By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Dollar bulls ignored the Federal Reserve’s warning about the uncertainty of fiscal policy and the impact that a strong dollar would have on inflation. Wednesday’s FOMC minutes were not as hawkish as we had hoped but investors were unfazed as they sent the dollar and U.S. yields higher after an initial dip. The rally fizzled a bit by the end of the North American session but dollar bulls remain in control -- for the time being. According to the minutes, the Fed’s optimism is based solely on Trump’s ability to follow through on his campaign promises for major tax cuts and big spending as “about half of Fed officials included fiscal policy in their forecast.” In other words, the Fed is betting on the Donald Trump to deliver, which is a risky gamble. Some policymakers recognize the risk, which is why they officially endorse a “gradual rate-hike pace” as the upside risk is debated. Most still feel that the Fed may need to raise rates faster because the labor market should overshoot as business and consumer spending improves. But the strong dollar is dampening inflation and the weakness abroad presents downside risks. The only reasonable explanation for the dollar’s resilience is the market’s focus on policy divergence. The Fed is the only major central bank raising interest rates and nothing in the latest FOMC minutes suggests otherwise outside of the fact that they are hinging their positive outlook on a new president who may or may not be able to reshape the world in the way he promises.
At this stage, we're leery of buying dollars, as the proof is in the pudding and we need to see consistently strong U.S. data to believe the Fed will press forward with raising rates in the first 6 months of the new year. The focus now turns to Friday’s nonfarm payrolls report. According to the Fed Fund futures, the market does not expect the central bank to hike again until the second half of 2017. In fact, investors are not fully convinced that there will be 3 hikes this year at all. For this reason and because of the dollar’s overextended rally, Friday’s jobs report is particularly important. On Thursday, some of our favorite leading indicators for NFP will be released -- they includes the ISM non-manufacturing report, jobless claims, ADP and Challenger. Even if the numbers are strong -- and they should be -- the problem is not job growth but wage growth. Average hourly earnings turned negative in November and while a rebound is expected in December, the forecasts are high. Economists are also looking for a higher unemployment rate, which could overshadow any uptick in payroll growth. Now is not the time to be buying dollars because weakness in Friday’s jobs growth could lead to more significant profit taking in the greenback.
Euro took aim at 1.0500 Wednesday and while it ended the North American session below this level, short-term charts suggest that we could see a squeeze as high as 1.0550. The Eurozone’s PMI reports were revised higher, thanks to stronger service-sector activity in Germany and France. The composite index rose to 54.2 from an initially reported 52.8 -- the strongest reading in 9 months. Consumer prices also rose slightly more than anticipated, which is not entirely a surprise after the hot German CPI report. Between the euro and sterling, the euro should have greater upside because of the significant degree of short positions.
Sterling also traded higher as U.K. data continued to surprise to the upside. The Construction PMI index rose to 54.2, beating the forecasts of 52.6. November's Consumer credit also saw an uptick to 1.9b, beating the 1.6b expected. Although construction activity increased in December, lending for dwellings took a small dip to 3.2b versus 3.3b expected. Mortgages approvals also took a small decline to 67.5 vs. 68.7k expected. Gains in the housing market have been hampered by concerns about potential restrictions on immigration in the coming year, not to mention worries about the economic impact of Brexit. The PMI composite and services-sector reports are scheduled for release on Thursday -- these numbers are generally far more important and potentially market moving than the manufacturing- and construction-sector releases.
All 3 of Wednesday's commodity dollars performed well against the US Dollar with AUD and CAD leading the gains. The biggest winner was the Canadian dollar -- rising almost 1% for the day taking USD/CAD below 1.33. The Loonie's increase was driven by the rise in oil prices and the USD's decline. The sharp rebound in prices was due to renewed confidence that oil producers would stick to their pledge for oil cuts. That confidence came after state-owned Kuwait Petroleum Corp. said it is committed to curbing output and has notified clients that output cuts would be in effect starting January. Meanwhile, the Australian and New Zealand dollars moved higher as gold prices ticked up. Australia’s PMI services report was scheduled for release Wednesday evening.