature to discuss additional BoJ measures. Some economists believe the central bank will need to increase stimulus to offset the consumption tax but Kuroda feels that they won’t need to undermine growth because wages are expected to rise next year, helping to offset the drag from the tax. Only time will tell how Japanese consumers will respond but in the meantime, as long Japanese stocks continue to perform well, we expect further gains in the Yen crosses.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.