Watch For Dollar Weakness Ahead Of FOMC

Looking For Further Dollar Weakness Ahead Of FOMC

The U.S. dollar ended the day lower against all of the major currencies with the exception of the Australian dollar. The FOMC is meeting next week and we could see additional liquidation of positions in the U.S. dollar ahead of the announcement. According to the CFTC’s latest IMM report on speculative positions, traders added to their long dollar positions in the past week. They increased their long USD/JPY trades, cut their long EUR/USD trades and only closed a small part of their short AUD/USD and GBP/USD positions. While this data is of Tuesday, we doubt that positions have changed significantly since then so if there are investors worried about holding too many dollars ahead of Wednesday’s announcement, the beginning of next week would be a good time to square up.

It is becoming increasingly difficult for the Federal Reserve to justify reducing stimulus next week. A slowdown in consumer spending, decline in confidence and sluggish job growth screams of a recovery that is losing momentum. Inflationary pressures are virtually nonexistent which means that if the central bank were to consider a policy action, arguments could be made easing and tightening. However the recovery is stable enough that the Fed is not worried about a sudden contraction in growth, which is why they are looking to reduce asset purchases. At this stage, there are only two motivations for changing monetary policy next week – timing and pricing. One of the greatest fears for the central bank is that 10-year U.S. bond yields will shoot through 3% when they taper and luckily the recent disappointments in U.S. data eased the pressure on bonds so there may not be a better time than now to tweak monetary policy. December is also a tricky period to reduce stimulus because the meeting is close to the holidays and the central bank risks sending stocks sharply lower, causing a retrenchment in spending that could make the holiday shopping season particularly difficult for retailers. With this in mind, the Fed cannot justify an aggressive move so if they decide to taper it may by only $5 billion to $10 billion per month.

The odds of delaying a reduction in monetary accommodation shot up after Friday’s retail sales report. Consumer spending is the backbone of the U.S. economy and unfortunately retail sales growth slowed to 0.2% from 0.4% in the month of August. Although the July figures were revised higher, the improvement does not diminish the grim reality of slower spending. Excluding autos and gas, the numbers were even more disturbing – sales growth slowed to 0.1% from 0.6% the prior month. High unemployment, slow income growth and greater payroll taxes restrained spending last month. For policymakers who may have been on the fence, Friday’s report could push them to vote against dialing back asset purchases in September. A number of U.S. economic reports are scheduled for release next week but this was the last piece of data that could have swayed the central bank’s decision. It is no secret that the Fed sees the housing market as the engine of growth for the economy and the decline in spending on building materials and garden supplies is another reason for them to be worried.

Producer prices on the other hand grew 0.3% in August but excluding food and energy costs, prices stagnated last month. On an annualized basis, year over year PPI growth slowed from 2.1% to 1.4%. The combination of softer inflationary pressures and weaker consumer spending means that tapering next week is not a done deal. In fact we expect the dollar to continue to weaken ahead of next Wednesday’s FOMC announcement, as the increased uncertainty and risk encourages a reduction in U.S. dollar positions.

EUR: A Focus On German Elections

The euro ended the week higher against the U.S. dollar but its strength masks underlying weakness and uncertainty for the euro-zone economy. Unlike other countries around the world that have reported better to uneven data, the economic reports from the euro zone have been consistently weak. The EUR/USD managed to rally only because traders are selling dollars. The weakness of the euro can be better seen through the crosses as the currency remains weak against the GBP, AUD and NZD. In Europe, the German election will be in center focus next week. The general election is scheduled for Saturday September 22 and while Angela Merkel will most likely be re-elected, her victory is far from assured. The polls are all over the place and according to the Financial Times, “Politbarometer, the leading poll published on Friday by ZDF, the second German public television channel, puts the combined vote of Ms. Merkel’s Christian Democrats, and her liberal Free Democrat partners, at 46 percent, just one percentage point in front of the combined opposition vote.” If Merkel wins, a grand coalition will be most likely be needed. For the financial markets, a third term for Merkel would probably trigger a small relief rally in the DAX and euro. Continuity is good for the currency and a big market reaction would only occur if the opposition party wins. According to a study by JPMorgan of the last four national elections (Greece, France, Netherlands and Italy), the euro “range traded in the month leading up to the elections and declined 3 cents in the month that followed.” While this trend may be strong, they attribute the move to cyclical rather than political factors. For Europe, the most important event risk next week is the German ZEW survey. The Swiss National Bank also has a monetary policy announcement but no changes are expected.

GBP Hits 7-Month Highs vs. USD And EUR

The British pound climbed to a fresh seven-month high against the U.S. dollar and euro this week. Consistent improvements in U.K. data followed by optimistic comments from Bank of England Governor Carney paved the way for a stronger rally in sterling. Looking ahead, we expect further gains in the currency as long as the U.S. dollar doesn’t suddenly spike higher. There are a number of important economic releases expected from the U.K. next week including the BoE minutes and retail sales. Given the comments from policymakers this week and the acknowledgement of a stronger recovery, the minutes could contain a slightly more optimistic tone that would sustain the rally in the currency. Retail sales however are expected to slow significantly and that poses a significant risk for sterling because consumer spending is the backbone of the economy. We will also hear from a number of policymakers in the coming week which means that sterling could be in as much as focus as the dollar.

AUD Extends Losses, NZD Presses Higher

It was a quiet end to a busy week for commodity currencies. The Australian dollar extended its losses against the greenback while the New Zealand dollar pressed higher. The changes, Friday, were small but the divergence in price action kept pressure on the AUD/NZD cross, which appears poised for a test of its July low of 1.12. The New Zealand dollar would have enjoyed a stronger rally if not for Thursday night’s weaker-than-expected economic reports. The expansion in the manufacturing sector slowed in the month of August according to the PMI report, consumer confidence declined and food prices edged lower. Thankfully the RBNZ won’t be overly concerned by these deteriorations because PMI is backing off of a nine-year high and the mood in New Zealand remains buoyant. The drop in confidence could be attributed to the recent restrictions in low deposit loans. The outlook for New Zealand’s economy is still promising and the currency will remain in focus this coming week with PMI services, current account and Q2 GDP numbers scheduled for release. No economic data was released from Australia overnight but the A$ is still feeling the sting of weaker labor market numbers. The RBA will release the minutes from its September monetary policy meeting and a more optimistic tone could lend short-term support to the currency. However without a dramatic and consistent turnaround in data, we still expect the AUD to underperform the NZD. Meanwhile with tensions surrounding the Syrian conflict easing, the Canadian dollar traded quietly for most of the week.

JPY: Investors Hold Out Hope For Offsetting Stimulus From Japan

The Japanese Yen extended its gains against most of the major currencies after the Cabinet raised its assessment of the economy. In their monthly economic report, they described Japan’s economy as “on the way to recovery at a moderate pace” which is an upgrade from last month when they said the economy is “picking up steadily and shows some movements on the way to recovery.” While there have been disappointments in Japanese data, the upside surprises overshadow the misses. According to the Cabinet’s report, business investment “shows movements of picking up, mainly in nonmanufacturing industries.” This has made the government confident that Japan is moving towards a self-sustaining recovery. However they are not without concerns – the Cabinet also lowered its assessment of consumption and exports for the first time in five months but this did not deter them from upgrading their overall outlook because they believe that easy monetary policy will boost income, business investment and exports in the coming months. The prospect of a higher consumption tax means that if Japan wants to maintain a stable recovery, they will need to offset the drag that it will have on the economy with stimulus. There’s been a lot of talk about the steps the government will take. Overnight a report in the Nikkei newspaper about a potential corporate tax reduction was denied but it is not off the table and the same is true of another stimulus program or tax breaks.

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